Reduce Operations Costs by 2% to Generate $100 Million Net Income

Using AutoZone as an example, eChain Technology illustrates the exponential impact that operational costs can have on a company’s net profit at the end of the fiscal year. With the exception of Wal-Mart, managing Costs of Operations (Cost of Revenue, Cost of Goods Sold) has not been as popular for US-based companies as growing Gross Revenues. But where else can a 2% improvement return a 16.6%, or $100 Million increase in Net Income? Illustrated below is a real-life example showing the significant impact that Operations Cost has on Net Income, and conversely, how a 2% INCREASE in Operations Cost requires a 20% increase in Sales to mitigate. Download PDF

It is time Corporate America to focus on reducing Operations Costs: An eChain Technology AutoZone Simulation for 2008

As a proponent and 12-plus year veteran of identifying, developing and implementing solutions and process that streamline the supply-chain and reduce operations costs, I have noticed that we have temporarily lost sight of the impact that those operations improvement efforts can actually have on a company of any size. Too often, we get caught up in piecemeal business solutions engagements, corporate firefighting, and a myriad of projects that start but never end, or projects that are terminated just prior to realization. These are too often projects with no overarching strategy or strategic vision that only bolster corporate silos and fiefdoms and the careers of a select few.

In our current economic climate, where costs are increasing for everyone including manufacturers and distributors, and where an estimated 100 shipping/logistics companies are going bankrupt each week, I believe it is time to refocus on the importance and impact that managing and reducing operations cost can have on a company. I used AutoZone financial information from Yahoo Finance for the purpose of illustrating the magnitude of the impact of operational savings for a representative US manufacturing/distribution/retail company. eChain is in no way affiliated with AutoZone, and this company is only used to realistically illustrate the profit scenarios below.

Results of Revenue Growth vs. Operational Costs Savings for AutoZone Pro Forma 2008

• Scenario 1: $17.5MM Net Income increase at status quo, 4% sales growth
• Scenario 2: $29.3MM Net Income increase by increasing sales 6%
• Scenario 3: $99.0MM Net Income increase by reducing costs of 2%
• Scenario 4: ($63.9)MM Decreased Net Income over 2007 if costs increase by 2%

* Income statement from finance.yahoo.com

Scenario 1: Status Quo, 4% Sales increase results in incremental 2.9% Net Income

The Status Quo scenario depicts what will happen at AutoZone in FY 2008 if the margins hold to their current trends and Total Revenue increases 4% in FY 2008 over FY 2007 as analysts predict. At 4% Revenue Growth and with no other significant changes, we expect AutoZone to realize a 2.9% increase in Net Income over 2007. The Status Quo scenario will produce Net Income of $613 MM, or $17.5 MM more Net Income than 2007.

The threat to the status quo scenario is the assumption that Cost of Revenue remains flat at 50% of Total Revenue, and that any resulting price increases due to the increased cost to procure, transport and warehouse inventory necessary to maintain the current Operating margin will not negatively affect sales.

Scenario 2: Increased Sales 6% results in an additional 4.9% Net Income

The most typical scenario to generate additional Net Income for US-based companies is to increase sales. Assume for simplicity the margins are the same as the Status Quo scenario (Scenario 1) and AutoZone is miraculously able to increase Total Revenue (without disproportionately increasing Sales expenses or discounting products) by 6% over 2007. The 6% Total Revenue increase will result in an incremental 4.9% increase in Net Income. For AutoZone, this translates to an additional $29.3 Million in Net Income over 2007.

The recurring mathematical theme is that for every percentage of increased sales (10% for example), established companies can anticipate roughly 0.75 to 0.80 percent increase in Net Income (8%) all other things being equal.

Scenario 3: 4% Sales Growth and REDUCED Costs 2% results in +16.6% N.I. (+$ 99.0 MM)

Now assume that AutoZone decided to initiate Operational cost cutting initiatives and streamline their Supply-Chain. They still expect to hit their 4% Total Revenue growth target as outlined in Scenario 1, but also succeed in reducing their Cost of Revenue by 2%. A 2% cost reduction is extremely conservative and could easily be accomplished in one year. Additionally, continued efforts to streamline operations and supply-chain could result in incremental savings over the next few years of 5 to 8 percent.

The 2% reduction in operations costs (cost of revenue) coupled with a 4% sales increase for 2008 would result in a shocking $99 Million in incremental Net Income! This is an increase in Net Income of 16.6% over 2007, and is 16.3% higher than the Status Quo Scenario 1.

Scenario 4: 4% Sales Growth and INCREASED Costs 2% results in -10.7% N.I. ($63.9 MM Decreased Net Income over 2007)

Scenario 4 is the Doomsday scenario. While the Status Quo Revenue targets were met by increasing sales revenue by 4% over 2007, costs increase by 2%. This situation is easily envisioned as we witness today rising materials costs, rising shipping costs, and rising storage costs. An even more realistic scenario would involve missing the sales target due to decreased consumer demand, and increased prices, but that would be unfairly extreme to model in order to prove the point.

In Scenario 4, AutoZone meets their Sales Revenue target of 4% for 2008, but has a $63.9 Million shortfall in Net Income due to a 2% increase in Costs of Revenue. This small increase in Cost of Goods Sold results in Net Income for 2008 being 10.7% less than 2007 Net Income, even after meeting the 2008 sales targets!

Perhaps more notably, AutoZone would need to increase Total Revenue 20% in 2008 to offset a 2% increase in Cost of Revenue.

Reducing Cost of Operations / Cost of Revenue / Cost of Goods Sold

There are many articles stating that projects and efforts to reduce Operations Costs do not work and that it is impossible to measure results from these initiatives. If Cost of Revenue represents 50% of Total Revenue for 3 consecutive years, and then drops to 48% of Total Revenue in the fourth year because of focused cost-reduction activities, then you have achieved costs savings as a percentage of Total Revenue. Yes, this is a simplistic view, but the point is that yes, Operational Cost improvements can be measured.

Operations Costs can be dissected into subcategories of business functions that can be benchmarked for underperformance and improvement opportunity. Many areas, metrics and variables within your company can be analyzed against best class benchmarks to easily determine a strategy of High-ROI and Low-Impact enhancements (low hanging fruit) that dramatically reduce costs and increase Net Income. The areas to explore include: logistics, procurement, service levels, SKU rationalization, inventory levels, inventory age, allowances for discounts and/or destruction of aged products, warehouse and storage costs, expedited transport, forecast error, inventory turns, etc.

Each Operations area can be analyzed, benchmarked, and ranked in terms of magnitude of improvement. Solutions and enhancements are then designed and estimated for the highest net benefit to cost ranking. Typically these solutions and enhancements can be self-funded, which means that the first initiative has such a high ROI that it pays not only for itself in a short amount of time, but also funds the subsequent enhancement efforts. Would you invest $100 if you knew you would get back $1,000 in one year? The magnitude of ROI that Operations and Supply-Chain optimization efforts deliver can easily be 10:1.

The key to realizing the ROI on Operations Cost reduction efforts is executive buy-in, passionate execution, and follow-through. It is not enough to simply implement another application, but to shepherd the total solution, business processes and applications, and facilitate unilateral adoption of the new solution across the organization. The true benefits are realized post go-live as the business begins to see the documented improvements provided by the new solutions, and then adopts and adapts to the updated capabilities provided by the new solution.

eChain Technology has a sample assessment link on eChaintechnology.com where you can download a nearly 100 page sample operational assessment to see our world-class approach and specific metrics and analysis that we deliver for our Strategic Operational Assessment.

About eChain Technology
eChain Technology (http://www.echaintechnology.com) enables companies to achieve world class performance through best practice business strategy hands-on expertise and technology solutions. We provide leadership and execution in many areas of the corporate enterprise that remove all excess waste and cost from your operations leaving you with seamless solutions providing flawless execution that provide a significant cost savings to you.

Mr. Lewis Kilby is a 20+ year business and solutions consultant and Managing Partner of eChain Technology. Email: lkilby@echaintechnology.com