How to Reduce Variable Costs for Better profit

Summary

Especially in a manufacturing business, the variable cost of parts, resources and energy etc are likely to be a substantial part of your overall costs. This 12Faces Menu is a collection of distilled business wisdom relating to managing and reducing these costs.

Variable costs are those that are directly tied to your level of production.  If you produce more of an item, more inputs are required.  If you produce less, you will have less variable costs.  They might be physical inputs to production, goods purchased at wholesale for retail resale or services purchased from others and sold by you on a commission basis.  

They are also often referred to as “Cost of Goods Sold”

By and large, you can’t remove a variable cost because it is, by definition, a necessary part of your production system otherwise it would not be there but you can often reduce them.

This is a collection of short  topics relating to variable cost reduction.  Its purpose is to raise possibilities and processes in your mind to assist you with your management of this class of costs. Labour is not really a variable cost (unless you have a lot of piece workers) so this material will not focus on reducing labour costs

Read this if: you have substantial variable costs in your operation.  The more you have and/or the larger they are as a proportion of your sales income, the more opportunity you will have to reduce them.  .

Related to: 80/20 Rule, accounts payable 

Degree of Difficulty: Yellow (entry level) Belt

Reducing Variable Costs

Especially in a manufacturing business, the variable cost of parts, resource and energy etc are likely to be a substantial part of your overall costs. This 12Faces Menu is a collection of distilled business wisdom relating to managing and reducing these costs.

Variable costs are those that are directly tied to your level of production.  If you produce more of an item, more inputs are required.

By and large, you can’t remove a variable cost because it is, by definition, a necessary part of your production system otherwise it would not be there but you can often reduce them.

The following is a collection of topics relating to variable cost reduction.  Its purpose is to raise possibilities and processes in your mind to assist you with your management of this class of costs.

Working with Suppliers to Reduce Variable Costs

One of the easiest, and least painful, places to start a cost cutting exercise is with suppliers.

Any activity in this area can have good pay offs.  For example, let’s assume that about half of your expenditure is on products purchased from suppliers.  These could be Variable Costs if you manufacture or Cost of Goods Sold if you retail.  If you can reduce the price you pay by 5%, you get 2.5% of that saving going immediately to your profits (50% of 5%) which gives you a new profit of 7.5%; a healthy 50% improvement over the current 5% profit.

When talking to suppliers, your normal purchasing officer in your business may not be the ideal person to conduct tough negotiations.  It might be better to have a working team of “good cop, bad cop”.  Ideally you want your purchasing managers to have a good relationship with suppliers and they might feel very uncomfortable pushing for a price reduction.  Better that you have a “bad cop” reset price points and the “good cop” conduct the day to day negotiations and liaison.

People experienced in this area say that savings of up to 30% are quite achievable in the purchase of services.  Service suppliers often have a high fixed cost and any incremental business, at almost any price, contributes to covering those overheads.

Overall costs, experts say discounts of 15% or more are achievable if you haven’t been paying careful attention to the prices that you are paying for your inputs.

Choosing Costs to Reduce

The items contributing to your variable costs will vary in their significance to your operation.  All things being equal, we would focus on the biggest cost items as a (say) 10% cost saving there, will have a greater effect, than a 10% saving on a small item.

For example:

A 10% improvement on an input’s variable cost of $1,000 – times – its use in the production of 10,000 units = $1 million in savings.

Whereas a 10% saving on a $100 input and a production of 1,000 units is only $10,000.

In keeping with our 80/20 philosophy (see The Amazing 80/20 Rule article), we would look at our largest selling products multiplied by their largest variable costs and work on them first because the greatest improvement is likely to be obtained in high volume areas.

Over time, you can work your way down the list of smaller variable costs times smaller product sales but there will come a point where clearly it is not worth going much further – at least in an initial push for profit.  We suggest that this is somewhere near the bottom of the top 20% of production volume times variable costs point.

Investing more time in the remaining 80% of variable costs is likely to be a less than effective use of your time.

Substitutes

It may also be productive to see whether some of the existing resources that contribute to your variable costs are close substitutes for other products.

Over time, you may have found that you are obtaining very similar resources from different suppliers and these could be bulked up into one large order with commensurate potential for quantity discounts.  This will also help your inventory system as you will only need to stock one product instead of all the closely related ones.  In turn, this should make your inventory management more efficient.

Stretch Accounts Payable Period

You can save costs across the board by slowing down the rate at which you pay your various suppliers.

While this can get you a quick boost to your profit, it is only a short-term solution because you will be paying those bills eventually.  However, this can free up cash in the short-term in case you need it to rejig parts of your business. 

Reference

Good cashflow is the key to a healthy business and a major determinant of the rate at which you can grow. 

You can see a collection of cashflow related articles in the Cashflow menu.