Aug 29

Written by: Ted See
8/29/2011 10:03 AM 

By using certain proven budget strategies and the proper financial approach you will be able to improve your profitability and enhance your current cash position. In the order of priority, we will consider each of the following financial sales and expense areas in the budget process to make sure each of these actions is considered and prioritized properly to insure the creation of the optimal budget.

 

The first five things, listed by priority that you can do to improve your profit are:

1) Increase the selling price.

2) Decrease and control the direct costs (labor and MESO).

3) Decrease and control the variable costs (associated costs to direct costs).

4) Increase the sales volume.

5) Decrease the fixed costs.

 

FIRST

The first thing you must do to increase your profit is to increase the selling price. Most companies currently have no way to insure that annual price increases, including even small cost of living increases, are implemented into their budget and pass through to their job costing/pricing system. Any price increase passes directly through to the bottom line as additional net profit since there are no associated variable or fixed costs connected with the increase.  This can be done as long as it is determined that any anticipated price increase wouldn’t adversely affect the sales volume and/or profits. A very successful budget strategy includes increasing the price of the company’s product(s) and/or services to a point where the “price shoppers” will go elsewhere. This resulting drop in sales doesn’t necessarily mean that there will be a drop in profitability. To the contrary, most of the time a price increase that was intentionally implemented to reduce the sales levels may actually increase the net profit of a company depending upon the actual amount of the price increase. Remember as the sales volume drops, the flow of order processing and paperwork also drops and gives more time to the administrative personnel to spend on more accurately managing expenses and the policies, procedures and systems that control them. Also, consider who the “price shoppers” are. You will find that they are probably the most demanding of your customers. Keeping this in mind, a drop in volume can be a very good corporate strategy.

 

Try it yourself. Increase the price of your product(s), starting with the cost of living increase (CPI) until you feel that the sales will adversely be affected. Adjust the new budgeted sales amount to reflect the amount of decrease that you would expect from such a price increase. Once done, look at the new budgeted bottom line profit. You will probably be surprised that the profits have actually increased although the sales were purposefully decreased. TheBusinessAnalyst.com automates this process for you. Remember that you can’t continue to increase your price more than the CPI and expect your customers to continue to pay it without simultaneously controlling your variable and fixed expenses. Customers will not continue to pay higher and higher prices just to compensate management for their inability to properly manage and control their variable or fixed costs. This is the fastest and most foolproof strategy to immediately increase your profitability.

 

SECOND

Secondly, you must decrease the company's direct costs. Direct costs are defined as the direct labor and/or Material, Equipment, Subcontractor and Other direct costs (MESO) associated with a specific job, product or service. Since the single largest percentage of a company’s sales dollar is usually consumed with costs in this category, a very slight percentage improvement in any of these areas will show a compounded benefit to the bottom line. Because of these phenomena, this is the second best place to look for profitability improvements that will reap the fastest profitability benefits. Direct Costs are variable costs. Be careful never to budget expense improvements in any variable cost line item unless you have identified the cause of the cost increase and structured the policies, procedures and/or systems needed to correct the higher costs. If you are budgeting lower expenses in variable cost line items without knowing how you will achieve the results, you are only fooling yourself because it is highly unlikely that the costs will be reduced. As an example you may install employee incentive plans to help control the direct labor and material costs or install better inventory systems to help control the material/inventory costs. You might also develop the strategies to better financially manage your company to take control of cash discounts, etc.

 

THIRD

Third, you must minimize all of the variable costs associated with each specific job, product or service. As was stated above, be careful never to budget expense improvements in any variable cost line item unless you have identified the cause of the increase and structured the policies, procedures and/or systems needed to correct the higher costs. If you are budgeting lower expenses in variable cost line items without knowing how you will achieve the results, you are only fooling yourself because it is highly unlikely that the costs will be reduced. If “Bad Debts” are too high, don’t reduce them in the budget without a plan that will be implemented to control them. Perhaps you will install better credit control measures that will properly screen new customers before they become a bad debt. Look carefully at any correlation between any of the direct costs and some of the costs in this variable expense category. As an example, if the direct costs of labor are reduced, the payroll taxes for the direct labor will also be reduced as will other expenses like union dues and other associated expenses. Certain improvements in the direct cost category will “ripple” down in the form of additional profits to other variable cost line items. The variable costs associated with a specific job, product or service is usually the second largest group of individual line item costs within a company. Because of this, it takes a smaller percentage of improvement on a larger line item expense to drop to the bottom line with a greater dollar amount of profitability. Therefore, this fact makes this area the third best place to look for profitability improvements.

 

FOURTH

Fourth, you may now look at increasing the sales to add additional revenue to your company. Once the direct and variable line item costs have been reduced, you have lowered the sales breakeven point and it is now the proper time to consider a plan to increase the sales because you will now receive a higher profit on each sales dollar generated. If specific sales focus can be identified and directed to say the more profitable departments, products or services of the company it will be even more to our advantage to look to an increase in sales as the next thing to do to increase profitability. The typical misconception here is thinking that the first thing that should be done to increase your profits is to increase your sales volume instead of waiting until the breakeven point has been reduced. It must be remembered that with each dollar increase in sales comes with it a proportionate increase in direct and variable costs. Keep in mind that there is a very big difference in raising the price and increasing the sales although both actions increase the line item entitled “sales”. An actual sales volume increase carries with it a proportionate share of the variable costs needed to finalize the sale but a price increase drops right to the bottom line with no cost increases. It takes proportionally more effort and expense to generate additional sales to increase profits than it does by better control the variable and fixed costs. Therefore, this is the forth area of priority to be considered for profitability improvement.

 

FIFTH

Fifth, and yet what is typically thought to be the first priority to maximizing profits is to cut fixed costs. The most obvious costs and easiest to cut are fixed costs. They are the most visible and easiest to blame. If you look a little deeper into each line item of the fixed costs category, you will realize that they are typically the single smallest percentage of sales and they represent the lowest percentage of costs. Because of this, even a large decrease in costs of some of the smaller line-items in the fixed cost category will typically have a smaller overall effect on profits than will a small decrease in costs of the much larger line item expenses in the direct and variable expense categories. There are some other issues that must also be considered here. Typically, some of the first costs to be cut are the administrative personnel because they are more visible and seem more obvious. Unfortunately, the administrative personnel are the ones who track and control the policies, procedures and systems that when implemented, reduce and control the costs in the direct costs and other variable cost categories. Being frugal in this area can easily backfire on company management who do not understand how to best properly prioritize and control the expenses of their company as we have explained above. Therefore, this is the fifth place to look for company improvement in profitability.

 

As new corrective measures are installed to control the different variable cost line items, systems will be created to control them. Management will then be managing the systems that control the details, not the details. This will allow management to control more items simultaneously and in less time. This “new found” time will then allow management to turn their attention to other items that are in need of attention but were not a priority earlier in the process. This fact causes the profitability benefits of the earlier corrections to exponentially improve and with it, profits and employee morale.