Managing costs is a simple textbook strategy to increase cash flow. It is so simple, even a child running a lemonade stand understands it – cutting costs means more money left in your pocket. And though it is quite simple, many companies overlook this as the quickest way to generate cash. But let’s face it, the task of digging through ledgers to find costs to cut is quite often much less pressing than the ongoing day-to-day operations. That is, until lack of cash becomes an emergency.
And it can be daunting to decide where to start. There are a lot of expense categories on your Profit & Loss statement. What you will learn here are suggested strategies to prioritize which expenses first need your attention – not only now, but as a day-to-day part of running your business.
In most cases, you will want to focus on direct cost reduction because it often has more of an impact on cash flow. These are the expenditures in your business that are directly associated with sales. Or another way to put it these are the things you pay for, then mark up and resell to your customers. Your Cost of Goods Sold (COGS). As the company grows, and sales increase, lower COGS means keeping more of that money in the bank. This not only helps generate cash flow now, but for every sale into the future!
Imagine for example, you profited forty cents for every item you sold. What would the impact be on your cash flow as you improved sales? It would always be forty cents on the dollar. But if you could improve your margin to say fifty cents on the dollar, you will keep all this newfound cash, not only now but into the future as your sales grow with your business.
Not all these seven cost-cutting strategies may apply to you. Select those that you think will probably have an impact on your company. Even though they are numbered one to seven, there isn’t a priority implied. However, be sure to review number seven about margin pricing. Once you have a good understanding of your direct costs, margin pricing will help you calculate the prices you should be charging your customers.
- Audit Your Suppliers and Vendors
- Negotiate Pricing with Your Primary Vendors
- Minimize Returns and Concessions
- Reduce Scrap and Waste
- Manage Inventory Levels and Turnover
- Manage Direct Labor Expenses
- Understand Margin Pricing
1. Audit Your Suppliers and Vendors
Review the products and services that you purchase that directly impact sales. Your suppliers are doing what they can to control costs, and costs are always trending up. To combat this, they must raise their prices too, which means a higher cost to you. Take some time to review your options. Is there another company that can deliver the quality you need for a lower price? Your suppliers have competitors who want your business. Do some shopping around. Are there alternative sources you could use that cost less?
Bear in mind, there are other costs that may be lurking with a new supplier that are not immediately apparent. Even though they offer a savings, there may be a reason they are cheaper; poor quality of materials or construction, problems with delivery, billing issues that take time to resolve. Do your due diligence on a new vendor prior to switching.
2. Negotiate Pricing with Your Primary Vendors
Another option with your suppliers is to negotiate terms for discounts, or to lock in prices for the future. More than likely, they want your business. They want to work with you rather than incur cost and effort to get a new customer.
First, obtain competitor quotes – these companies want new customers and may have offers and incentives to get your business. Then negotiate price agreements with your primary suppliers. If you have a great relationship with a vendor who is vital to your business, see what you can do to negotiate terms and conditions that will be a win-win for the relationship. If you can, periodically review prices with them each year and lock in prices where you can.
One word of caution here – before deciding to use another vendor, consider the quality and timeliness you get from your current supplier. If their products and services are critical to your production, and they have excelled in their ability to deliver what is needed and on time, their price increase may be warranted.
3. Minimize Sales Returns and Rework
There are times customers are dissatisfied, and they will want to return a product or want some kind of concession to feel they have received value. Keep a sharp eye on your return rate. Investigate any increases in returns for the reasons why customers are dissatisfied. Is it because of defective parts or does it appear to be an employee problem such as a lack of motivation, a lack of training, or perhaps the individuals responsible simply lack the necessary skills to do the job properly the first time.
To keep your eye on this important performance indicator, have a separate line on the Profit & Loss Statement for Sales Returns, Re-Work, Refunds, or any other name that fits the category of a customer returning something that was previously sold to them. Do not hide it by simply subtracting it from current sales.
4. Reduce Scrap and Waste
Scrap has the same cost impact as returns. It increases your material, labor, and opportunity costs. The way you deal with this is similar to returns. Begin by investigating the reasons for the failure: was the scrap produced due to defective tools or processes? Did defective parts play a role or is it a lack of training or skill on the part of the employee?
If you find the problem to be defective tools or parts, seek immediate compensation from the supplier. If this situation continues, investigate alternate suppliers. If it turns out to be an employee problem, it may only require additional on-the-job training. But don’t stop there. Determine if the scrap produced can be recycled or reworked.
Remember, the scrap being thrown in the dumpster represents cash flowing out of your business. But also bear in mind that there is a return. I recall my father, owner of his own construction company, telling me about union carpenters… they don’t pick up dropped nails. The time it takes to find the nail and pick it up compromises their rhythm and productivity. It justifies leaving it on the floor and letting someone else sweep it up and throw it away. Always seek out your employees’ feedback and suggestions regarding ways they might suggest eliminating scrap. They’re on the front-line day in and day out. You can bet they have specific and innovative ways your scrap could be dealt with.
5. Manage Inventory Levels and Turnover
Inventory is a fickle concept. You want to have the product on hand when you need it such that it does not impede with efficiency. Yet the cost to have the product sitting idle on the shelf implies two costs; the cost of the product sitting there, and the profit lost from storing products that readily sell and/or produce a better margin. The cost of the storage space to hold your inventory needs to pay for itself.
Consider implementing the following:
- Install an electronic inventory system
- Identify which products have the fastest turnover
- Compute the margins of each product, the sales price less the cost
- Develop Standard Operating Procedures (SOPs) on warehouse logistics. Who is doing what? What is going where?
- Implement warehouse safety protocol for efficiency and to protect employees
- Consider Just-In-Time (JIT) production systems
One word of advice before you discard an item that is rarely used, assess how important it would be to have it available when needed. And how difficult it is to get it when needed. Are there any issues with finding a supplier of the part? Are there shipping issues? Or price increases? How often is it needed? These are questions to ask yourself and those in the company who fill orders from the stockroom. If it is not critical in today’s operations, and easily replaced when needed, let it go.
6. Manage Direct Labor Expenses
Direct Labor are the payroll expenses directly attributable to the production of goods or services being sold. Examples are manufacturing and assembly costs, filling orders, and contractors used to perform work. It is also the sales commissions that are paid as a percentage of sales. Simply put, it is the labor costs that directly contribute to the delivery of the product or service being sold to the customer.
Direct Labor expense comprises two parts:
- Amount paid to the employee – what they get
- Efficiency or productivity – what you get
In a competitive labor market, you will naturally want to make sure you are paying a fair wage. Employees are also looking for fringe benefits, and these perks can attract and retain the ideal workforce you are looking for. Take some time to evaluate the insurance, time off policies, workplace amenities, and other benefits you provide your employees.
The other side of direct labor expense is what the labor force produces for the company. Your responsibility is to provide a safe, clean environment for them to work efficiently. Operating procedures and employee responsibilities need to be documented and reviewed on a regular basis. Consider employee incentives that are just and promote better productivity.
The bottom line is to develop a culture that attracts ideal employees who want to work and want to stay. This comes from an environment where they are given a competitive wage, good benefits, a safe and productive workspace, and rewarding them in such a way that they feel they belong to a team.
7. Understand Margin Pricing
Although margin pricing doesn’t have a direct impact on COGS, it uses COGS to ensure you’re charging your customers the correct price to attain your desired margin, so make sure you’re using “margin pricing” properly.
For example, let’s say you want to have a 50% Gross margin on Sales. This means that for every dollar sold, half of it remains in the company to cover overhead expenses. You have a product you are about to sell that costs you $100 from your supplier. How much should you charge your customer to generate a 50% gross profit?
The common answer is to charge $150, thinking that a $50 profit on $100 is obvious. But let’s look at the math. The sales price is $150. The profit is $50. 50 divided by 150 equals 33.33%! To generate a 50% margin, the sales price needs to be $200.
The formula for computing the desired markup factor is as follows:
100
(100 – Gross Profit %)
The result is the amount you need to apply to costs to derive the sales price.
This Margin Pricing Strategy can be used further to help set forecast goals for Sales. Add the General & Administrative Costs plus the desired amount of Net Profit. This is the forecast amount of Gross Profit that needs to be generated. By then applying Margin Pricing, you can compute your Sales forecast goals.
Summary
Any one of these seven strategies can produce significant results. There is a lot of work that goes into generating sales for the company. The key here is to manage the Direct Costs of those sales, thereby keeping more of the incoming cash flow in your pocket. Remember, if you have a 30% Gross Margin, you only keep 3 out of every 10 dollars of each sale. Improving your margin to 40, 50, or 60% means keeping more of this hard-earned sales revenue in your pocket. As mentioned at the outset of this article, this concept is so simple to understand that even a child running a lemonade stand gets it. Maximize the amount left over of each sale you make. But it does take some work. Set aside time each month to review these expenses to ensure your margin, the difference between what is sold and how much it costs, adequately covers your overhead and profit.
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