I posted a blog a couple of weeks ago about the late Brian Warnes and his brilliant concept of Dynamic Budgeting. He also introduced me to the 5-Line P&L, again a brilliant and simple concept.
During a recent one-to-one mentoring session with one of the members of my Vistage CEO peer group, we were discussing some instances of indifferent performance of their supply chain and it occurred to me that Brian’s 5-Line P&L might supply some form of solution.
If we analyse the P&L, Sales comprises Volume and Price and Cost of Sales is Labour and Materials. This applies largely to a manufacturing businesses, of course.
We should always be aiming to increase the gross margin, the true income of the business so for a start let’s see how this can be achieved. Sales as we said comprises volume of product sold together with price.
Volume can and indeed should be affected by our sales and marketing procedures but can be seriously affected by competition.
Please mote; competition is NOT restricted to price.
There are many reasons why customers buy from us and price is frequently number 4 or 5 on the list below the product itself, quality, service and so on.
We do, however have control over the price for the product and on the basis of getting the basics right for a start, we should be able to increase prices. Vistage speaker Malcolm Smith, for example, runs an excellent session called “It’s Not About The Price”.
If then we consider the cost of sales it usually comprises labour and materials with an adjustment, if required, for stock.
If we can’t or don’t want to reduce the labour cost, the spotlight falls inevitably on the materials component.
As a side issue it is interesting to do the 1% test on your 5-Line P&L because we don't always realise that tiny incremental changes can have a significant effect overall. For example if the objective is to increase the gross margin, then we can increase sales, either by more volume or increased prices. Do this by 1% which automatically increases cost of sales by 1% with fixed costs remaining the same.
If we then reduce costs by 1% and recalculate, just take a look at the effect on the net profit. One of my members did the same exercise at 2% and he was astonished to find that it doubled the net profit. Remember that even a 2% change should be relatively easy to achieve with a little imagination.
If we increase prices then the increase goes straight to the bottom line. If we decrease the cost of sales, then the same applies so it seems sensible to concentrate on both of these factors.
Taking the cost of sales component, the part that needs to be considered is the materials costs.
My member discovered that the purchasing team, once they settled on a supplier then a certain amount of complacency set in and there was little examination as to how they could reduce the purchase costs other than by negotiation with one supplier.
There was some reluctance to look for alternative suppliers which immediately raised concerns as to why this was the case. For example, was it laziness or something more sinister?
He took the decision to insist with purchasing that for major supplies defined using Pareto Analysis (80% of all purchases result from 20% of suppliers) they were able to identify precisely where competition could be introduced.
The upshot of the exercise resulted in an overall 8% reduction in purchasing costs and a more active, competitive and responsive supply chain.
This is all very simple and I would be surprised if you are not working this yourself. The question is: how effective is your purchasing and what could be achieved with a little more analytical activity and imagination?
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