With competition fiercer than ever before, businesses can no longer remain complacent and expect that eroding profitability be simply reversed with a strategy of increases in sales prices, sales volumes, or both. Implementation of cost reduction strategies can allow the business to operate financially leaner, more efficient and consequently more profitably.
With sustainable cost savings effectively falling directly to the bottom line, the long term financial benefits to the business can be significant without increasing sales revenue. However if sales strategies where employed to increase profit, what increase in sales revenue would be required to generate the equivalent cost reduction profitability? The result may surprise you.
As an example, Company XYZ has sales revenue of $10m and generates $1m of operating profit, or earnings before interest and tax (EBIT). Using the ratio of $ EBIT / $ Sales Revenue, Company XYZ currently has an operating profit 10% EBIT. If Company XYZ was to successfully implement a cost reduction strategy to reduce costs by $0.5m, the new operating profits would be $1.5m or 15% EBIT.
What sales revenue would be required to achieve the same profit increase? Based on current operating profit of 10%, if Company XYZ endeavoured to increase profits by $0.5m with a strategy of increasing sales revenue instead of by cost reduction, they would need to increase their sales revenue by $5m (this is calculated by $0.5 / 10% = $5m). Therefore total sales revenue would now need to be $15m, or increase by 50%, to achieve the same increase in profit. Operating profit % still remains at 10% EBIT.
It could be argued that there would be some costs that would remain fixed and would not increase with an increase in sales revenue. Assuming that any incremental sales would generate a 15% margin (rather than the current business average of 10%), sales revenue would need to increase by $3.333m to increase profit by $0.5m. Total sales revenue would then be $13.333m, or need to increase by 33.3%. This is still a significant growth requirement. While operating profit % would improve to 11.3% EBIT, it is lower than 15% EBIT achieved by a cost reduction strategy.
As this simplified example demonstrates, the results from cost reduction strategies can be significant in terms of profitability. Furthermore the effort to effectively implement a cost reduction strategy can be less than the effort from sales strategy to achieve a corresponding profit improvement result.
And where the company is market leader in a mature or declining market, there may be a ceiling on revenue growth potential.
A review of a company’s cost structure, resource levels, processes and vendor reviews may identify opportunities for cost reductions. Be careful to ensure that those cost reductions are sustainable, don’t creep back as other expenses, and don’t negatively impact the customer experience.
“There are more ways to increase profits other than increasing sales”
Have you been able to achieve significant increases in profit by cost reduction strategies?
Scott Pickering - is an operational consultant with Scopic Group Pty Ltd, with substantial experience assisting organisations to review capabilities and systems, re-engineer processes and implement cost reduction strategies. Need support and advice - contact Scott 1300 723 761.
The information contained in this publication is intended as general commentary and should not be regarded or relied upon as financial or legal advice.
Are Workplace Demotivators Severely Impacting Employee Morale?