What is expense analysis? A hidden goldmine that impacts your bottom line
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Companies are often fixated on top-line growth in pursuing corporate success. They often explore avenues to diversify revenue streams, lure customers to buy products, and experiment with product mix to gain larger market share.
Then, organizations will dissect and analyze the revenue and study customer behavior by piling up gigabytes of data and deploying robust data analytics tools.
Generating and growing revenue is great, but what matters most is the bottom line.
In my experience, companies tend to neglect other elements impacting the bottom line. Most companies don't realize this until they are in financial distress, a recession hits, or a natural disaster occurs.
Then, they resort to cost savings strategies. The easiest of all cost optimizations is to let their talent go and reduce staff costs. After that, they begin analyzing other expenses line-by-line to find cost-saving opportunities.
I saw that happen when COVID-19 hit, and the multi-billion-dollar cash-rich company didn’t implement cost optimization strategies until revenue dried down, and saving costs was the only way to weather the storm. This made me ponder why a line-by-line expense analysis wasn’t performed when the business was thriving with an ever-growing top line?
Let’s come to the fundamental questions:
- Why is it important to review and analyze costs and expenses?
- How do you perform monthly/periodic expense analysis?
How to perform a line-by-line expense analysis
Expense analysis is only a quarter of the battle won. It's a five-step process to implement a cost optimization strategy:
- Line-by-line expense analysis
- Investigate the root cause
- Improve and implement processes
- Leverage technology to automate/streamline processes
- Continuous improvement by tracking the effectiveness of changes
In the following steps, we’ll analyze major expense lines on the income statement. You’ll appreciate the application of the five steps weaved into the discussion, where applicable.
Let’s dive in, starting with the cost of goods sold (COGS).
1. Product/service level COGS analysis
- Break down COGS by each product or service category.
- Calculate the percentage of total revenue represented by COGS for each category.
- Identify products or services with high or increasing COGS as a percentage of revenue.
- Best practice is to benchmark the percentages with the industry.
- Assess where you stand as compared to the industry.
- If percentages are higher than the industry average, explore avenues to reduce cost through vendor negotiations, searching for alternative suppliers, and eliminating waste.
2. Gross margin analysis
- Gross margin analysis can identify the percentage of COGS to the revenue generated for each product.
- Calculate the gross margin for the overall business and individual product lines.
- Analyze gross margin trends over time. Is it improving or deteriorating?
- If deteriorating, find out the root causes and address them. This might even lead to strategic decisions to discontinue a product(s).
- Identify the impact of changes in production costs, materials, or supplier relationships on gross margin.
3. Inventory management
- Analyze inventory turnover rates and carrying costs.
- Assess whether excess inventory or stockouts are impacting COGS.
- Optimize inventory levels to reduce carrying costs.
- Calculate days inventory outstanding (DIO) by measuring the average number of days it takes to sell inventory. A lower DIO indicates a faster inventory turnover.
- Implement techniques to reduce inventory holding period. For instance, Toyota’s just-in-time (JIT) inventory management is a proven technique to reduce inventory. However, the effectiveness of JIT is highly dependent on the efficiency of the supply chain and vendor performance.
4. Production efficiency
- Evaluate production processes and efficiencies.
- Identify bottlenecks or areas where production can be streamlined to reduce costs.
- Monitor production waste and scrap rates.
- Use cost accounting methods to allocate costs to specific products or processes.
- Adopt lean manufacturing principles to eliminate waste and streamline processes.
- Identify and eliminate non-value-added activities that don't contribute to the final product.
- Implement robust quality control processes to minimize defects and rework. Address root causes of defects to prevent recurring issues and associated costs.
5. Fixed vs. variable expenses
- Analyze the behavior of variable expenses in relation to revenue changes.
- Differentiate between fixed and variable expenses.
- Conduct a break-even analysis to determine the production level at which total revenue equals total costs. Identify the contribution margin (selling price minus variable cost per unit) to assess the profitability of each unit.
- Perform sensitivity analysis by assessing how changes in production levels impact fixed and variable costs. Identify the point at which certain costs become variable due to changes in production.
- Assess the flexibility of fixed expenses and explore opportunities for cost reduction. This can be achieved once a line-by-line expense analysis of other operating expenses (OPEX) is completed.
6. Employee productivity
- Evaluate metrics, such as revenue per employee or sales per employee.
- Assess the impact of changes in headcount on production or sales output and OPEX.
- Identify areas for workforce optimization or training.
- Assess the percentage of assigned tasks completed within the specified timeframe. Benchmark the results with the industry best practices to assess employee productivity and performance.
- Identify and track relevant key performance indicators (KPIs) that reflect employee performance. Examples include output per hour, sales targets, customer satisfaction scores, and error rates.
- Explore outsourcing options. Outsourcing certain functions can increase efficiency and reduce cost. However, be vigilant with the due diligence of outsourcing partners to ensure performance is in line with expectations.
7. Expense category breakdown
- Break down OPEX into various expense categories (e.g., salaries, marketing, rent, utilities).
- Calculate the percentage of total revenue represented by each expense category.
- Identify expense categories with significant or increasing percentages.
- Compare actual expenses to budgeted or historical expenses. Analyze variances and understand the reasons behind them. Determine whether expenses are in line with expectations.
- Once you have completed the expense category breakdown, the following steps will help perform line-by-line analysis of major expenses.
8. Marketing and advertising ROI
- Analyze marketing and advertising expenses to revenue generated.
- Calculate the return on investment (ROI) for marketing campaigns.
- Adjust marketing strategies based on cost-effectiveness.
- Clearly define the goals of your marketing and advertising campaigns, whether it's brand awareness, lead generation, sales, or customer retention.
- Establish specific KPIs aligned with your objectives (e.g., website visits, conversion rates, customer acquisition cost).
- Calculate ROI using the formula: ROI = (Net Profit / Cost of Campaign) x 100.
9. Lease and rental analysis
- Review lease agreements and rental contracts.
- Assess the cost of leasehold space and its impact on OPEX.
- Explore renegotiation options or location optimization.
- Create a comprehensive inventory of all leased assets, including real estate, equipment, and vehicles.
- Classify leases based on their importance and impact on business operations.
- Conduct a cost-benefit analysis for each lease to evaluate its contribution to business operations. Compare the benefits derived from leased assets against the associated costs.
- Evaluate using office and warehouse space to make sure it aligns with business needs. Consider adopting flexible work arrangements to optimize office space usage.
10. Energy and utility efficiency
- Evaluate energy and utility consumption and costs.
- Identify energy-saving opportunities and cost-reduction initiatives.
- Implement sustainability practices to reduce environmental impact and costs.
- Perform energy audits or use energy management software to analyze usage patterns.
- Upgrade to energy-efficient lighting technologies (LEDs). Implement motion sensors and timers to control lighting usage.
- Plan and budget capital expenditure to replace outdated equipment at the end of useful life with Energy Star-rated or energy-efficient alternatives.
- Conduct a life-cycle cost analysis to evaluate cost-effectiveness.
11. Technology and IT expenses
- Assess the cost of technology infrastructure and IT services.
- Ensure technology investments align with business needs and provide a positive ROI.
- Explore opportunities for technology consolidation or optimization.
- Negotiate current recurring IT services contracts or explore options for cost-effective alternatives.
- Assess cost-benefit analysis of in-house server rooms versus third-party cloud services. Make sure that due diligence is performed on third parties' data security and privacy policies.
You may be overwhelmed with the work and resources all these initiatives require. Here are two suggestions to relieve you of intimidation.
First, if you closely review the above initiatives, you will realize that you may not need to perform all the analysis monthly. You can schedule them on a cyclical basis. Even some of the analyses can be carried out annually.
Second, you can automate most of these analyses, if not all, by leveraging technology. Technological advancements offer a cost-effective solution to almost everything that doesn’t cost you an arm and a leg.
For instance, Ramp’s Accounts Payable solution or Expense Management software promises to seamlessly eliminate manual work and automate invoice processing and expense management.
In summary, while companies usually focus on revenue and top line, they often overlook managing and analyzing their expenses effectively. This becomes a problem when tough times hit, or unexpected events occur. Learning from experiences during the COVID-19 pandemic, it's clear that understanding and controlling expenses is imperative even when things are going well. Act now! Before it is too late, and laying off your talent seems the only immediate way to save costs.
The five-step plan we've discussed provides a practical way for companies to optimize their costs. By carefully looking at different expense categories, businesses can optimize cost and work more efficiently.
Don't let the thought of all this analysis overwhelm you. You don't need to do it all every month. Some things can be done less often. Plus, technology and automation can be a big help. Leverage and deploy technology and you'll be glad you did in the long-term.
Maximize your bottom line with Ramp's effortless expense management
Ramp revolutionizes expense analysis with its automated expense management software, integrated seamlessly with your corporate cards, reimbursements, invoices, and more. Ramp empowers your team to control spending proactively, with policies built into employee cards, and custom workflows for budget approvals. Ramp's user-friendly platform eliminates traditional expense reports, automates receipt matching, and ensures compliance with real-time monitoring and AI-powered insights.
By providing instant visibility into every transaction and uncovering cost-saving opportunities, Ramp transforms your expense management into a strategic tool for financial optimization, making it essential for any growing business.