Tuesday 13 December 2011

Effective Cost Management - Understand Your “Burn Rate” And Cost Base

Do you know how much you spend, and on what? Surprisingly, many often don’t. When they find out, it’s a shock. As long as the money has been coming in and the business has made a profit, they’ve been happy. Your “burn rate” is how much cash you need every month just to keep the business running in its current state after meeting costs of sales (i.e. what you need for the "other expenses", which for me includes depreciation).

Some costs are “fixed” (they don’t change depending on the level of business – rent, for example). Others are “floating” or “variable” (they rise and fall depending on business volumes). Ideally, a business needs as many costs as possible to be “floating” so that when times are slow, costs are low. One example of this is sales reps who are paid a low (or no) salary but make their money on commissions from sales. High sales mean high levels of commission (and high costs).

For an organisation with a high proportion of fixed costs, when times are good, profitability will be good because the bulk of costs are fixed. However, when times are bad, painful decisions have to be made.

An organisation with a high proportion of variable costs may see its profitability increase during hard times as its cost base will reduce significantly.

In reality, the nature of the business determines the proportion of fixed and floating costs. Where there is a higher proportion of fixed costs, you need to understand what can be reduced, by how much and how quickly without significantly impacting product or service and driving away paying customers. Simply making 10% of staff redundant across the board doesn’t necessarily do it if the ones that go are the ones that add value.

There are costs that add value and those that don’t. For example, sales people and customer service people add value because they make the sales and look after the customers who buy products/services. However, they may be the first in the “firing line” because they cost more. Understand which staff and departments add real value (cash) during hard times, and you know where to make headcount cuts.

One way of determining essential costs is to map the processes that result in products or services for which customers pay. See who and what is directly involved in the sourcing, production, delivery and collection of cash for these. Next, see who is peripheral, e.g. what IT, Admin, HR and legal/compliance support is needed for those directly involved. You will come up with a chain of those closest to and furthest from the action and those that add the most and least value.

The trick is to determine during the good times what you can cut without significantly impacting your cash flow. Have this plan ready for when times change.

I have spent more than half my life working in different world markets from the most developed to “emerging” economies. With more than 20 years in the world financial services industry running different service, operations and lending businesses, I started my own Performance Management Consultancy and work with individuals, small businesses, charities, quoted companies and academic institutions across the world. An international speaker, trainer, author and fund-raiser, I can be contacted by email . My website provides a full picture of my portfolio of services.

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