Keeping COGS variable to sales is the second biggest problem in business, starting with direct labor.
This past week, I was helping a client in Evanston, Wyoming, manage a job because they had more work going on than they had management to help deliver the work. The good news for the client is they are not having to fight the number one problem in business—new sales. As of this post, they have more sales than they can deliver as currently staffed.
This experience served as an absolute reminder of the second most significant challenge in business—the crucial task of maintaining the Cost of Goods Sold (COGS) in line with sales—particularly as it relates to direct labor. For any business with fluctuating sales volumes, this is a discipline that can make or break their financial stability. It’s a delicate balance, sending people home when sales dip to ensure it stays within the targeted percent of sales range, or not, and making less money 100% of the time.
Academics will tell you that maintaining COGS variable to sales is a complex task, largely due to the influence of external factors. Fluctuations in raw material prices, unexpected supply chain disruptions, and high inventory levels can all conspire to negatively impact COGS’s variability to sales, making it a challenging puzzle to solve.
Most consultants will tell you that production inefficiencies, such as unproductive workflow processes that need to be redesigned because of material waste and rework, raise COGS without correspondingly raising sales. The smart ones will identify fixed costs buried in COGS, like depreciation or admin salaries, that are being reported in COGS, thus overrepresenting COGS and underrepresenting overhead.
What doesn’t get enough attention is the difficulty of sending direct labor home without pay when sales are down. My client had hired a local crew of Hispanics from Mexico and Nicaragua to help demo a bridge. They were a solid group of workers who helped us do the work my client had been contracted to do. The problem was the next step in the workflow involved a subcontractor who delayed the project two weeks by not making themselves unavailable at the last minute.
The management implication was does my client choose to create busy work for this immigrant crew, so he has them in two weeks when he needs them or lay them off? He chose to lay them off and risk their not being available when needed because the sales weren’t there to cover their payroll costs.
My client made the difficult choice to let them go even though he knew they were in high need of the money the job paid them. The fear of the unknown in their faces on where they were going to get their next paycheck broke my heart. They were hard workers who wanted to do good work, yet in this situation, the work wasn’t there.
Unfortunately, most of our elected officials would have my client keep paying them out of his own pocket even though the sales weren’t there to cover their payroll expenses. They believe they deserve the paycheck regardless of its impact on profitability. Because most of these overpaid “public servants” never had to sweat generating sales at a profit, they don’t understand that the fastest way to lose money is to allow variable costs to become fixed costs.
Every time a business owner creates busy work that is nonrevenue-generating, they turn a variable cost into a fixed cost that must be covered by future sales. You protect yourself by ensuring direct costs vary with gross sales. The failure of a “variable expense” to decrease by a similar percentage or less when sales decrease is an operations management failure.
The result is cash outflows exceed cash inflows 100% of the time. Correct this by monitoring your actual COGS relative to your planned COGS as a percent of sales. When they become out-of-balance, you have an area of profit loss to fix.
The first step to protecting your bottom-line and thus your employees further is accurate financial statements. If you don’t trust your financial statements to be accurate, click here for a “free” assessment of your chart of accounts from a certified BusinessCPR™ Business Scientist. They will review your P&L Statement and Balance Sheet to see what they reveal about your business.
