A Dollar is a Dollar

A dollar spent in your business is a dollar gone.

It doesn’t matter on what this dollar was used to buy, it is gone.

The only hope is that this dollar returns more than a dollar of revenue to offset this expense.

Getting the most value from your spend is the goal of Cost Management.

Cost cutting is not Cost Management

Today, our topic is why companies put more emphasis on managing the spend on the portion of the income statement above the Gross Profit line than they do on those expenses that fall below the Gross Profit line.

This is the line of demarcation in most companies.

It is the source of “us” vs. “them.”

Operations feels they are the heart and soul of the company. “Without us, there would be nothing to sell.”

Sales counters with, “without us, there is not a market for what you produce.”

"Operations is nothing but a cost center."

"Sales and their support departments are the revenue producers."

The items included in product cost such as materials, factory labor and plant overhead are amortized into your products and placed into inventory to be relieved upon their later sale. Those costs will then be transferred to Cost of Goods Sold.

Within these three cost buckets, there is an assumption of both variable and fixed costs, but by the act of allocating them to a product level, they all essentially act as variable costs from this point forward.

They are then perceived to be “controllable.” The organization typically believes that sales variation should lead to an equal variation in cost.

Below the Gross Profit line are corporate costs such as Sales, General and Administrative (SG@A), Warehousing and Distribution which all are known as Period Costs. For the most part, these are viewed as Fixed Costs with the exception of Freight costs.

Within the SG@A is also Depreciation costs to account for asset purchase expense allocated over the life of that asset.

The EBITDA line is the key that most companies reference for overall business performance, company valuation and a marker for cash flow performance.

Here Interest, Taxes and Depreciation are removed.

Simplified the formula is Revenue - Spend = Profit.

We are going to focus on spend.

There is a lot of belief out there with CFO’s and their finance teams in partnership with the Sales team that Product Cost is a component of Price. Therefore, anything that impacts product cost drives the same impact on sales price. In fact, an increase in a component of product cost of a dollar actually means that the sales price must increase by $1.30 in reaction to that cost (with an expected margin of 30%.)

There is no direct correlation in product cost and price. The price for your product is decided by what the market will bear for your offering. Your willingness to offer at a certain price should not be based on expected Gross Margin, but on expected EBITDA as your outcome.

Go to this link to better understand the relationship between product cost and price.

Product Cost is not a part of Price

What am I getting at? The majority of manufacturing companies will view all costs in the product cost realm as needing to be cut and very closely controlled. They will negotiate, buy in volume, micromanage labor, cut preventive maintenance and make other short term decisions because of the alleged link of product cost to price.

At the same time, decisions made in the departments that hit SG@A will be managed in a much different manner. Justification for spending there may not have the same scrutiny.

It is usually assumed that the money spent there is more value added and likely to fund itself. This spend is an "investment" not a cost.

Finance will hire extra accountants and task them with “controlling costs in the factory.” Sales and marketing will justify head count under the idea that it will fund itself with associated increases in revenue.

This is where the battle lies.

The silos within the organization grow taller with root cause being this built-in conflict.

Austerity measures implemented in the factories to mitigate rising material costs can easily be lost by offset spending below the gross margin line.

Here are some real life examples:

1. While negotiating a new labor contract with a union where every dollar was important and the company stance was firm.

No more.

Take it or leave it.

Holding the plant labor costs was key to future product cost and therefore holding pricing in a competitive market. The gap was about $15,000 between what the union was seeking and where the company stood. The union acquiesced and there was celebration. Lots of effort and angst over a relatively small amount of money. The day after wrapping up the negotiation a companywide email is distributed announcing the hiring of an unbudgeted, additional marketing person to reduce their workload. The position, fully funded most likely equated to 5 times the amount fought for in the negotiation. If the company couldn’t afford the $15,000 they couldn’t afford $75,000.

2. A company who was struggling with cash flow following some difficult times began to cut back on costs. The focus was keeping factory costs low. Some factory employee services were cut and some seemingly low priority repairs were canceled.

In order for the management team to focus on further cost savings and business strategies, it was decided that the team should go off-site to a resort, out of state to get on the same page.

Reduced spending above the gross profit line that had been hard earned and painful had been easily eroded by the increase in spending below the gross profit line.

These types of decision making are examples of the idea that money spent on product cost are more impactful than money spent at corporate.

Applauding the increase in Gross Profit while at the same time increasing SG@A costs that more than offset the gross margin dollars is not improving the bottom line.

This sounds like a simple concept but most companies don’t believe that the same dollar spent on product cost is of equal value to those spent on sales or corporate expenses.

The math doesn’t lie.

A dollar is a dollar.

DO BUSINESS BETTER!

? Do Business Better. All Rights Reserved