Tuesday, January 3, 2012

Cost and Expense - How it can perform magic to the bottom line

CEOs and investors alike all wishes that their companies can grow its net profits yearly and of course the higher the profit growth the better it is. In this quest for higher profit, many always look for ways to grow the revenue through more marketing and advertising, acquisition of competitors, reduction of price to attract a larger customer base and e.t.c.

However, most people have in fact overlooked how a control in expenses can have a huge impact on the profit. Yes, as many have known the equation to calculate net profit is:

Net Profit = Total Revenue - Total Cost

But, the extent of increase in profit from a reduction in cost is not as simple as it seemed to be.
Refer to the following tables for an illustration:

For company with 5% Net Profit Margin
For company with 10% Net Profit Margin
For company with 20% Net Profit Margin

Using CIMB trade tool, of the 741 companies in SGX, 115 have net profit margin of more than 20%, 110 of them 10-20%, 131 of them 5-10% and remaining 385 with less than 5% margin.

From the above table, one can see that a 5% increase in revenue without any increase in cost can easily result in an increase of 25%-100% in profit. And another important point to note is that the impact of control in cost is being magnified the lower the profit margin of the company.

Of course, some will question that this is quite impossible given that a huge proportion of cost comes from raw material or inventory purchased. This brings me to the next 2 points:
  1. While it may be quite impossible to achieve a 5% revenue growth without any increase in cost, it is not impossible to expect a slightly lesser increase in cost compared to revenue. For a company with margin of 10%, a 5% rise in revenue and 4% increase in cost result in profit growth of 14% and this figure is 24% for a company with margin of 5%. This is possible through economies of scale like bulk purchase, a lower staff cost, depreciation and interest expense per unit, and more importantly the awareness of the management to control cost.

  2. It is possible though to achieve a growth in revenue at a minimum increase in cost for company providing a service instead of selling products. For these type of companies, the bulk of the cost is usually fixed cost and not variable cost as they are not working much from the inventory which often occupies most of the variable cost. For e.g. for a brokerage firm, a significant increase in trading volume will not result in much increase of cost as at most a few more people will be hired to handle the volume, but such cost will not be in proportion to the rise in revenue. This explained my preference for companies with similar cost structure.

In conclusion, cost is a very important variable in the profit equation that people might not have been concerned with. However, there is definitely a limit as to the extent that a company is able to grow its revenue infinitely. But, neither is it feasible for a company to be able to cut its cost forever. What i wish to emphasize then is that management should pay more attention to cost control. During a recession, there will always be news that company XXX will be exercising cost control through a retrenchment exercise or other methods like cutting down on sponsorship or advertising. In the first place, why can't a company keep itself lean right from the start to enjoy a fatter profit margin and higher cashflow?

1 comment :

  1. Hi, if you don't mind sharing, would appreciate how your numbers come about. Thx.