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Thursday, July 31, 2014

Study Finds Revenue Follows Cost Optimization

Enterprises routinely expect procurement and other departments to contribute to annual revenue targets even when business is slow or slumping. By improving operational efficiency, procurement managers can achieve significant savings and meet revenue targets.

In recent postings I examined consultant studies that show how important thinking outside the box is when it comes to key areas like cost management and supplier relationships. Innovation goes a long way toward improving financial returns.

Accounting

Image Credit: adamr, FreeDigitalPhotos.net

Yesterday, I cited a study by FTI Consulting of London, which affirms the sizeable returns in EBITDA that companies achieve by addressing non-labor costs, which accounted for more than two-thirds of revenue spending by medium and large enterprises in the report, which examined members of Europe’s FTSE 350 stock index. In this posting I will look closely at the numbers and FTI’s conclusions.

One point FTI makes is that in a global economy the need for “specialist knowledge, complex products and just-in-time delivery” means companies look beyond “their own organizations to meet customer demands.” Few if any companies are so vertically integrated that they operate without extensive and usually global supply chains. Consequently, FTI explains, labor costs have declined in the past 25 years to an average 12.9% of revenue from as much as 30-40% a generation ago. “Much of today’s non-labor cost base was previously internal headcount and direct costs,” FTI notes.

Bringing the non-labor cost base under control, FTI adds, “represents a greater opportunity … to make more meaningful improvements … to profits …”

This is a view that most finance leaders believe will prevail as shareholders reassess performance metrics. While 67% of finance leaders believe shareholders are more concerned about revenue rather than cost reduction as a way of gauging performance, 86% of finance leaders believe shareholders should focus on “profitability as a measure of underlying performance,” especially when low revenue growth is forecast.

In fact, as FTI’s data analysis shows, a 1% reduction in labor costs increased EBITDA by only 0.8% on average for the FTSE companies, while the same reduction in non-labor costs produced an average 3.6% increase.

FTI projects that the trend toward non-labor costs accounting for a higher percentage of revenue will continue, while labor costs will shrink.

Some industries, moreover, will realize higher-than-average savings by reducing non-labor costs. Enterprises cited by FTI include: construction materials, where a 1% reduction in non-labor costs yielded a 17.2% rise in EBITDA for the FTSE companies; chemicals and food and drug retailers, an 11% gain; general retailers, an 8.6% jump; and energy, a 6.7% increase.

Cost management, FTI concludes, should be the focus of revenue efforts, although procurement managers and others may need to show senior executives ways in which “profitability can be improved and sustained through cost optimization.”

“[T]he scale of the potential uplift in profitability from investing in better cost management … is substantial,” FTI writes. It also demonstrates the benefits of progressive thinking and best practices. Procurement departments, dealing as they do with supply networks, are well positioned to lead efforts in this area, and help enterprises rethink profitability and how best to achieve it.

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