What’s the first thing that comes to mind when I say cost control? I bet you think of cutting costs, don’t you? Well, it may come as a surprise, but slashing costs is not the main theme of this post. Cost control is just one element in the larger playing field of profit management. The best, or optimal, cost is not always the lowest cost. A roughly reaction is that costs should be lower. Don’t rush to judgment. In some situations, increasing costs may be the best path to increasing profits. It’s like coaching sports: You have to play both defense and offense. You can’t play on just one side of the game. Making sales is the offense side of business; defense is keeping the costs of making sales and operating the business less than sales revenue.
As the title of this post says, in this post I discuss not only about cost control, but also profit management to give a richer fundamental and perspective in scrutinizing your cost. For faster page load, I break this post into five pages. You can go foreward or backward by using the page navigation at the bottom of each page of this topic. here are topics discussed:
- Page 1: Viewing Costs and Profit the Right Way; (2) Cost Control on The Implementation Level; and (3) Putting Cost Control In Its Proper Context
- Page 2: Starting Control With Sales Revenue Change
- Page 3: Focusing on Cost Of Goods Sold and Gross Margin
- Page 4: Secrutinizing the Operating Expenses
- Page 5: Focusing on Profit Center. And this post will be closed with “Cost Reduction Excercise Checklist”
As I use some case examples to ilustrate the insights, I will refer all calculations and overviews to a “Profit and Lost Example”. To not back and forth for refering the profit and lost example, I post the profit and lost example on every page of this post. Enjoy!
Viewing Costs and Profit The Right Way
Of course, you shouldn’t waste money on excessive or unnecessary costs. If possible, you should definitely save a buck here and there on expenses. There’s no argument on this point. In my personal experience, small business owners/ managers don’t particularly need tutorials on shaving costs. Rather, they need to stand back a little and rethink the nature of costs and realize that costs are pathways to profit. If you had no costs, you’d have no revenue and no profit. You need costs to make profit. You have to spend money to make money.
The crucial test of a cost is whether it contributes to generating revenue. If a cost has no value whatsoever in helping a business bring in revenue, then it’s truly money down the rat hole. The key management question about costs is whether the amounts of the costs are in alignment with the amount of revenue the business is generating. A business manager should ask:
Are my expenses the appropriate amounts for the revenue of my business?
Cost Control On The Implementation Level
Controlling costs requires that you evaluate your costs relative to your sales revenue. Suppose that your business’s salaries and wages expense for the year is $425,000. Is this cost too high? There’s no way in the world you can answer this question, except by comparing the cost against your sales revenue for the year. The same goes for all your expenses.
In an ideal world, your customers are willing to pay whatever prices you charge them. You could simply pass along your costs in sales prices and still earn a profit. Your costs would be under control no matter how high your costs might be. Because you earn a profit, your costs are under control and need no further attention.
The real world is very different, of course. But this ideal world teaches a lesson. Your costs are out of control when you can’t set sales prices high enough to recover your costs and make a profit. It’s hardly news to you that small businesses face price resistance from their customers. Customers are sensitive to sales prices and changes in sales prices for the products and services sold by small businesses. In setting sales prices, you have to determine the maximum price your customers will accept before turning to lower price alternatives, or not buying at all. If the price resistance point is $125 for a product, you have to Profit and Loss Example out how to keep your costs below $125 per unit. In other words, you have to exercise cost control.
Putting Cost Control In its Proper Context
Cost control is part of the larger management function of revenue/cost/profit analysis. So, the best place to focus is your P&L report. This profit performance statement summarizes your sales revenue based on the sales prices in effect during the year and your expenses for the year based on the amounts recorded for the expenses. (There are some issues regarding the accounting methods for recording certain expenses).
Say that you’re the principal manager of a business. The business is a pass through income tax entity, which means that it doesn’t pay income tax itself but passes its taxable income through to its shareholders, who then include their shares of the business’s annual taxable income in their personal income tax returns for the year.
The example presents the P&L report of your business for the year just ended and includes the prior year for comparison (which is standard practice). This P&L report includes the percents of expenses to sales revenue. It also breaks out and facilities expense — the cost of the space used by the business — and reports it on a separate line.
Facilities expense includes expenditures for leases, building utilities, real estate taxes, and insurance on your premises. Depreciation isn’t included in facilities expense; depreciation is an unusual expense and it’s best to leave it in an expense by itself.
In this case, the business moved out of the red zone (loss) in 2008 into the black zone (profit) in 2009. Making a profit, however, doesn’t necessarily mean that your costs are under control. Dealing with the issue of cost control requires closer management analysis.
You can attack cost control on three levels:
- Your business as a whole in its entirety
- The separate profit centers of your business
- Your specific costs item by item
Profit and Loss Example is the P&L for your business as a whole. At this level, you look at the forest and not the trees. It’s helpful to divide your business into separate parts called profit centers. Basically, a profit center is an identifiable, separate stream of revenue to a business. At this level, you examine clusters or stands of trees that make up different parts of the forest. For example, Starbucks sells coffee, coffee beans, cup ware products, food, and other products. Each is a separate profit center. For that matter, each Starbucks store is a separate profit center, so you have profit centers within profit centers. Last, you can drill down to particular, individual costs. At this level, you look at specific trees in the forest.
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