Money Management - November 2001

The Profitability Question

To Increase Sales or To Cut Costs?

by David Chavez

Many of us started our businesses in good times – such as this past decade. However, we are now facing our greatest challenge since starting those businesses: Can we survive in a declining economy? The answer is simple, but it requires us to focus on issues we may not have paid close attention to over the past 10 years.

Increased Sales: Will They Increase My Profit?

Look at the bottom line of your income statement as a clear indicator of how small a portion is yours in each dollar of additional sales. Many business owners consider themselves fortunate if the company has a 10 percent bottom line net income. Consider this: In order for your company to earn $1 million of additional profit, it would need to boost sales by $10 million, assuming you are bringing 10 percent of sales to the bottom line. Do you have the financial resources to carry the costs associated with the additional volume of sales?

Additional costs are part of every new sale. And the costs can be numerous if you don’t try to cut them. For example, you incur the expense of sales personnel, trucks to deliver the merchandise, billing clerks who send invoices and statements, and collection people who become involved when accounts aren’t paid on a timely basis.

Using ABC Corporation as an example, in order to increase profits by $1 million, sales would need to be increased from $10 million to $20 million. Ten percent net profit on $10 million of sales will produce a bottom-line profit of $1 million. Imagine the effort and cost associated with increasing sales by $10 million. Because a sale at the first of the month might not produce cash for 60 days or longer, sales may need to be increased even greater than $10 million, to offset the costs associated with financing the increased sales activity. Many companies can’t afford to grow to twice their existing volume because there wouldn’t be enough working capital to finance the sales.

There can be great savings associated with greater volume. And typically, all costs don’t have to go up in proportion to the increased sales. Yet, when there’s significant sales growth in a company, profits are often minimized due to the strain on the company’s resources.

What are the Benefits of Cost-Cutting ?

Keep in mind there is no additional cost associated with decreasing expenses. With cost-cutting, savings are often significant and require less effort than producing additional sales. The savings derived from cost-cutting puts no financial strain on the company when implemented properly.

Let’s go back to the ABC Corporation and look at what a 10 percent cost reduction can do. At $10 million in annual sales and a net bottom-line profit of $1 million, their costs are $9 million. If the ABC Corporation cut costs by $900,000 and maintained its current sales volume, its profit would be $1.9 million – almost doubling its bottom line.

Consider forming a cost-cutting team within your company with a qualified business facilitator and establish a goal to reduce cost, with a target of 10 percent. The cost-cutting team will benefit from having an outside advisor; the advisor can help take some of the emotion away from cutting in some areas the team may not want to cut.

Once a plan is developed, follow-through is crucial. This is where a facilitator can really provide the most benefit. No matter how you go about cost-cutting, a clear plan is needed that includes defining the goal, implementing the plan and following through.

David Chavez
David Chavez, CPA, is the managing shareholder of Chavez & Koch, CPA’s, Las Vegas.