How Cost-cutting Destroys Profit and How to Do It Better

Why is Downsizing So Popular?

It seems every day we hear about another corporation laying off employees.  Great firms thrive by selling more and introducing new products.  So why do so many companies embrace downsizing?

Out of sales revenue, a company must pay to create the product, cover its expenses, and pay taxes.  So a dollar of sales will yield less than a dollar of profit.

By contrast, a dollar saved drops straight to the bottom line and will yield exactly a dollar of profit.  So cutting costs $X produces a much greater impact on the bottom line than increasing sales $X.  Further, one can cut expenses immediately where sales are unpredictable and happen over time.  Viewed this way, one might sympathize with management and agree that downsizing is an easier and more certain method to grow profit than trying to boost sales.

In fact, firing a few dozen highly compensated employees and enacting sweeping budget cuts will almost certainly cause a spike in profit.   But that’s not the only impact.

From sales revenue, the company pays overhead and variable costs leaving the remainder as profit.  For more sales, only variable costs – those that pay for creating and selling product – will increase.  Overhead has been paid so we can strip out this cost.  The company doesn’t need to lease twice as much office space, for instance, to move twice as much product.

This allows us to calculate incremental profit on every dollar of new sales revenue.

In our example below, profit increases three-fold by deducting overhead. Why is this significant?  Because every dollar of new revenue adds three times more profit.  So if the company grows sales simply at the rate of inflation it will yield 10% more profit.  That’s respectable growth for simply keeping pace with the cost of living index.

Other Disadvantages of Downsizing

When a company cuts, it targets the most highly compensated people. These people are also the most senior.  As a result, they hold valuable institutional knowledge that the company dearly paid for over years of training and indoctrination.  When these people are forced out, the company loses this intellectual capital.

Further, layoffs tarnish a company’s image, fostering resentment among former employees and prompting anxiety among remaining people.  The company loses its standing in the community as a just corporate citizen.  To make up lost ground, it invariably must resort later to costly PR campaigns and philanthropic efforts.

The True Bottom Line

Increasing revenue through innovation and solid strategy while retaining its key employees serves a company best in the long run.  Enacting sweeping cuts  to pacify Wall Street is reactive short-term thinking.  It’s best to run a lean enterprise customarily than trim the fat solely to meet Wall Street’s expectations.

The Mathness Behind the Method: drilling down into the numbers

Our hypothetical company sold $1 Billion for the quarter.  Overhead was $200 Million.  On this first billion the cost to produce goods was $600 Million and variable expenses were $100 Million.  This yielded a profit margin on the first billion of 10%.  At this point, we’ve covered overhead.  Only the cost of goods and variable expenses will increase with new sales.

Out of each new dollar of sales, the company pays 60¢ to create the product and 10¢ to sell it.  A total cost of 70¢ leaves 30¢ profit for every dollar of new sales.  This is 30% margin on new revenue compared to the 10% on the first billion.

The original financials show $100 Million gross profit on $1 Billion.  A five percent increase of the original revenue is $50 Million.  At 30% margin, this yields $15 Million extra profit.  So the company will generate $1.05 Billion total sales revenue and earn $115 Million profit, a 10.95% combined profit margin.  This new overall margin is an increase over the original 10% margin of 9.5%.  So 5% new revenue growth will improve company profit by 9.5%.

Next time I’ll share an easy way to pacify an irate customer.  And shortly I’ll introduce an ingenious sales call method to bypass the dreaded gatekeeper so you get put right through to the decision maker.  It’s all coming up in the next few days so stay tuned.  Until then,

profitable business All!

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