Managing costs

A professor of mine once said, “you can only cut costs so much, you need to work on increasing revenue”. Which is true, cutting costs too close to the bone could start to erode value, however, maintaining tight control over both fixed and variable costs is an essential ingredient in maximizing cash flow and profits in any business.

Initiating any business involves evaluating the production costs of a product or service and then calculating an acceptable selling price for that product. Occasionally business is deemed “unprofitable”because the entrepreneur is unhappy (or unsatisfied?) with the anticipated slim profit margin or there is no margin or profit in the business. President GeorgeW Bush said America was addicted to oil; probably because the USA was the world’s number one importer of oil and the US break-even price in 2007 was $72.37  per barrel. Fast forward to 2019, the cost of producing oil is now $23.33 per barrel. The price of oil adjusted for inflation has consequently dropped from  $78.13 to $46.25 . Thanks to advances in technology and fracking, the USA is now a net exporter of oil.Exporting even to Saudi Arabia. Notice how a 67% drop in costs has resulted in profit margins of 98%. Clearly, by managing costs, a company can turnaround business, and maximize cash flows.

Before considering cost, management there must be an understanding of a company’s activities that generate or activate these costs. Costs can be fixed by nature; such as rent and maybe a particular insurance policy, or they can be variable; such as hired labour for land preparation or harvesting a crop.

The entrepreneur needs to know:

–   how costs behave

–   what activates them

–   how they occur  

–   when they are expected to occur and

–   what they cost

If there is no understanding of a business’s cost behaviour it cannot be managed effectively. However, there are a variety of tactics entrepreneurs can employ to rein in costs or prepare for unforeseen costs that arise during the course of the year, such as the following:

1. Make a plan

Sit with an accountant and critically evaluate the current position of the business and the targets which it should meet in the future. This evaluation will give better insight into how the company costs behave and what factors cause them to arise or shape in a particular manner. This evaluation should result in a plan or budget that enables the entrepreneur to forecast costs and prepare for contingencies.

If, for instance, the business is awarded a contract to guard 20 additional telecommunication towers in Northern and Luapula provinces, any related costs should be included in the forecast. As the adage goes, “if you can’t measure it you can’t manage it.”

2. Track costs diligently

If the business has been operational for at least a year, a review of its historic costs should be understood before planning for future costs. Data must be gathered effectively and efficiently. Several accounting tools can be used to help gather and track your business costs although, it is advisable to consult with an accountant or auditor before investing in such software, to ensure it is a purchase of practical use; for example, a cloud solution may not work for the farmer that has intermittent electricity supply and a weak internet connectivity – even if it is the most modern and applicable farm accounting software. What’s good for the goose isn’t necessarily good for the gander. Tracking your costs shouldn’t be an afterthought, it needs to be an integral part of a company’s ongoing operations.

3. Benchmark against your industry

It is a necessity to establish metrics that are meaningful to your business and comparable to those used by other companies in the same industry. Obtaining such industrial metrics can be difficult to impossible in Zambia, but the use of a proxy of a similar company quoted on an active stock exchange could help make adjustments for say size, income levels and units sold, etc. Comparisons with the proxy should highlight over expenditure in certain line items, where an entrepreneur should investigate further and take appropriate action.

4. Manage variable costs

The company’s relationship of your variable costs to certain line items – most especially how these costs change with individual revenue lines, must be understood; for example, feedstock costs should be compared against the number of quails produced and sold – not against total farm revenue which may include income from the disposal of assets. Review the company’s variable costs and calculate the percentage of sales they represent. Historic percentages provide both a good indicator of potential future costs and a benchmark to use in keeping those costs in line with selling activity.

5. Get tough on fixed costs

Businesses are generally complacent with fixed costs and take them as a given. As an entrepreneur, you should constantly seek new relationships with alternative suppliers and seek better deals by negotiating early payment discounts if need be or a moratorium on price hikes. One way of obtaining good value is by requesting proposals by open tender or to selected suppliers. At the very least, this sends a message to your supplier that you are watching your costs.

6. Invest in technology

Technology can offer competitive advantages that raise barriers to entry if adopted appropriately. Would a combine harvester reduce wastage and reduce the business’ labour costs? Should chicken production be automated? Calculate the costs of investing in technology and compare it against the current position. Occasionally an investment in technology can give good yields in the long-term. If production costs are reduced significantly because of technological investments, this in itself could create a barrier to new entrants as the service or product prices become more competitive. Exploration of new technology may help improve efficiency, increase productivity and reduce costs.

7. Offer incentives to staff

Open up with staff about financial challenges that the business is facing and communicate financial benchmarks and make these a point of discussion. Make staff accountable for costs and establish a reward system for staff initiatives to reduce costs. Doing this will help create a zero-waste culture within the company.