You’ve heard the phrase: “We must cut costs!”
When the CFO or Financial Controller is yelling that, it means life is about to get unpleasant in the workplace for a while.
A common approach that companies take when looking to increase their financial efficiency, is to concentrate only on the operating costs. This is certainly one way of improving the financial position and it is the easiest in some situations.
However, it’s not the only way.
There is a simple but powerful financial equation that describes this process. It’s called the Return on Investment, here it is:
Return On Investment = (Gross Income – Operating Expenses)
The ROI tells you how attractive the business proposition looks. It is used to compare alternate options for the potential investment.
The top line (or numerator) is the net income. You can also state it as (Sales – Cost of Goods Sold).
The bottom line (or denominator) is the line of interest to this discussion. It’s the capital investment outlay made to create the infrastructure needed to generate the income.
It should be clear to most, that if you only reduce the “costs” (the operating expenses in this equation,) you’re missing the maximum effect on your business outcome. You still have the same denominator reducing the value of the net income numerator.
By reducing the original investment, you’re increasing the ROI yield.
“But we can’t change that, we’ve already spent it!”
That might be true, to an extent, but there’s two other points to consider:
- When deciding the amount of capital to be invested, ensure that the amount invested is limited to only that essential to achieve the required business performance outcome.
- When continuing to maintain or improve the necessary infrastructure, employing further sustaining capital, ensure that the changes generate value for the defined lifecycle of the asset you are improving.
When undertaking a capital investment (often in the form of a construction, or purchase project), the company must control the cost, the scope of work and the quality of the completed asset. Restricting scope to only that which is essential is critical, as it has a major impact on the overall cost. By ensuring quality of the design, construction and commissioning of the new asset, the company can be confident that the value provided by the new asset is maximised and as expected.
To address the argument that the capital has already been expended, let’s consider the lifecycle of the asset. Most assets employed in production businesses have medium to long term lifespans. This life might be, say five to fifteen years, or longer.
The longer the asset can remain in use, the more value it can generate for the business. Any asset will require maintenance during its life to manage the wear and tear of its use. You have to replace your car’s tyres when they wear out, so you’re already aware of such periodic costs.
Managing how the asset is used and maintained in its operational duties, is the science of asset management. It’s not just a ‘maintenance thing,’ it is a structured management approach to ensure value for the business, through a balanced approach.
Asset management considers the cost of maintenance, modification or renewal of the asset in relation to its production contribution. This is a critical and ongoing management function, for any capital-intensive business. It includes the continuous improvement approach, which aims to always improve on the results that we currently produce.
If you are about to make a capital investment in your business, take time to think about those two key points:
- Invest only what is essential to generate your targeted outcome. Be thorough in the planning and financial approval process. Focus on ‘needs’ of the business, not the ‘wants’ for stakeholders.
- When improving an in-service asset, consider the cost and the result, over the remaining lifecycle of that asset. Include the ongoing maintenance, production output volume and value, and replacement cost of the asset. Reliability becomes an important factor for older assets, as it usually decreases with age. This introduces risk to the business which may not be acceptable.
When looking to improve your financial efficiency, look for the ways how you can increase your ROI by addressing both Operating and Capital costs.
Are you looking to increase your profitability?
Within SER Solutions, Peter Crane and the team have spent over thirty years working with Tier One operating companies. They have assisted clients deliver efficient capital investments, reduce waste, improve performance, and increase investor confidence.
Armed with practical experience in engineering services, capital planning, project delivery, construction management and strategic asset management to the infrastructure and resources sectors, Peter offers a unique insight into operational roadblocks – and how to fix them.
If you are interested in learning more about effective business management and operational practices that will benefit the way you do business, why not schedule a discovery call with Peter and the team at SER Solutions today?