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Increasing profits through cost reduction must be based on the concept of an organized, planned program. Unless adequate records are maintained through a proper accounting system, there can be no basis for ascertaining and analyzing costs.

Cost reduction is not simply attempting to slash any and all expenses unmethodically. The owner-manager must understand the nature of expenses and how expenses inter-relate with sales, inventories, cost of goods sold, gross profits, and net profits.

Cost reduction does not mean only the reduction of specific expenses. You can achieve greater profits through more efficient use of the expense dollar. Some of the ways you do this are by increasing the average sale per customer, by effectively using display space and thereby increasing sales volume per square foot, by getting a larger return for your advertising and sales promotion dollar, and by improving your internal methods and procedures.

Profit is in danger when good merchandising and cost control do not go hand in hand. A big sales volume does not necessarily mean a big profit, as one retailer, Carl Jones, learned.

Jones’s pride was stocking stylish and well assorted lines of merchandise. Each year, sales volume increased. This increase was attributed to good merchandise which Jones felt took care of the steady rise in expenses.

But Mr. Jones began to have doubts when he found it necessary to get bank loans more often than had been his practice. When he discussed the problem with his banker, Jones was advised to check expenses. As the banker said, “A large and increasing sales volume often creates the appearance of prosperity while behind-the-scene expenses are eating up the profit.”

Paying The Right Price
Your goal should be to pay the right price for prosperity. Determining that price for your operation goes beyond knowing what your expenses are. Reducing expenses to increase profit requires you to obtain the most efficient use of the expense dollar.

Look, for example, at the payroll expense. Salesclerks are paid to sell goods, and their productivity is the key to reducing the payroll cost.

If you train a salesclerk to make multiple sales at higher unit prices, you increase productivity and your profits without adding dollars to your payroll expenses. Or, if four salesclerks can be trained to sell the amount previously sold by seven, the payroll can be cut by three persons.

An understanding of the worth of each expense item comes from experience and an analysis of records. Adequate records tell what has happened. Their analysis provide facts which can help you set realistic goals, you are paying the right price for your store’s prosperity.

Analyze Your Expenses
Sometimes you cannot cut an increase item. But you can get more from it and thus increase your profits. In analyzing your expenses, you should use percentages rather than actual dollar amounts.

For example, if you increase sales and keep the dollar amount of an expense the same, you have decreased that expense as a percentage of sales. When you decrease your cost percentage, you increase your percentage of profit.

On the other hand, if your sales volume remains the same, you can increase the percentage of profit by reducing a specific item of expense. Your goal, of course, is to do both: to decrease specific expenses and increase their productive worth at the same time.

Before you can determine whether cutting expenses will increase profits, you need information about your operation. This information can be obtained only if you have an adequate recordkeeping system. Such records will provide the figures to prepare a profit and loss statement (preferably monthly for most retail businesses), a budget, break-even calculations, and evaluations of your operating ratios compared with those of similar types of business.

A useful method for making expense comparisons is break-even analysis. Break-even is the point at which gross profit equals expenses. In a business year, it is the time at which your sales volume has become sufficient to enable your over-all operation to start showing a profit.

Once your sales volume reached the break-even point, your fixed expenses are covered. Beyond the break-even point, every dollar of sales should earn you an equivalent additional profit percentage.

It is important to remember that once sales pass the break-even point, the fixed expenses percentage goes down as the sales volume goes up. Also the operating profit percentage increases at the same rate as the percentage rate for fixed expenses decreases – provided, of course, that variable expenses are kept in line.

Locating Reducible Expenses
Your profit and loss (or income) statement provides a summary of expense information and is the focal point in locating expenses that can be cut. Therefore, the information should be as current as possible. As a report of what has already been spent, a P and L statement alerts you to expense items that bear watching in the present business period. If you get a P and L statement only at the end of the year, you should consider having one prepared more often. At the end of each quarter might be often enough for some firms. Ideally, you can get the most recent information from a monthly P and L.

Regardless of the frequency, for the most information two P and L statements should be prepared. One statement should report the sales, expenses, profits and/or loss of your operations cumulatively for the current business year to date. The other should report on the same items for the last complete month or quarter. Each of the statements should also carry the following information:

  1. this year’s figures and each item as a percentage of sales.
  2. last year’s figures and the percentages.
  3. the difference between last year and this year – over or under.
  4. budgeted figures and the respective percentages.
  5. the difference between this year and the budgeted figures – over and under.
  6. average percentages for your line of business (industry operating ratio) when available, and
  7. the difference between your annual percentages and the industry ratios – under or over.

This information allows you to locate expense variation in three ways: (1) by comparing this year to last year, (2) by comparing expenses to your own budgeted figures, and (3) by comparing your percentages to the operating ratios for your line of business. The important basis for comparison is the percentage figure. It represents a common denominator for all three methods. When you have indicated the percentage variations, you should then study the dollar amounts to determine what line of operative action is needed.

Because your cost cutting will come largely form variable expenses, you should make sure that they are flagged on your P and L statements. Variable expenses are those which fluctuate with the increase or decrease of sales volume. Some of them are: advertising, delivery, wrapping supplies, sales salaries, commissions, and payroll taxes. Fixed expenses are those which stay the same regardless of sales volume. Among them are: your salary, salaries for permanent non-selling employees (for example, the bookkeeper), depreciation, rent, and utilities.

Taking Action

When you have located a problem expense area, the next step obviously is to reduce that cost so as to increase your profit. A key to the effectiveness of your cost-cutting action is the worth of the various expenditures. As long as you know the worth of your expenditures, you can profit by making small improvements in expenses. Keep an open eye and an open mind. It is better to do a spot analysis once a month than to wait several months and then do a detailed study. Take action as soon as possible. You can refine your cost-cutting action as you go along.

This Financial Management article was written by on 3/1/2005

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