Provided by My Own Business, Content Partner for the SME Toolkit
OBJECTIVE:
Your business growth will come about by not only making money but by carefully investing the cash produced by frugal spending. You will learn the importance of minimizing your expenses and how to achieve it.
Wealth accumulation is a matter of frugality
The Man Next Door
The greatest motivation for your being in business is to build wealth. This goal is not accomplished just by making money…it is also a result of not spending money. There is a famous study of the characteristics of wealth by researchers Thomas Stanley and William Danko in their book The Millionaire Next Door. It revealed that most people with high incomes fail to accumulate lasting wealth because they also live high lifestyles.
On the other hand, wealthy people generally have a high income and a frugal mindset. You may be surprised to learn that the unpretentious person in your neighborhood who drives the ten-year-old Chevy (“the man next door”) may be the only millionaire on the block. According to Stanley and Danko, the common characteristics of wealthy people include:
- They are frugal and live well below their means.
- They allocate their lives efficiently in ways conducive to making money.
- They value financial success more than showing off wealth.
- They were self-made men and women (not inherited wealth).
- They chose the right business to begin with.
Accomplishing wealth in business is also not just a matter of making money…it is also a matter of not spending money. Your business growth will come about by not only making money but by carefully investing the cash produced by frugal spending.
The power of compounding
Compounding has been called the eighth wonder of the world and the investor’s best friend. By definition, it happens when interest is added to principal so that the interest that has been added also earns interest. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount. The real power comes into play over time so it’s a good idea to start early. Its power is also based on the interest rate, or rate of return, which is earned.
Money you have put in or add to your business is called equity. How much you earn on each dollar you put in is called return on equity or ROE. Return on equity will vary from industry to industry. For example, the ROE of the top five companies in the railroads industry ranges from 15.5% to 12.2%.
Each year the money you save by being frugal will be invested in growing the business. The measurement of your success will then depend on how wisely you allocate your compounded earnings.
The value of the money you save
We can now place a dollar value on your frugality. Let’s assume you can cut out $10,000 of costs each year for the next ten years. Each year the $10,000 saved will be going into expanding the business. Your ROE is 15%. At the end of 10 years, the $10,000 you have saved each year will be worth:
$280,017 (Over a Quarter Million Dollars)
The Wal-Mart Model
Keeping cost low and discounting heavily.
Sam Walton grew up poor on a rural Missouri farm during the great depression of the 1930’s. He learned the value of money by growing up in poverty. In his stores, he gave people what they wanted by focusing on low selling prices.
Ranking number one in ratio of expenses-to-sales.
For decades, Wal-Mart has accomplished the lowest expenses to sales in their industry which enabled them to discount deeply. However, the huge savings that Wal-Mart has accomplished did not affect the product quality: savings were entirely focused on costs unrelated to product cost or quality. According to Sam, the two most important words he ever wrote were on the first Wal-Mart sign: “Satisfaction Guaranteed”.
Following the worldwide financial collapse of 2008, firms began cutting out expensive habits that had been built up over time. Cost savings were mandated and even as businesses began recovering, the savings continued to be enjoyed. Generous spending habits were permanently replaced by lower cost disciplines. For example, many firms replaced expensive travel budgets with online conferencing and have continued the practice.
While Wal-Mart provides a good example of successful frugality in the discount department store industry, any business in any industry can enjoy the same benefit that happens when costs are reduced: every dollar saved can be reinvested in the business and continue to grow on a compounded basis.
Share profits with your managers
Implementing incentive plans that are based on profit sharing can become a powerful tool in maintaining ongoing frugality and efficiencies because the plan will be consistent with the objective of cutting out unnecessary costs. To a profit-sharing manager, a penny saved means money in his or her pocket. And as long as the plan is implemented, the incentive to cut costs will remain intact. By sharing your profits with all your managers, you can be perceived as a partner and together you all can perform beyond your expectations.
Operating principles
Along with a deeply embedded spirit of frugality Wal-Mart also embedded these operating principles:
- Commit to your business
- Share your profits with all your associates
- Motivate your partners
- Communicate everything you possibly can to your partners
- Listen to everyone and get them talking
- Exceed your customer expectations
Frugality does not mean compromising quality
A warning: a misguided frugality program can lead to the diminishment of product quality and market share. Cost reduction of expenses should not be made at the expense of product or service quality. Over-zealous cost reduction programs can impact in product quality resulting in diminishing hard-earned reputations. Here are two examples:
- Toyota – Toyota experienced loss of market share when the emphasis on cost reduction spilled over to quality compromises that were even obvious to the customers. Even in luxury sedans, driver’s floor mats developed a hole at 25,000 miles while earlier models were still fine after 100,000 miles. Expense reduction programs must be limited to expenses that do not impact product quality or safety.
- See’s Candy – On the other hand, for decades, See’s has been an earnings powerhouse in the boxed candy industry by avoidance of any cost reduction efforts that could detract from the quality of their candy. Their secret of success lies in their trademarked logo: “Quality Without Compromise©.”
Other risks in cost-control plans
Deferred repairs and maintenance
Deferred maintenance is the practice of putting off maintenance activities such as repairs on property or machinery in order to cut costs. As a rule, an ongoing policy of deferred maintenance will result in higher costs, the breakdown of assets and even adversely affect health and safety. For example, following the 2010 oil spill in the Gulf of Mexico it became evident that safety and cost drives had clashed and that deferred repair was a “critical factor” in the incident.
When maintenance budgets are left in the hands of managers whose compensation is based on earnings, there could be a temptation to defer maintenance in order to increase earnings. A remedy could be mandating a maintenance budget each year based on past experience.
Inadequate product development and research (Research and Development: R & D)
In businesses with fast changing technology, research and new product development is a necessary cost of doing business. Your larger competitors will disclose their research budgets as a percentage of sales in their published annual reports. Once again, managers on income-based incentives could be tempted to underfund development and research. As with deferred maintenance, a solution could be mandating the R & D budget. In cases where a pilot plant is required to prove out a concept, care must be taken to patiently take the time and expense to fully make an evaluation.
Ways to accomplish ongoing frugality goals
Create profit sharing incentives
Profits are diminished by expenses. So if you pay incentive compensation to your managers based on earnings you will create a powerful group of partners who will have a direct incentive to reduce costs. Basically, you will be paying bonuses to your managers in return for the value they provide to the company by cutting costs….with the result of the greater overall success of the company.
Practical cost saving ideas
Most all businesses readily claim that they’re already operating at the lowest possible level of costs. But the truth according to cost containment expert Max Friar of Alliance Cost Containment is that every company is bleeding profits through a thousand little cuts. And most companies are spending 15-30% more on indirect operating costs than necessary. While it is easy to focus on high-dollar costs such as healthcare insurance, few managers are watching the pennies. Here are some opportunities Mr. Friar points out:
- Corporate Purchasing Cards. Why permit staff to buy items at full retail from multiple vendors rather than getting volume discounts by shopping through designated suppliers?
- Utilities. Your electric utility can provide an energy audit and give you a long list of conservation tools.
- Association Discounts. Your industry association may offer group purchasing discounts your company could take advantage of including fleet services, insurance, workers compensation premiums and many other opportunities.
- Travel and entertainment. If you don’t have a per diem allowance when not entertaining, you are probably paying more to feed the staff than you need to. Are employees directed to specific hotel groups to capture bonus points?
- Supplier Consolidation. Set a goal of reducing your suppliers by 5% next year and pay bonuses to employees who figure a way to do it. This results in better pricing through higher volume.
- Parcel Shipping. Are packages sent via overnight delivery qualified to go 2nd-day delivery? Are you using multiple shipping vendors and missing out on volume discounts? A few policy controls and supervision can pay back big dividends.
Build an image of austerity
During the economic depression starting in 2008, chief executives found their firms could function perfectly well with lower levels of spending on travel, supplies, and office space. But over time abuses can creep back in. The ongoing challenge is to adhere to tight budget disciplines and not allow expense from creeping back.
To truly accomplish the credential “Number 1 in your industry for lowest ratio of expenses-to-sales” you must also lead by example and operate in a truly modest mode. For example,
- Operate in modest, unpretentious premises
- Drive mid-size not luxury cars
- Everyone flies cabin class
- Replace travel expenses with video and Web conferencing
- Do not delegate authority for capital expenditures
- Limit authority on operating expenses
- Require travel expenses to be reported monthly rather than quarterly
Top Ten Do’s and Don’ts
THE TOP TEN DO’S
- Live well below your means.
- Value success more than showing off.
- Invest compounded savings to build wealth.
- Create profit center incentives.
- Replace travel by use of online conferencing.
- Share profits with your managers.
- Strive for the lowest cost in your industry.
- Maintain ongoing focus on frugality.
- Treat your managers as partners.
- Build an image of austerity.
THE TOP TEN DON’TS
- Live beyond your means.
- Compromise your product to cut cost.
- Defer repairs and maintenance.
- Delegate authority for capital expenditures.
- Locate your business in expensive premises.
- Ignore the power of compounded savings.
- Drive a luxury car and fly first class.
- Be secretive with your employees.
- Allow abuses of expenses to creep back into your austerity plan.
- Compromise on research and development.
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