The Total Cost Picture
In my previous article What Drives Your Pricing? I wrote about the importance of understanding the total cost picture in order to develop and implement a strategic cost and pricing model. Here I want to elaborate on that and discuss the various categories of costs, how they influence the bottom line and how they can be managed and controlled over a long period of time.
Take the example of Company ABC Inc., which sells 100.000 units every year at $40 apiece. Here is how their Income Statement might look like:
As you can see from the table above, there are mainly three broad categories of costs (or expenses) that a company incurs: 1) Cost of Goods Sold, 2) Operating Expenses and 3) Interest, Assessment and Taxes. The last category is somewhat outside the direct control of the company, so we will leave that aside for now. The first two categories, however, are worth discussing, because they are the ones that can be managed and controlled to reduce the overall expenses and increase the net profit of a company.
1. Cost of Goods Sold (COGS):
These are direct costs associated with manufacturing the products being sold, such as materials, direct labor and shipping costs. They may also include items like excise taxes on certain products. These costs are directly associated with the number of units produced and change as production volume goes up or down. On the surface it would seem like nothing much can be done about reducing these costs. On the contrary, companies should constantly evaluate them and come up with cost reduction ideas. Here are some examples of how these costs can be reduced:
- Consider bulk purchase of raw materials that translate to a better price per unit
- Enter into long term contracts with suppliers to get “preferred” prices
- Outsource manufacturing of component parts to reduce direct labor costs
- Consider contracting the assembly of component parts, packaging and shipping of the finished product
2. Operating Expenses: Fixed Manufacturing Expenses:
These are costs that do not fluctuate with volume, such as rent, utilities, maintenance costs, insurance, lease expenses, depreciation, fixed labor salaries and so on. This is a balancing act because these costs are “fixed”, but sales can fluctuate quite a bit, making it very difficult to plan for periods of high growth as well as downturns. Idle equipment or other infrastructure costs incurred during slow periods can quickly eat into a company’s bottom line. Here are a few ways to minimize the impact of fixed expenses:
- Plan ahead when building or leasing a facility to make the best use of manufacturing footprint. Smaller space will result in lower utility costs, rent, property taxes (if you own the facility) and so on.
- Explore opportunities to utilize idle equipment by contract manufacturing for other companies.
- Hire temporary workers (indirect labor such as administration) if your business is cyclical and somewhat predictable.
They do not occur on a periodic basis, such as costs incurred for capital expenses or major retrofits. The time to plan for these expenses is not when a major equipment breaks down due to age or lack of proper maintenance. Sales, General and Administrative Expenses or SG&A: These costs include:
- Sales and Marketing Expenses: These expenses do not directly benefit the customer in terms of incentives or promotions. They are expenses for advertising, field sales force personnel, and so on. Today, there are numerous channels for “getting the word out” to customers, some of them free. Any business not taking full advantage of the social media is destined to fall behind. Social media is also a powerful tool to create “communities of users” and “brand advocates”. An ineffective and expensive advertising campaign can siphon off valuable time and resources from the company. Every business is different; find out where you will get the most for your money.
- General and Administrative Expenses: These are expenses associated with “running a business” and can include administrative salaries, legal and financial services, IT infrastructure and human resources. This is where a huge opportunity exists, particularly for small businesses, to reduce costs. Functions that are not part of a company’s core business should be considered for outsourcing. For small and medium size businesses, outsourcing legal, financial or human resources services, for example, can actually be cheaper and more efficient than hiring permanent employees.
When you have a good grasp of your total expenses you can then see where there are opportunities to reduce your costs and make a higher profit, assuming your revenue remains the same. With reduced expenses, you could possibly reduce your price and sell more units realizing a higher margin. The important thing is to pay attention to the details and formulate a long-term strategy. Happy cost cutting!