The worst thing you can do is to try to reduce your costs, without conducting a proper cost analysis.
Sometimes the analysis of the cash flow impact of doing things a cheaper way, show that in the short term, this will damage your business and lead to an overall increase in your costs.
That’s why it is so important to do a cash analysis or net cash impact of changing the way you are currently doing things.
Cheaper Options, Cost reduction.
One of the most common ways your business can fall foul of this, is when choosing a cheaper option. This may be in a bid to save money.. For example, trying to save money on your delivery costs by switching to a new raw material supplier. When looking at alternatives, it is important to also consider what will be the overall impact on the business? Undertaking a proper cost analysis, will mean looking at both the profit and cash impact of a savings idea.
For example, if you are to change to a new delivery service, will this impact on how long it takes you to supply your customers? Can we consider this a saving when in fact, the extra cash required to implement this option will increase. Your profit line will go up, but your cash will reduce.
All that Glitters is not Gold
Confused! Well let’s look at an example. In fact, I recently came across this dilemma with a small business I worked with. This business was thinking of switching to shipping their raw materials in from abroad, rather than using air freight. They were dazzled by the promise of a reduction in costs. due to changing their delivery method. The costs of shipping by sea freight were estimated to be only 10% of the costs of air freight.
Given they spend around £15,000 a month on air freight, this reduction of £13,500 a month was tempting. It felt like a done deal.
However, let’s consider now the impact on the business stock levels .A more thorough cost analysis exercise uses cost benefit analysis and looks at both the impact on profit as well as cash.
Stock is a Hidden Cost
By switching to sea freight, the time it takes from placing an order to delivery back here in the UK, would increase by at least 8 weeks. The Supplier was based overseas.
The current level of stock that the company holds is around £100,000. Their current stock holding equated to holding 4 weeks of stock. It currently takes around 4 weeks from placing an order, to receiving the goods by air. Moving to Sea freight would take 12 weeks, an additional 8 weeks.
If the time it takes you to order and receive your goods increases, this means you will need to hold more stock. Simplistically speaking, this company was holding the equivalent of £25,000 of stock per week of lead time.. So, increasing the lead time would mean that instead of holding 4 weeks they would need to hold 12 weeks of stock, to avoid running out of stock. The increase of stock required would be £200,000.
This company, to reduce their monthly costs by £13,500 would need an investment in stock of £200,000. Or put another way, it would take £200,000/£13,500 which is nearly 15 months to pay back on the initial lump sum investment in stock.
Most of the companies I know are cash flow sensitive. Unless you have a very healthy pot of reserves to fund this investment, now will not be the right time to take this initiative forward.
The principle of measuring the cash impact on changing the way you do things, also applies to your choice of customers.
You may be considering your options around increasing the amount of credit you give to a customer. In order to win a contract, a customer may require an extended period of credit. This is particularly prevalent when dealing with government owned industries or larger customers. The increased certainty (reduced risk) with dealing with these types of customer, must be weighed against the impact on cash flow to the business.
Increasing your credit terms to your customers should really only be entered into when the business has a healthy cash reserve.
Alternatively, invoice discounting or factoring may help. This will help to negate the impact of having to wait extra time for the cash to arrive in your bank account. But please heed some of the pitfalls of this type of financing, which i cover in a previous blog here. A strong plan for bridging the gap should be put in place before you agree to the extended terms.
Sometimes, this extended period of time is just not right for the business however big the contract sounds. Infact it may be the tipping point between growing but running out of cash.
Likewise, if you are thinking of switching to a cheaper supplier. This may result in having shorter payment terms or even having to pay upfront. Switching to a cheaper supplier may also impact on your overall delivery times.The suppliers lead time to supply you may be longer than your current supplier. If so, then we will have the whole impact on your stock levels again!
Consider the Balance sheet
Each proposal must be looked at in terms of the specifics of your business. Are you cash strapped or do you have a healthy pot of cash. If so, then you are ready to invest in your business for profit margin improvements.
The key consideration will be to see how the saving idea will impact on any of your balance sheet items. The balance sheet is the area most ‘hidden’ to you. Stock, Payables and Receivables are all balance sheet items. so any increase in these items will not show up on your Profit and Loss. Their impact is not on your profit but on your cash.
If you enjoyed this blog, please check out more practical finance tips on my blog page here