Controlling expenses is necessary to improving your profitability and cash flow. Understanding your operating expenses is similar to watching a horse race.
In a horse race, all of the horses begin the race in the starting gates. Throughout the race, some horses will close in on the lead horse and may over take him, and some horses will fall behind. Every horse has a name. This makes it easy to differentiate between them. In your business, your most important horse is called Revenue.
To see how fast he is running, you can do a simple calculation. You subtract the current period’s revenue from the previous period’s revenue. After you have this number, you divide it by the previous period’s revenue. This will tell you how fast he is running.
Here is an example. Suppose your current annual revenue is $600,000 and last year’s revenue was $500,000. First you would subtract the current year from the previous year (600,000 – 500,000 = 100,000) then you divide this by the previous year’s number (100,000 / 500,000 = 0.20 or 20%). Revenue is running at a 20% annual growth rate. You can calculate this rate on a daily, monthly, quarterly, annually, or any other time period.
The other horses in the race are your operating expenses. You don’t want any of these expenses running faster than revenue. If revenue is running at 20% and your employee wage expense is running at 30%, it could eventually overtake revenue if you do nothing.
Each expense should run at a slower rate than revenue. If you want to widen the lead in the race, you increase the rate of revenue and at the same time decrease the rate of your expenses. In a recession, it is even more important to watch this race closely. If you don’t, you can find yourself out of the race.
If revenue declines at a 20% (negative 20%) rate and an expense is still increasing at 30%, it can quickly catch up to revenue and surpass it.
In a recession, expenses like wages, advertising, inventory purchases, office supplies, are usually the first expenses to be adjusted. Expenses like insurance, loan payments, and salaries, are more difficult to slow down. These expenses are fixed. They do not increase or decrease with the change in revenue. Having too many fixed expenses can inhibit your ability to make adjustments.
In an economic downturn with revenue declining and cash reserves falling, it is not prudent to sign long-term contracts with suppliers. I suggest negotiating agreements on a shorter time frame. This gives you more control.
If you find yourself short of money, a few calculations in a computer spreadsheet program can reveal which areas of your business are growing at a faster rate than revenue. The expenses with the highest growth rates and the largest dollar amounts are the ones you should focus on first. Your ability to manage expenses has a direct impact on your company’s profitability and cash flows.
by: Joseph Phelon