During a difficult economic environment or in markets with significant price pressure, sales growth is often elusive and seldom a near-term solution for increasing the profitability of a business. Cost reduction, on the other hand, can have an immediate positive effect.
When companies do a “deep dive” analysis of their cost structure, they can almost always find ways to cut costs without sacrificing quality or customer service, and that “win-win” drops right to the bottom line.
In our experience, a 30-day review of costs will yield extensive insight that can translate directly into cost reduction. We recommend a “quick and dirty analysis” led by a strong cross-functional team. We suggest two specific techniques for conducting this kind of analysis:
Ratio analysis
This is a tool used to conduct a quantitative assessment of a company’s financial statements. Ratios are evaluated by comparing each major cost category to prior years. This internal analysis can then be compared to a peer group of companies.
Ratio analysis of financial statements encourages decision-makers to look at the trend of costs versus activity levels (sales) over time. It enables you to spot trends in the business and compare current performance with the best ratios of prior years.
To get a complete picture, the ratios should be measured against peers’ ratios, as well as comparing the business’ performance over several years. We suggest paying special attention to when and how any unfavorable trends may have developed.
When looking internally, the business should evaluate at least five years (ideally, up to 10 years) of historical numbers in fundamental areas such as sales, materials and labor costs, overhead, gross profit, selling, general and administrative costs.
A macro analysis requires the team to identify the best ratio in each category. For example, if the third year has the best ratio in a category, then that ratio provides a snapshot of the “ideal” situation. Once the other best historical ratios in each category are identified, the business will then have a complete picture of what’s possible.
We recommend conducting a macro analysis not only internally but also against a peer group. The macro analysis should be done with the major cost categories on your company’s profit and loss statement.
As a next step, a micro analysis allows the business to drill down into the specific cost elements in each major category. For example, if the macro analysis category was general administrative, that area could be segmented into salary, wages, fringe benefits, supplies, travel and entertainment. These segments would then get a similar ratio analysis conducted upon them.
While this type of analysis is often laborious, it can provide very clear indicators of what can be done to “claw back” unnecessary costs.
The purpose of micro and macro ratio analysis is to take the best ratios of each cost category and build a target profit and loss statement utilizing those best ratios. You then try to get your current P&L statement to replicate those best ratios. The benefit of cost reduction is that it requires little capital cost and no working capital or debt.
Constant dollar sales per employee
This technique measures the average revenue generated by each employee of the company, and is calculated by dividing a firm’s revenue by the total number of employees.
Revenue per employee is a rough measure of how productive a particular company is utilizing its employees. In general, relatively high revenue per employee is a positive sign that suggests the company is finding ways to leverage more sales out of each of its employees.
The reason for measuring constant dollar sales is that the CDS calculation removes inflation. Labor needs vary from industry to industry and labor-intensive companies will typically have lower revenue per employee ratios than companies that require less labor.
Hence, a comparison of revenue per employee is generally most meaningful among companies within the same industry. Ultimately, increasing your constant dollar sales per employee will lead to expanding margins and improved profitability.
Matthew P. Figgie is chairman of Clark-Reliance, a global, multi-divisional manufacturing company with sales in more than 80 countries, serving the power generation petroleum, refining and chemical processing industries. He is also chairman of Figgie Capital and the Figgie Foundation, a member of the University Hospitals Board of Directors, corporate co-chairman for the 2013 Five Star Sensation, and chairman of the National Kidney Walk.
Rick Solon is president and CEO of Clark-Reliance and has more than 35 years of experience in manufacturing and operating companies. He is also the chairman of the National Kidney Foundation Golf Outing.
