Find The Hidden Waste Stealing Your Company Profits
As a business owner, you are constantly working to use the limited resources you have to achieve the best results and highest possible returns. You have to be effective (i.e. get things done) and efficient (i.e. get things done with the least resources). It’s an ongoing effort rather than a one time “mission” to accomplish. The Japanese concept of “Kaizen”, which stands for constant improvement, allowed Japanese companies to add incredible operational innovation to the world.
When business owners and managers are faced with tough times (e.g. economic crisis or lagging profits), they naturally take a closer look at their company to see where they can cut the fat to ensure the company’s longterm survival.
Lets imagine you run a company that sells two products. Each of Product A and Product B sells for $100 with $50 cost of material. Now after years of being in business, your company is breaking-even (i.e. zero profit) while competitors are profitable. That’s annoying because your quality and sales are the same as competitors.
The Usual Suspects
So you look at your expenses to find the fat eating up your profits. You explore the three usual suspects:
- Suppliers: You bargain to drop their prices or find cheaper suppliers. You conclude that you are getting a fair price from suppliers.
- Non-essential expenses: You look at cutting travel costs, employee fringe benefits (free snacks, etc). You find a few items you can cut, but they are too small to make a difference on your bottom line. Also, you believe employees like them, which improves their productivity and loyalty.
- Staff: It’s your company’s biggest expense, so you look to cut unproductive or nonessential employees. You conclude that all your employees are actually as, or more, productive than the industry average. Also, they are all working at full capacity so dropping any of them will be hurt your sales.
What to do?
There is another type of waste in your company that is more costly than these three combined. You will not find it by looking at your financial statements, but it’s there.
Easy As ABC
Activity Based Costing (ABC) from managerial accounting comes to the rescue (insert Mighty Mouse theme music). What we want to do is take all the activities (i.e. time in production, selling, travel, design, selling, clean up, etc) and allocate them to their products.
Lets say your employees spend 3 hours making product A and 7 hours making product B. Assuming you pay employees $10 per hour, that means product A is costing you $30 per unit while product B is costing you $70 in activity costs. This means you Product A is giving you $20 margin ($100 price – $50 material cost – $30 allocated production activity = $20 margin) while Product B is taking $20 ($100 – $50 – $70 = -$20) from your profits.
There it is!
Product A is subsidizing Product B. If you sell more of product B, you will lose money and if you sell more of product A you will make profit. By having your activity costs (e.g. salaries) as a fixed cost, you will assume it is allocated equally between your products. That’s a mistake.
Knowledge is power and now that you know, you can take action to improve your profitability. You can increase the price on Product B so it makes money, redesign the process to reduce the activity time spent on it, or drop the product from your portfolio.
This applies to services since they are based on activity your company is doing to provide the service. You just won’t have the material cost in services.
It’s a worthwhile exercise that can save your company and prevent you from blaming your employees for your mistake.
Do you have that hidden cost at your work? Share your experience with us.