It lurks around your business, sometimes at the edges of your operation where you’re unlikely to notice, other times right under your nose: cost creep.
Is your business losing profitability on a product or service because your margins have gone down?
Deteriorating margins can catch business owners by surprise, with small reductions in price combined with small increases in production costs suddenly turning your product into an unprofitable one.
For example, you might pooh-pooh a 1 percent increase in the cost of producing a product. But what if you suddenly realize that the cost of making five products has gone up 1.5 percent each, and you haven’t passed any of the extra cost along to the customer?
How do you manage cost creep?
1. Utilize the 80/20 rule by customer and product, i.e., 80 percent of your business comes from 20 percent of your product. Or 80 percent of your sales come from 20 percent of your customers.
2. With this in mind, analyze the standard selling price and costs to determine your profit margin on the product. The key is that every time you do this, you must have up-to-date costs on material and labor. When you analyze this, you have a good idea of the details driving your price margin on the product.
3. Evaluate discount pricing impact on standard margins.
In a customer analysis, look at your sales to your largest customers and compare to the standard cost to determine your actual profit margins by customer. Remember the 80/20 rule when selecting customers to analyze.
You may have negotiated an agreement with a large customer that, even at a slim profit margin per product, will transform your business. But what if your costs in producing the product increase or the customer seeks additional discounts? Any slight changes in the margin could easily slip into a situation where you are looking at break-even or losing money on the deal.
4. Take action
1) Look to reduce the cost of production. That includes negotiating with your suppliers; looking for ways to improve the manufacturing process (this could involve capital expenditures).
2) Inquire about possible price increases to your customers. In any price increase discussion, you need to be prepared to tell yourself, “Hey, I may have to fire this customer, and be prepared to restructure my administrative costs accordingly if that happens.” Obviously that’s not your preference. You want to raise the price to a fair level. Your customer wants you around for the long haul. Make sure your profit levels will allow for a long term sustained operation.
Ideally you’re able to reduce costs and get a price increase to raise that product and customer profitability back to where it needs to be. Keep a keen eye on the profitability of your products and customers, and you’re unlikely to be surprised by cost creep.
Chuck Williams is dean of the College of Business at Butler University. J. Christopher Stump, CFO Services project manager, Butler Business Accelerator, contributed to this article. For more information on the College and its “real life, real business” approach to business education, www.ButlerRealBusiness or e-mail Chuck at firstname.lastname@example.org.
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