The Profit Leverage Effect Relating to Purchasing
The purchasing department is in a strong position to leverage cost savings into profit. The profit leverage effect dictates that reducing operating expenses is more efficient than increasing sales. Situated at the beginning of the production process of a product or service, the procurement stage is in an excellent position to reduce overall costs, especially in the short term. This is why companies often resort to reducing headcount when they run into financial difficulties. Reducing operating costs is the fastest way to produce a short-term impact on the bottom line.
With this in mind, let’s talk about purchasing’s profit leverage effect. The following example will display how every dollar saved in purchasing goes directly to the bottom line, and it does so in a way that is more efficient that it would be through increased sales.
Your sales are $120,000 and your cost of goods sold (COGS) are $60,000. Within your COGS is your cost of purchased goods, which is 75% of your COGS ($45,000). Let’s say you reduce your cost of purchased goods through a combination of supplier relations and negotiations by 10%, you would save $4,500. Your cost of purchased goods is now $40,500. Your COGS are now $55,500.
Reducing costs of goods sold decreases your COGS from 50% to 46.25% of sales. Your operating income (net profit) therefor increases by the same amount. Let’s say operating income was $25,000 or 21% of sales, after the 10% of purchasing cost savings, net profit increased by 18% to $$29,736. That’s pretty good!
Now let’s look at what the sales department would have to do to achieve a comparable increase in net profit. To calculate how many more sales dollars would have to be generated we divide the needed additional profits ($4,500) by the operating profit margin (21%). The sales department will therefore have to sell an additional $21,428.57 worth of your product or service, which is the equivalent of increasing sales by 15%. And that does not factor in the marketing costs associated with increasing sales.
Which is easier? Decreasing the cost of purchasing by 10% or increasing sales by 15%? For most companies, that large of an increase in sales with no increase in advertising spend would be an incredible challenge, especially in the short run. On the other hand, reducing the cost of purchases by 10% is very attainable for organizations who have not traditionally managed purchasing as a strategic function.
Key Takeaway: every dollar saved through purchasing goes straight to the bottom line. By contrast, only 21% of sales goes to the bottom line, the remainder is consumed by the costs associated with doing business.