Getting profitable by careful cost management

Management performance evaluations and incentive compensation are key

JUDGING BY RECENT ECOnomic statistics, we may be in the midst of an economic turnaround. Capital expenditures are rising, as are economic growth and corporate incomes. Many U.S. industries were deeply shaken by downturns and new foreign competition. Whether or not the apparent improvement reaches full fruition, companies need to position themselves for a new era. Today, international influences are more pronounced than ever before.

To remain competitive in these times, managing costs is paramount. Clear lines of responsibility must be established within the company. Profitability must be a recognized objective, which should ideally be tied to management performance evaluations and incentive compensation.

Improve turnover

Assets, such as inventory and accounts receivable, represent investments of cash. Until the assets are realized, the cash they represent becomes unavailable for other uses. Excess investment in assets is a luxury that few companies can afford today. Turnover measures how quickly these items become cash. It is most simply determined by dividing annual sales by each asset category, although there are other ways. The quicker that assets turn, the better.

If payment terms are net 30, accounts receivable should in theory annually turn twelve times. The collections effort must be ongoing. Companies that do poorly at collection lack good processes. Success takes discipline. Procedures must be documented and applied. Calls and letters after certain time intervals should be automatic. Credit holds should prevent customers from growing balances that are too large. Without these efforts, accounts receivable can quickly blossom out of hand, particularly in tough times.

As inventory represents invested dollars, it should be monitored as closely as a bank controls its cash drawers. Its costs are not only the time value of funds invested, but also the carrying costs of warehousing, storage, insurance, property taxes, personnel, and equipment. Typically, these costs amount to 25 cents per year for every dollar value carried in inventory. If a line of credit is used in financing, the interest expense adds to this cost.

Some successful companies take extreme measures to control this investment. They include reflecting the cost directly in sales incentives. One adds carrying costs to inventory value each month to reflect the reduced margin on the product as it is sold. This, in turn, impacts the sales commission earned. Similarly, another company charges back aged inventory to the responsible salesperson.

Finally, any available idle or little used equipment should be converted to cash. There is little reason to keep the cash tied up.

Convert fixed expenses

A central concept in managing costs is distinguishing those that are variable from those that are fixed. Variable costs change with the level of sales, whereas fixed costs do not. Fixed costs are, in effect, determined by infrastructure decisions. They are usually budgeted as constant monthly amounts.

One problem with the analysis is that many companies view "fixed" costs as predetermined and make little attempt to manage them each day. Nothing could be further from reality. In fact, variable costs need less attention than "fixed" costs do because, by definition, they adjust automatically as a direct reflection of sales.

A significant way of improving a company's flexibility as well as reducing costs when things get tough is to convert costs that are "fixed" to "variable." Say revenues are $1 million per month and expenses are $500,000. Given a choice in uncertain times, a company would do better to make the costs variable. If volume dropped to $500,000, for example, variable expenses would become $250,000, leaving the other $250,000 as profit. If the expenses were fixed, on the other hand, profits are zero.

Labor and facilities are the largest fixed costs day-to-day. To make labor costs variable, for example, temporaries might supplement a labor force. Some companies rely upon them for operations in which required skills are low. Similarly, a need for more space might be satisfied through a public warehouse. Conversely, excess space might be subleased. These efforts combine to build a stronger operation.

Use buying power

Using leverage with vendors is nothing new. But over periods of years, many companies become complacent with existing arrangements. There is a reluctance to question how things have always been done.

One company, for example, dealt with many different trucking companies for product deliveries. It would arrange carriers daily, trying to optimize costs of each delivery. The practice, though, wound up costing, rather than saving, money. Ultimately, the company found that by consolidating its demand with two major vendors, it was able to negotiate much more favorable pricing.

Even many multi-location companies do not adequately coordinate and negotiate better purchasing terms with vendors. Here, opportunities are particularly attractive. Buying leverage can become powerful, resulting in exponential savings. Multiple location blanket orders can decrease prices by double-digit percentages.