Cost Drivers in Small Business
The textbook answer defines cost drivers as those factors that determine the overall cost of operations. As an example, in manufacturing the cost drivers may be processing time or number of steps to produce the product. With service, the cost drivers could be the actual ratio of billable to non-billable time. Or it may simply be the actual compensation package cost for labor. The key is that this cost driver is used to allocate the general overhead and administration costs through Activity Based Costing (ABC Costing).
But this article isn’t about the textbook answer; it’s about understanding what drives costs in the small business world. Sometimes it ends up being the textbook answer, but most often it is some common denominator with the company that prohibits greater profits. I’ll give you a simple real life example.
Ray’s Auto Repair
Back in the 90’s I had a client named Ray. His wife ran the office of the auto repair shop. He had four bays and four mechanics and was open five days a week. At the end of each month they barely made enough money to survive. He asked me why he’s not making more money. His labor rate matched the competition and he had plenty of work. After several years of going there and interacting with him and his wife it really wasn’t hard to figure out. Sometimes the obvious is ignored.
First, he didn’t have enough bays to process the volume of work necessary to generate enough gross profit to cover his general operating costs. Why do you think Firestone and Goodyear facilities have no less than 10 bays? In addition they are open seven days a week.
A common discussion issue with my visits related to the inability of the mechanics to get the work done quickly. It was always the same issue, lack of experience or training.
Here in this small business, what drove the cost up as a percentage of revenue were these two cost drivers. This is what I mean by cost drivers in the real world of small business.
To understand cost drivers I’m going to first explain the relationship of cost drivers to profit. Next I’ll attempt to teach you how to evaluate your business and identify the cost drivers. Finally an economic lesson in controlling cost drivers to enhance profits is illustrated.
Cost Drivers and the Impact on Profit
The key to cost drivers is understanding their relationship to profitability. Always look at cost drivers in the here and now and not in the ideal world. The reason for this is because as you determine the current cost driver and then control this cost driver, a new one will take over and you’ll have to begin the process all over again. Basically it is an ongoing never ending process for continuous improvement. You don’t need to do this every day, but it should be a part of an annual self-evaluation.
Allow me to illustrate this relationship in a simple business operation. Suppose you owned a hot dog stand. What do you think drives down profit? Notice I didn’t say what drives costs? This is because the term cost drivers is the industry term used but in reality it should be referred to as profit dampening or profit reducers. But I’ll stick to cost drivers because this is the universally accepted terminology. OK, back to the question, what drives down profit? For the novice businessman he’ll say it is the cost of food or maybe not enough revenue associated with the sale of the hot dog. Me, I would say weather! I know, you are asking the question, ‘How do you derive at weather as the cost driver?’ Allow me to explain.
Let’s suppose you have the perfect spot for the hot dog cart. You are right outside the courthouse and there is a lot of activity in and out of the courthouse every business day. This is the perfect setting for a hot dog cart. If this is true, then you’ll have opportunity to be open about 220 days a year. Unless this courthouse is located in Arizona, I think you have a weather issue. Obviously, weather will reduce the volume of sales and ultimately the profitability of your hot dog cart. My first inkling as a cost driver would be weather for this type of business. My next cost driver might be a lack of margin between the revenue and the cost of the hot dog. Another might be the inability of the preparer to process enough dogs during the lunch rush period. If you have a line of six to seven people long every day at lunch time, a lot of customers will avoid your stand and head over to the next one. Processing of food could be a revenue reducer and ultimately drive down profitability; with production, the term ‘Throughput‘ is used to explain this cost driver.
Now let’s go to the larger industries and look at their cost drivers. With construction it is often lack of capital. In technology service, a cost driver (profit reducer) is most commonly lack of education or training for the technicians. In professional services, typically experience enhances profit so the cost driver in this industry is lack of experience within the professional staff. With retail, the most common cost driver is the lack of volume in sales driven by lack of customers. In effect, competition is constantly reallocating market share. With food service, price competition is the primary cost driver for profit. Think about it, you have to sell a lot of $1 burgers in order to make a real profit with your fast food restaurant.
How much do you think weather impacts a hot dog stand? Let’s figure this out. For the sake of calculating this, let’s suppose the stand sells 150 dogs a day at $2.00 for one and $3.50 for two. Overall, the stand generates around $120 per day of profit. Assuming it rains 75 days out of the year let’s figure out how much profit is lost. First step, calculate the percentage of days that it rains. Answer: 75 divided by 365 equals .2055. Next, determine the number of operating days that will be rained out. Answer: multiply the percentage of rain days by the number of available days which equals .2055 times 220 or 45 days. Finally, multiple the number of rain days times the lost profit per day and we get 45 days times $120 per day which equals $5,400. Overall, weather affects profitability to the tune of $5,400.
Remember when I started out that I said your novice businessman would go with cost of the food or lack of margin over the cost of the food? Well, let’s see if this has a greater bearing on the profit than the weather. Assume the cost of the hot dogs and buns increased 15 cents per serving; what is the daily impact on overall profit? Since we sell 150 dogs per day, the overall cost increase equals 150 times 15 cents which equals $22.50 every day of sales. Since we only have 175 days of sales (remember the weather equation), our total annual lost profit is $3,940. Notice how much more the weather affects our profit than the large increase in the cost per serving of the hog dog?
What about changing the price matrix? OK, let’s just go with $2 per hot dog and no discount to buy 2 at a time. Alright, the first issue is that of the 150 hot dogs we sell; let’s say 50 are at the discounted price. If 50 are at the discounted price; that means 50 were sold at the regular price to add the 2nd discounted dog at the reduced price. Therefore, of the 150 dogs sold each day, 50 are at the regular price, 50 more are at the regular price with 50 at the discounted price. With this knowledge we now can see that only 50 dogs per day add another 50 cents each to our pool of cash. Therefore, we will increase our overall profit by $25 per day. Remember, there is only 175 days of operation. Therefore, profit would increase $4,375 per year if we increased our price by 50 cents for the second hot dog. However, I will argue that overall sales will decrease because many of the 2nd dog buyers are only buying the 2nd hot dog because of the discounted value. Without the discounted value, many of these customers will only purchase one hot dog. Based on my experience, I would be willing to bet that we will lose more money than the price increase will offset.
Often, business owners fail to see the real cost drivers in the operation. There is a direct correlation between the profit and the cost driver in every business. As the business owner you need to be able to evaluate cost drivers and then arrange a plan to minimize the cost driver’s impact.
Evaluating Your Cost Drivers
Now that you understand the relationship between the cost drivers and the bottom line, you want to evaluate your own business operation. How do you do this? Quite honestly, each industry is different and it really requires the owner to process the information. I generally start with the outside factors that are difficult to control from the business perspective. Some of the external forces that impact business include the following:
- Governmental Regulation – if your business is strictly licensed and there are significant regulations governing your day to day operations; this could be a cost driver
- Acts of God – do you depend on acts of God to generate revenue? Will a single act of God greatly influence your ability to continue operations and what is the risk factor? A perfect example is farming or fishing; droughts or availability of resources will impact operations
- Access to Resources – do you have enough raw resources to conduct business across a vast spectrum of sales. A perfect example is opening a brewery in a remote location. Before he began construction, I asked the owner if he had access to enough water. He didn’t think about that and his well couldn’t provide enough water to operate the small brewery. It was a significant setback for him.
- Location, Location, Location
- Workforce – are there enough of the correct type of laborers for your business operation in the local area?
This is just a short list of external factors. Now you can look at your internal drivers to evaluate the cost driver or drivers that greatly impact the profitability of the company. Look at your income statement first and determine if there is adequate gross profit. If not, what is driving the cost up (cost of goods sold) or revenue down to impact the gross profit? How about the general and administrative expenses? Are certain costs greatly reducing the profitability of the company?
Example – Marketing and Advertising
The new car sales industry spends an incredible amount of dollars for advertising. The local dealerships are constantly bombarding the public with TV ads, junk mail, and inserts. On top of that, we get radio commercials and even trick letters. Then they use their marketing tricks at the lot to boot. For every dollar of revenue, they have one of the highest budgets for advertising. In their case, they also have a law of diminishing returns. They often spend large sums of money on campaigns that produce less revenue per advertising dollar. It’s easy to calculate but often not an objective model. For the dealership, other issues come into play for spending this money. Maybe there are too many cars in the inventory which costs interest via their floor plans (financing programs for the inventory) or maybe the servicing department lacks enough volume to turn adequate profits from that division.
Spending too much on advertising may not be a bad thing; it just depends on the situation at the dealership. But only the management team can figure this out, the financial reports only provide the necessary information to spawn the question.
Other financial reports can point to other issues. The balance sheet can lead us to ask about slow paying customers, inadequate capital, or maybe too many fixed assets to manage. The key is to look at the internal financial information and see if maybe a cost driver exists within the data.
Other areas to search for cost drivers include:
Operations – there may be bottlenecks with production or operating outside the range of production.
Throughput – go back to my hot dog cart example above; if you can’t move product fast enough, then you are losing out on opportunities to increase revenue and gross margins.
Personnel – are there personality conflicts with personnel or possible the wrong type of worker for your company, do you have a true understanding of the work environment?
Customers – there is a good chance you are selling to wrong customers. Does your niche match the customer?
The key to this whole exercise is to brain storm and create a list of possible cost drivers. From here, research these drivers and rank them from the one with the greatest impact on the profit to the least. Now that you have your list, it is time to control the cost driver and increase profits.
Controlling Cost Drivers
Now that you have your list, it is time to go about addressing the problem. Ideally, you will want to have as much knowledge about this as possible so start out by researching the cost driver. With knowledge come answers. I provided some insight to some issues on my site, but often you’ll need to ask others in your industry what or how they address these drivers. If you belong to a focus group, the members there will be glad to assist you. Most likely they have already dealt with the problem and can offer some good advice.
Remember, some drivers will take a lot of time to affect change while others may be easy to moderate or eliminate. Be reasonable and practical in implementing a solution. I have seen where the solution is worse than the original cost driver. This is where the old adage of ‘the medicine is worse than the disease’ comes into play.
And finally, don’t forget, there are some cost drivers you can do nothing about. Sometimes you have to accept them as a function of business and adjust your business model to alleviate the pain of this particular cost driver. If you having trouble or need some outside feedback, contact me via the comments section below and I’ll give you my thoughts.
Eliminating the Cost Driver – A Real Life Example
As promised, here is a real example that made a significant difference in this company’s overall situation.
A children’s services company had two divisions. One division provided mental health services and employed 120 staff. The second division employed 30 staff. The mental services division generated nearly 3 million dollars of revenue and a three quarter million dollar gross margin. The second division did a little over 2 million in sales and generated about half a million in gross margin. General overhead and operating costs ran just a little over a million per year and therefore, the company’s net profit ended up just under a quarter of a million.
The owner was working about 55 hours a week and under constant stress related to the mental health care issues. In the state they operated in, the law required a lot of documentation and constant training with staff. Suddenly the insurance companies that pay for the service rendered, dropped their hourly compensation by $10 per hour. On an annual basis, this reduced the revenue for the company by over $300,000. Yet the costs to conduct business didn’t change. I had already evaluated this division several times and even prior to the revenue reduction I was advocating termination. I explained to the owner that by eliminating the division the overall cost of operations for the company would drop more than the contribution margin this division generated. In effect, the company would make more profit. The sudden reduction in rates from the insurance companies was the final straw and the owner terminated the division. Yep, it took him 6 months to complete the termination as the law required him to transfer the cases or complete the cases on the books prior to termination. During this time, the company was successful in transferring over 80% of the division staff to other companies performing similar services.
About a year after the termination, the financials reported similar profits as in the past with $3 Million less revenue. In addition, the owner went from working 55 hours a week to working around 35 hours a week. His stress level dove where he actually smiled more often. There were a lot less issues to deal with and the work environment improved significantly. In this case, the cost driver was the actual service that was provided by the company. This service had an unusual level of compliance requirements and not enough revenue to fully cover the associated costs. Act on Knowledge.
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