guest commentary by David Potts
Editor’s note: David Potts is a certified public accountant with more than 33 years experience. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case. Feel free to e-mail topic suggestions or questions to firstname.lastname@example.org
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The power of compound interest is one of the first subjects a person is taught when learning about personal finance. Compound interest uses the leverage of time and returns (interest, dividends, etc.) to accelerate growth of an investment.
A one-time gift to your grandchild of $10,000 that earns an annual return of 10% will grow to $27,296 in 10 years. That same one-time gift of $10,000 will grow to $1,465,813 in 50 years, a dramatic difference. Unfortunately my Granny didn’t have the money to gift me $10,000 when I was born, so I have to trust the math in this illustration, not personal experience.
If you’re a business owner or a manager responsible for bottom-line results, consider what happens when you apply the principles of time and returns to cost control.
In a compound interest scenario understanding your return is simple. If you place $10,000 in a high yield bond that earns 10% interest annually, at the end of the year you will have been paid $1,000 of interest income (assuming the bond doesn’t go into default). In a business that implements cost controls, the returns are your cost savings and increased productivity.
Controlling costs isn’t simply buying material and services cheaper. The focus must be on productivity and efficiency too. Buying a cheaper material to produce your widget at the expense of more defective finished goods could actually increase your product cost. So a slash-and-burn cost-cutting policy without contemplation could be detrimental to your bottom line. You have to analyze the cause and effect of change before making your decision.
What could be the impact of effective cost control? If your business’ starting benchmark is $1 million in sales and sales are growing at 5% a year, and your cost of operations is 75% of sales, a permanent 10% reduction in operating costs would accumulate to $943,000 in 10 years. My point is that a consistent and persistent focus on business costs with the intent of controlling costs and increasing productivity and efficiencies is beneficial and profitable to any business.
Large companies understand this. But they have an advantage over smaller businesses in that they can afford to hire financial and accounting professionals that have expertise and experience to effectively build cost management into their culture. Smaller companies often overlook this area of focus and have to be more intuitive in their analysis and decisions. The advantage small businesses when compared to large businesses is the management might be closer to the production floor with a more intimate understanding of the company’s costs.
Before we look at the how of cost control management, let’s consider the why.
Ten years ago the economy was growing at a healthy rate and a company’s growth in sales was easier because of strong economic growth. The made cost management less important because earnings growth followed sales growth. And that is always preferred.
Businesses now operate in an environment that is less business friendly than a decade ago and our economic growth is consistently anemic. These conditions make topline growth more difficult. In this environment cost control becomes a more important path to maintaining and\or increasing a company’s profitability.
What are the elements of effective cost management?
The heavy lifting is the commitment to reduce costs. A company that commits to cost reduction will generally experience pushback from managers, key employees, and spouses who no longer get to drive an expensive company vehicle. Cost management can make life less convenient and challenge external relationships with vendors.
Effective cost control requires persistence and vigilance. A focus on your business’s costs of operations is not a one-time event. It needs to become part of the company’s strategy and culture. Its benefits are compounded through persistence and vigilance over time.
Strong leadership is required. The company’s leadership must first believe that cost control and cost reduction is both important and achievable. A 10% reduction in costs may not be simple, but it’s generally achievable. Management must also establish accountability for who is responsible to reduce costs.
Controlling costs requires an effective reporting system. It’s assumed that business owners and managers have access to an accurate and timely accounting and information reporting system. Timely and accurate reporting is required for success. Without it you’re guaranteed to fail in your efforts.
Business owners and managers can’t control the current lackluster economy, but that tends to be where much of their focus is directed, a by-product of the 24-hour news cycle I suppose.
But every business owner and manager can focus on and achieve cost reduction and productivity gains. Focus on what you can control.