1.6 Tools: The Profit-Leverage Effect
One way to convince top managers that purchasing has a huge impact on the company's financial performance is to show them the numbers. In fact, a common saying at a leading company in the semiconductor industry is, "If you don't have the numbers, it's just your opinion." Demonstrating the profit-leverage and return-on-assets effects of purchasing gives you powerful numbers to communicate how purchasing affects your firm's bottom line.
The Profit-leverage Effect Defined
The profit-leverage effect translates the impact of purchasing cost savings to the sales equivalent required to have the same profit impact. A dollar saved in purchasing almost always has a greater impact on profit than a dollar increase in sales.
Why, you ask? Remember, only a small portion of each sales dollar makes it to the bottom line. The rest is spent on the costs of doing business—e.g., cost of goods sold, administrative, logistics, and marketing costs. These costs must be deducted from each sales dollar to determine its contribution to operating profit (aka, earnings before interest and taxes). By contrast, every dollar you save through purchasing goes straight to operating profit. Table 1-1 shows simplified financial statements
| Income Statement | Balance Sheet | |||
|---|---|---|---|---|
| Sales | 100,000,000 | Assets | ||
| - Cogs | 68,750,000 | Cash | 10,000,000 | |
| Gross Profit | 31,250,000 | + Accounts Receivable | 10,000,000 | |
| - Logistics | 5,000,000 | + Inventory | 10,000,000 | |
| - Sales & Administrative | 18,250,000 | Total Current Assets | 30,000,000 | |
| Total Operating Profit | 8,000,000 | + Fixed Asets | 20,000,000 | |
| - Interest and Taxes | 3,000,000 | Total Assets | 50,000,000 | |
| Net Income | 5,000,000 | |||
| Liabilities | ||||
| Current Liabilities | 10,000,000 | |||
| + Long-term Debt | 20,000,000 | |||
| Total Liabilities | 30,000,000 | |||
Imagine you are starting an internship at the company in the table above and your mentor asks you to compare the impact of purchasing savings to the impact of a sales increase in terms of contribution to profits. Your best tool for doing the job would be the profit-leverage effect. Let's walk through the analysis:
Your operating profits are $8 million, on sales of $100 million, for an operating profit percentage of 8.0% ($8/$100). For every dollar that the company sells, eight cents goes to operating profit.1 As we noted above, a dollar saved in purchasing goes straight to the bottom line and is thus comparable to $12.50 in new sales ($1/$0.08 = $12.50). Sales impact and contribution to profits are something that management understands.
The Profit-leverage Effect Exemplified
Let's look at a specific example. If purchased goods account for 80% of your COGS, then your total cost of purchased goods is $55 million ($68.75 × .8=$55). Now, if you were able to reduce the cost of purchased goods by 10%—from $55 million to $49.5 million—what is the equivalent sales you would need to generate to have the same profit impact? Take a minute to run the numbers.
What did you get? If you said $68.75 million (i.e., 5.5/.08 or 5.5 × 12.50), you nailed it. Congratulations.
When you explain savings impact in this way, you get top management's attention. You need to be careful to position this as the "equivalent impact" as opposed to the "same impact as". It is not the same as selling $68.75 million more of product. Selling more helps a company gain market share, visibility, and growth. If you want to take a deeper look at how the profit-leverage effect works, watch the following video:
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