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 A measure of how many dollars of additional revenue are needed to have an equal profit impact as a dollar of cost reduction. 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. 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 Profit earned from core business operations (also called Earnings Before Interest & taxes, or EBIT). It is calculated as follows: Revenue – COGS – Operating Expenses – Depreciation/Amortization. (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 Assets | 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 this company 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. You naturally turn to 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, $.08 goes to operating profit1. 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/.08=$12.50). Sales impact and contribution to profits are something that management understands.
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? Answer: $68.75 million (i.e., 5.5/.08 or 5.5 × 12.50). 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" versus the "same 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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