Financial statements Featured

12:35pm EDT March 28, 2006
If you review your financial statement, does your revenue look okay but have a bottom line that does not hold up to your expectations? When faced with this problem, many businesses immediately try to increase sales. That sounds great, but in reality “selling your way out” only creates short-term cash flow and can mask the real problems within the business.

Mike Rudd, director of client services for International Profit Associates (IPA), spoke with Smart Business about how to control business costs.

Why do business owners look to increase sales when the company is under-performing?

The vast majority of business owners are from the entrepreneur mindset. They built their businesses with vision, hard work and an innate ability to sell themselves, their ideas and the product or services of the business. Increased sales create a positive cash flow that allows the business to survive and, in some cases, actually produce a profit.

What are some issues that cause a company to have eroding profitability in spite of increasing sales?

When a company is in start-up mode, it is generally under-capitalized. Every dollar is treated like a precious commodity. The entrepreneur knows where every penny goes. In that environment, $100 can literally be the difference between success and failure.

As the business grows, the demands on ownership’s time is geometrically increased, and the ability to micro-manage the operations is supplanted by reliance on ‘gut’ feeling. Questionable feedback from employees provides a false sense of security. ‘Throwing money’ at problems becomes the norm instead of controlling the critical variables that drive the company’s profitability and operations.

As companies mature, ownership relies on key employees to maintain operations at a profitable level. However, systems and controls consist of ‘tribal knowledge’ and the perception that ‘working hard’ will produce profit. There is nothing in place to actually measure performance, and rewards are based on the ‘benevolent bonus’ system. Invariably, this leads to a feeling of entitlement and increased costs across the board.

Which is easer, reducing cost or increasing sales?

Sales figures can be somewhat deceiving. High sales dollars mean nothing if the sales volume does not allow for the company costs to be recovered and profit required to fund growth. Choosing whether to increase sales or reduce costs as a strategy requires some basic understanding of how costs and revenue impact the financial statement.

When looking at the impact of cost reduction on general and administrative overhead, each dollar of cost reduction goes directly to the bottom line as profit. For every dollar of revenue, only a small fraction goes toward the bottom line due to fact that variable cost must be covered.

What are the best methodologies to control business costs?

First, identify the critical variables in the business. Every business has specific key indicators that give management the ability to monitor the company’s pulse and activities. This includes what you need to know and when you need to know it.

Second, develop a chart that reflects actual operations. Typically, a chart of accounts is developed by an accountant. Although this is adequate for tax purposes, the information is generally limited to revenue and expenses with little or no regard for actual operations. Revenue categories should reflect the actual income streams of the company. Direct variable expense should include all of the expenses involved in the production of the product or service, such as labor, material, sales commissions, royalties, equipment rental or any other cost that fluctuates with revenue. Indirect overhead consists of costs that may be semi-fixed and semi-variable but must be allocated to all of the production components, such as estimating wages, sales wages, fuel and oil, training expense, small tools and supplies. General and administrative overhead are expenses that occur regardless of revenue, like rent, utilities, depreciation, owner’s wages, utilities and interest expense.

Third, measure the percentages, not the dollars. Variable discrepancies can only be measured by comparing percentages. For example, labor during a particular month might be $25,000, and 23 percent of that is revenue. The next month, the labor expenditure may be $19,000, but the percentage of revenue is 24.5. In this case, the company actually does worse the second month but spends fewer actual dollars.

Percentages are the only way to identify and track the company’s critical variables. By comparing the variation between the critical variables, you can effectively control costs and manage for profit.

Fourth, implement excess-based profit incentives. If you do not provide incentives, employees will create their own by stealing time and materials. Keep them simple.

Incentives must be tied to factors the employees have control over such as labor, overtime, waste, small tools and supplies. The incentives should have positive and negative components to force employees to focus on cost. As well, the incentive plan must reward the employee group as a whole. Performance will improve as each employee’s performance affects the group as a whole.

MIKE RUDD is director of client services for International Profit Associates of Buffalo Grove, Ill. IPA’s 1800 employees offer consulting services to businesses throughout the United States, including Alaska and Hawaii, as well as Canada. Reach Rudd at (800) 531-7100 or mike.rudd@ipa-iba.com. or at www.ipa-iba.com.