Finding Business Efficiencies in the Financial Reports

I just got back from a continuing ed class on biz finance and wanted to pass on one of the case studies.  ABC was a biz that was experiencing growth through expansion.  Its sales had increased from $1.5M to $1.7M to $2.1M in the last few years yet its gross margin and profit margin were shrinking and its debt had skyrocketed.  The training highlighted all of the little places you can look to find savings to right the ship.  One method is by comparing your business with industry standards.

Gross Margin

ABC’s gross margin ((Sales-Cost of Goods)/Sales) was 3.7% below the industry average.  3.7% looks pretty insignificant, but that translates to $80,000! (Sales of $2.16M x .037).  If I told you that you had $80,000 lying around in your business, your first question would be: “Where?”  We will construct a simple plan to find this money.

Cost of Goods (COGS) is made up of materials purchases and direct labor.  ABC’s accounts payable (A/P) was also considerably higher than the industry standard of 37 days, demonstrating that it wasn’t taking advantage of supplier discounts.  The first part of our plan will be to pay at least half of our materials purchases within 2 days to get the vendor discount.  ABC had $1M of material purchases so this amounts to $10,000 ($1M x .01)

Expansion almost always leads to inefficiencies in a company.  New employees have a learning curve.  New machines require installation, testing and training.  ABC has experienced some growing pains.  The next part of our plan will be to increase efficiencies in the operation of the business.  ABC had $760,000 in employee costs.  A 4% increase in efficiency amounts to $30,000 ($760,000 x .04).

We are half way there!  It is time for ABC to get some concessions from its suppliers or shop around for better pricing.  Its volume has increased year over year, yet its materials costing has increased.  The next part of our plan is to negotiate a 2% cut in pricing from ABC’s suppliers which will amount to $20,000 of savings ($1M in material purchases x .02).

ABC has rewarded its many customers for years with quality products and reasonable prices.  A modest price increase of 1% will almost go unnoticed by the customer, but will go a long way to closing ABC’s gross margin gap.  The final part of our plan is a 1% pricing increase amounting to $20,000 (sales of $2.16M x .01).

By implementing the 4 parts of this plan, ABC has moved toward the industry standard for gross margin and found $80,000 in its operation that was threatening its sustainability.

Inventory

Inventory management is a difficult task for many business owners.  Some service businesses even erroneously think that they have no inventory.  In the broadest sense, anything you purchase or pay for (including labor) that results in sales is inventory.  Most businesses have a good portion of their working capital tied up in inventory.  This highlights the need for proper management of this asset on the balance sheet. 

ABC is holding inventory 12 days longer than the industry average.  What does that mean?  The industry is averaging 4.9 turns of inventory per year – or 74 days.  ABC is only turning its inventory 4.2 times a year.  This doesn’t seem like much, but we can give it a dollar value which translates into cash to use for its payables that are averaging more than 60 days.  The industry target for inventory size would be $359,000 (COGS/4.9 turns).  ABC has an inventory of $419,000.  ABC can decrease its inventory through more efficient re-ordering, correct ‘on-hand’ quantities, reduction of shrinkage, reduction of breakage and removal of obsolete material.  If ABC can get to industry standards, it will have access to an extra $5,000 per day ($60,000/12 days) to get its payables caught up.

Accounts Receivable

Collecting from customers is not an issue for many businesses, but enterprises that invoice customers for products and services, businesses involved in government contracting and exporters need to manage their receivables wisely to ensure sustainability. 

ABC was only 2 days above the industry average for customer collections.  That doesn’t sound like much but let’s give it a dollar figure to bring it into perspective.  The industry target for receivables was $254,000 (Sales/8.5).  ABC has $270,000 of receivables on its balance sheet.  That translates to $8,000 of cash each day that it cannot access for other uses.

This example demonstrates the value of monitoring your business against industry standards.  This monitoring shows trends in your business and trends in your industry.  By equaling or exceeding your industry’s performance, you can increase the cash flow and profitability/sustainability of your enterprise.  In this short exercise we found more than $150,000 of efficiencies and cash in this company.  How much money is hiding in your financials?