Are your overheads too low?

If your business is losing money or making only small profits, the chances are, you’ll be under pressure to cut your overheads. Sometimes this pressure is self-generated and sometimes it’s applied by banks, accountants, financial advisors and financiers. But is it really the right thing to do?

In some cases, it most definitely is. If your overheads are disproportionately high relative to the throughput of your business, then you need to cut them. This is true whether you’ve let them grow too fast or whether sales have declined and you haven’t yet downsized.

But in many other cases, cutting overheads to address bottom line under performance is entirely the wrong thing to do; and I’ll explain why.

When comparing overheads with direct costs, overheads are usually much easier to control. You just say “No”. A manager wants an additional person in his/her department: you say “No”. An employee wants a pay rise: you say “No”. There may be a need for repairs or renewals: you delay them. There may be a requirement for investment in plant or equipment: you make do with what you’ve got. Your IT system may be past its sell-by date: you ignore it. So by just doing nothing you’re controlling many of your overheads.

In most businesses, there are some overhead costs that should be reviewed regularly, with a view to making savings; utility bills, outsourced services etc. This is simply good practice and should apply irrespective of bottom line performance. There are also some overheads that are difficult to influence in the short or medium term; rent and business rates being the obvious examples. So in practice, you’re stuck with them, irrespective of your bottom line performance.

When it comes to cutting overheads, there can be some difficult emotional, personal and personnel issues to address because it usually entails making people redundant. But predicting the costs that will be taken out through downsizing and achieving those predictions are relatively straightforward processes.

Now think about direct costs. In many businesses, the two major direct costs are raw materials and direct labour. So how do you control them?

Material costs don’t just depend on the price you pay for them. They depend on: –

• Efficient stock control, keeping losses and damage to a minimum
• Efficient utilisation that minimises wastage
• Getting orders right first time to minimise errors
• Quality output to minimise replacements.

Direct labour costs don’t just depend on the numbers of operatives or the rates they are paid. They depend on productivity and the level of output that is achieved. Furthermore, achieving the right balance between the number of operatives, their individual wage costs and their combined output isn’t just a question of how well they are managed day to day, although that is extremely important. It depends on the operational efficiency of order processing, planning, procurement and stock control. Well maintained modern machinery and appropriate levels of automation, as well as effective batching and efficient materials handling systems, are also essential in manufacturing businesses.

Effective control of direct costs is, therefore, much more complex and much less predictable than the effective control of overheads.

Now consider the relationship between direct costs and overheads.

In some businesses, such as professional services, overheads are likely to account for a much larger proportion of total costs than are accounted for by direct costs. So, in businesses of this type, where bottom line under performance is an issue, reducing overheads may be the only option.

However, think about a light manufacturing business or a home improvement service provider – windows, conservatories, kitchens, bathrooms etc. A typical profit and loss statement will show direct costs accounting for somewhere between 60% and 70% of total sales, whereas overheads may account for only 20% or 30%. In these situations, direct costs are much greater than overheads; and this is actually typical of lots of small and medium sized businesses in many different sectors. It’s also where the wrong approach to addressing bottom line under performance often occurs.

If the majority of your costs are direct and your business is under performing, reducing those direct costs, as a proportion of sales, is likely to provide far greater returns than cutting your fixed costs. But to many small and medium sized businesses, this is often perceived as a much bigger challenge.

In reality, most under performing businesses, in this category, are under performing because of operational inefficiencies. As a consequence, their direct costs are too high and that is why their bottom lines are under pressure. But few of them fully appreciate the extent of their inefficiencies; even fewer realise how much it’s costing them; and fewer still make any serious attempt to quantify that cost. So they focus on their comfort zone, namely overheads.

If you then look at why these businesses are operating inefficiently, it’s usually because they are under resourced. Their processes, controls and management information systems are often inadequate. Their administration often depends on too few managers and employees; and they put too little emphasis on the training and skills development of the people they employ.

Where businesses of this type are under performing, the right solution is, very often, to increase overheads to provide a more effective level of resource that can support greater operational efficiency. This will, in turn, reduce direct costs. So there may be a trade-off; for example, increase fixed costs by three percentage points (of sales) in order to achieve a ten percentage point reduction in direct costs, giving a net bottom line improvement of seven percentage points.

The problem with this approach, as perceived by many small and medium sized businesses, is that they need to commit to the increase in overheads with no guarantee that the direct cost reductions will be achieved. However, in reality, the risk associated with addressing the problem might be more immediate but the risk of not addressing the problem is usually much greater. Although, this can sometimes be difficult to reconcile, particularly when cash flow is under pressure.

There are several lessons to learn from this.

The first is not to get into this position in the first place. Always recycle a reasonable level of profits back into the business to invest in appropriate plant & machinery, automation, IT, systems & process, staffing and training. By so doing, you will have the best chance of maintaining effective control over your direct costs.

The second is that, if your fixed costs are starting to drift, either because they are going up or because those of your key competitors are falling, act sooner rather than later. The short term risk of an increase in overheads is much lower when you have a strong balance sheet and the ability to fund the additional costs reasonably easily.

The third is to recognise that if you have lost control of your direct costs, there will be an additional cost to regain that control. It’s unavoidable and the longer you leave it, the higher the costs will be and the less cash you will have available to fund them. It’s a vicious circle leading to a downward spiral; and the sooner you act the more chance you have of recovering the position.

The fourth is to understand the level of risk, to which your business is exposed. The earlier you recognise and address the problem, the lower the level of risk. If you don’t address the problem, the level of risk will increase, the number of available solutions will decrease and the risk of those solutions not working, when you do eventually try to implement them, will also increase.

Finally, if you’ve recognised that you have a problem but you’re not sure what to do or whatever you are doing isn’t working, bring in professional help. Yes there’s a cost; but it’s likely to be a much smaller cost than losing your business.

Anthony Pratt
AP Management Consultants
May 2013

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