Chapter 9: Cost and Margin Management

Continuing with the chapters of the“10 foundations of business success”, an excellent very practical book by my friend and colleague Guy Hamilton.

If you missed any of the articles in the topic, see links below.

Series Intro – 10 Foundations of Business Success

Chapter 1: Market Segmentation Part 1

Chapter 1: Market Segmentation Part 2 – The Steps

Chapter 2: Customer Needs – You only have a business if a customer wants to buy your products.

Chapter 3: Value Propositions – What a customer perceives as good value is all that matters. A business view of value does not count.

Chapter 4: Customer Experiences – When a customer really engages with a product or service they become a passionate advocate for it. This is at the heart of repeat or referred business.

Chapter 5: Metrics and Performance Management – What gets measured gets done. It is as simple as that!

Chapter 6: Dealing with “the Competition” – If managed well, competition is fuel for a vibrant business with a continuing right to win.

Chapter 7: Tasks, Accountabilities and Competencies – Good leadership often is no more than making sure everyone clearly understands their role, their tasks and where they fit in the big picture.

Chapter 8: Organisation and Dependencies – There is a direct link between running a joined-up business and good financial outcomes.

Today, I bring to you, the 9th Chapter: Cost and Margin Management – If you get the cost base right, profits will follow. This is an important chapter in Guy’s book, and a detailed one. I am constantly amazed at the number of small businesses where the owners/managers do not understand the difference between revenue, margin and profit. In fact, I have seen some businesses where with some lines, the more product they sell, the more money they lose, as costs are not understood. Here I am providing a very brief summary of important detailed financial advice around the topic of cost and margin management.

It has been highlighted that maintaining or building profit margins is central to sustained financial success. An ongoing focus on improving productivity and available margins from a given cost base is essential to building and sustaining your profits and enterprise value.

Many small businesses are unable to talk in any detail about their current cost base, primary cost drivers or how their gross profit margin is achieved. Many appear to take a simple view of “profits” being based on sales revenues less known expenses, which leads to “margin management” being, in practice, “Is there enough money in the bank?” Since costs are a key to building and maintaining profit margins, you would think a business would have relevant costs, facts and figures to hand!

Let’s be clear: good cost management does not mean investing as little money as possible into a business. This rarely leads to a good outcome. Cost management is about understanding the cost dynamics in a business and making good decisions that optimise the use of available resources based on where they can provide the best profit margin.

There are two clear benefits of focusing on unit costs:

1.   Clarifying a product’s margin enables managers to consider whether the margin is sufficient to justify the time, effort and resources involved.

2.   Splitting out the cost components enables a disciplined review of how each might be reduced, and the profit margin improved.

Here are four basic cost disciplines that can add tremendous value and insight, and underpin a growing culture of cost management.

RULE 1: Track and measure costs simply and consistently.

RULE 2: Understand the unit cost of production by core products/activities and by distribution channels.

RULE 3: Manage the business challenges presented by fixed and variable costs.

RULE 4: Manage your business dynamically against a simple cost-volume-profit model

The Steps:

How can a business start to capture practical and useful cost data by activity in a way that does not create a fog of meaningless data and numbers?

1.   Start tracking and allocating unit costs simply and pragmatically. Resources to stages, processes, product, etc. For some materials or departments, this allocation may be challenging but try to do it as accurate as possible without making it too complex.

2.   Track channel costs simply and pragmatically. Your choice of channels will increasingly drive unit costs, margins and therefore profitability. A good channel-based distribution model can improve margins, and as such is a fast-emerging business competence required for most businesses. Developing such a model can seem challenging; however, here are some tips:

• Identify specific costs associated with each channel.
• Identify sales or servicing transaction volumes going through each channel.
• Create a standard unit cost for a standard transaction in a channel (e.g. specific channel costs divided by volume).
• Allocate a weight transaction cost for each transaction type by channel.

3.   Add production costs, channel costs and any central cost allocation to come up with a consolidated view of relative unit costs of production across products and across channels.

4.   Analyse your fixed and variable costs to understand the ratio between the two elements.

5.   Do a simple sensitivity test on your base financial model. Understand at what point your margins become too thin to be regarded as “safe”.

Good cost management is based on a culture of good measurement and tracking. Watch the main cost items, track tends and forecast changes over the medium term. Business that understand and manage costs well can create a sustainable advantage over those that do not. As margins compress in an industry, those with the best cost base will be the survivors.