Which Is Better: Reducing Costs or Increasing Sales?
Hint – It’s not what you think
Say you’re the CEO of a company with $100,000 to spend on generating more profits. You have two alternatives: Invest the money to achieve a 5 percent cost efficiency reduction or fund a sales initiative to raise revenue 10 percent.
While that latter appears to make the most sense, you’ll generate more profits by reducing costs first. Lowering your Costs of Goods Sold (COGS) before working on making more sales is exponentially better to improve your bottom line today and increase the long-term value of your business.
Here’s what I mean. Let’s say you spent the $100,000 in year one and got your COGS down from 65 percent to 60 percent. The benefits are not just for that one 12-month period, but for EVERY year moving forward. Once you have your operations as efficient as possible, then invest in generating more sales.
When you do, not only will your top line grow, but so will your total net income in absolute dollar terms and, perhaps more importantly, your margins: net income as a percentage of revenue.
Reducing costs is also valuable if you are planning to exit the business sometime in the future. Companies with higher profit margins are considered more attractive, generate interest from more buyers and ultimately sell for more money. Many private equity groups specifically call out a target net income percentage as part of their acquisition criteria.
Here’s an example. There are two companies in the same industry with the same revenue growth rate but different margins. Both have $2 million in net income. The first has 13 percent margins and the second has 17 percent margins. That means the first company has to generate $15.3 million in sales while the second business needed only to bring in $11.7 million to achieve the same net income.
Put it another way. To hit that $2 million mark, the first company had to perform 30 percent more activity. That’s a lot more headaches and overhead to get to the same place.
Moreover, buyers will gladly pay a higher dollar amount to acquire the second company should the business owner be interested in selling. Let’s pretend that the first company (the one making $15.3 million) can be sold for a “4.0X” multiple, or four times its earnings. It’s likely then that the second business could sell for “5.0X”. That’s a $2 million difference! I don’t know about you, but I could go for another couple of million in my pocket!
Most business owners tend to look at the problem of driving more value for their business through the revenue growth lens. Taking a cost reduction approach will uncover substantial, yet before unseen, equity for a company. Doing so empowers the owner to either negotiate a much more lucrative sale or, in many instances, reignite the passion they once had in the business. Sometimes the right economic choice is to keep what is now a more efficient and profitable business!
This is not to say that generating more sales isn’t important. It’s crucial, but not at the expense (pardon the pun) of ignoring your cost structure. Focus on that first, then transition to getting more business. Your bank account, investors and your wallet will thank you.
About The Author: Andy Peters is the Managing Partner at AAKEN Business Brokerage that helps small to mid-sized companies improve their operational performance to generate more profits and interest from potential buyers. He can reached at email@example.com.