Driving enterprise cost reduction
Posted 04 Apr 16
The critical aspect to understand when analysing the cost structure of an organisation is to view costs as an equation of efficiency rather than a quantum. It is often a trap to identify the larger expense lines on the profit and loss statement as the areas requiring rationalisation to achieve the most significant impact on their bottom line. Often those larger expense lines are driving the top line and GP growth. So it should be a process of eliminating waste.
To identify the areas of waste in the business the analysis needs to go deeper than just looking through the profit & loss statement. Costs need to be categorised by nature and by type to show how efficient that category has been to the business. This is where choosing the correct efficiency ratio is critical.
Whether to use a ratio against top line revenue, gross margin or contribution margin depends on the expense. Whilst the tendency is to use the top line revenue number for all expenses, it shouldn't be a one-size fits all approach. The only rule should be that the organisation adopts a consistent method for all expenses within the same category or type.
For example, it might be most appropriate to view the efficiency of Selling Costs (marketing, advertising, promotional materials etc) as a return against top line revenue as this is the number which an organisation is trying to impact by its marketing spend. Whereas your Labour Cost efficiency is more appropriate to analyse against gross margin as that is what your investment in human resources returns to your business.
Calculating the efficiency ratios provides the organisation with the information required to assess whether they are getting bang for their buck, and whether the allocation and spread amongst the individual expense lines within a category are appropriate.
Scheduling regular review of your organisations efficiency ratios is what can drive improvements in profitability. An organisation which introduces a continuous and robust cost management process will find that over time, the labour efficiency ratio is the most critical and influential driver of enterprise cost reduction. If you think about it, all expense categories within any organisation can be linked to a labour component and so improving this will indirectly improve the efficiency of the associated costs.