A Publication of WTVP

Assuming your company is like every other in America, let’s suppose you’d like to increase profits by 25 percent over previous figures.

Which would be easier to accomplish, trimming overhead costs by 3 percent or increasing sales by 25 percent? In today’s tight economy, most company managers would opt for the 3 percent goal.

Ironically, both figures would provide a pre-tax increase in profits of $250,000 or more on $10 million in revenue. But the methods are completely different.

Say the cost of goods sold is 90 percent. Under the current program, that’s $9 million, leaving $1 million as pre-tax profit. If you increase sales by 25 percent to $12.5 million, a 10 percent profit leaves $1,250,000.

On the other hand, if you cut the cost of goods sold by 3 percent, that reduces the expenses to $8,730,000, leaving approximately $1,270,000 profit—even more than if you increased sales. In effect, the two very different activities have nearly the same impact on the bottom line.

So why don’t more companies focus on cutting the cost of goods in their effort to increase profits? A lot of them do, but they’re often aiming at the wrong target because managers continue to focus cost reduction activities based on a 1920s profile. Back then, direct labor represented 65 percent of production costs, while overhead and materials accounted for 15 percent and 20 percent of the costs respectively.

Today, labor costs are typically less than 10 percent of the cost of goods sold, while overhead and material costs have grown to around 45 percent each.

Unfortunately, labor is still the focus of the majority of all cost-reduction activities, and managers assume material cost savings can be achieved by shopping around for the lowest price. The focus on reducing overhead is dramatically lacking.

More and more, the competitive environment is the world stage.

Not only has competition increased from foreign suppliers, but most labor intensive jobs have been shifted to foreign countries—even by American companies. That, in itself, accounts for part of the reduction in labor costs.

Unfortunately, the efforts intended to reduce either labor or material costs result in increased overhead costs. And if you’re not careful, the increase can be greater than the reduction in labor or material expenses. Hence, it’s important to understand the relationships and interdependency of labor, material and overhead costs.

There are several ways companies can control overhead costs, including the implementation of lean manufacturing techniques like just-in-time manufacturing and cell-based manufacturing. Anther technique is to increase throughput, which spreads labor and overhead costs over a greater number of products. This, in effect, reduces the cost of production of each item you sell.

Still, you must be cautious about taking the wrong approach. Attempting to make the current process more efficient, without significantly changing the process itself, may accomplish nothing more than making a bad process faster.

Improvements in one area often shift costs to another function as well. Increasing throughput without managing inventory, for example, may only increase warehousing and bookkeeping costs.

Consider identifying and analyzing all opportunities for cost control as a first step, tightening production costs through setup reduction, increasing throughput, shortening lead times, and equipment purchases; and controlling inventory at the end of the line. IBI