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profit margin by industry

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									Controlling Spend in an Improving Economy
By Brad Artery, Silver Oak Solutions

The U.S. economy added 144,000 non-farming jobs in August 2004, and the unemployment rate fell to 5.4%, the lowest level since October 20011. Many companies are now confronted by the positive challenges of hiring employees and insisting upon higher employee productivity. Does an improving economic situation mean that companies can now focus their assets on boosting sales and stop worrying about spending? Not really. Another look at the value and impact of spend management - regardless of the macro-economy - will ensure that corporations should continue to focus on understanding and managing their spending habits.

The Past 10 Years
From a business standpoint, the late 90’s are usually considered the “good times.” Most companies didn’t focus on spend management and cost-cutting because they simply didn’t need to do so. The bubble-burst of 2000 brought businesses back to reality. Decreasing sales, depressed stock valuations, and low consumer and investor confidence forced companies to look closely within as they sought to stay profitable. The response by many companies was to restructure by laying off employees and attempting to do more with less. Many companies were unable to do more with less and so perished. Others found ways to reduce costs and remain profitable despite the challenging economic times. While there is no clear-cut structure or formula to lead a company through a declining economy, there is a common theme: focus efforts on activities that will have the most impact on the bottom line.

The Aid to Survival
For many companies, a driving force behind their survival and profitability in the down economy was the implementation of strategic sourcing strategies. Strategic sourcing refers to the processes used in the planned purchasing of goods or services. While companies often made an attempt to understand and control their direct expenses (purchases used to manufacture an end product), they often overlooked the significance of understanding and controlling indirect expenses (purchases that support business activities). Companies had to understand where they were spending their money, by identifying the products and services purchased, and with whom they were spending their money, by identifying all their suppliers. In order to achieve this goal, companies exercised many options, including software tools, training, and/or the hiring of consultants. Once they understood their spending, companies were able to take action to create savings. Successful strategies were discovered and are now in place at many companies. Currently, companies put more contracts out for competitive bid and also leverage their consolidated purchasing volumes to receive preferred pricing. They have implemented spend analysis and contract compliance systems, ensuring better compliance with newly negotiated contracts. These and other new procurement practices mandated by the down economy have been successful for one primary reason: they affect the company’s bottom line.

Bottom Line Impact
The true benefit and differentiator of any cost savings measure is its effect on the bottom line. Every dollar that is not spent on a direct or indirect expense is another dollar of profit. A review of profit margin across a variety of industries helps to highlight this point. Profit margin (or return on sales), defined here as net income divided by net sales, indicates the contribution of sales to the profitability of a company. Table 1 illustrates profit margin (before income tax) for several diverse industries over the past three years.

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TABLE 1: PROFIT MARGIN BY INDUSTRY TYPE
2002 (%) 5.3% 14.6 5.9 2.8 4.4 1.4 21.3 13.9 7.8 2003 (%) 4.4% 12.0 4.8 2.6 8.0 1.5 19.7 34.1 6.0 2004 (%) 1.2% 14.9 4.7 2.4 13.3 1.4 22.0 30.8 4.6 Average (%) 3.6% 13.8 5.1 2.6 8.6 1.4 21.0 26.3 6.1 Sales Increase for $1M Increase in Profitability ($ Millions) $27.8 7.2 19.6 38.5 11.6 71.4 4.8 3.8 16.4

Industry Apparel Manufacturing Computer and Peripheral Equipment Manufacturing Construction – Heavy Food and Beverage Stores Investment Banking and Securities Dealing Motor Vehicle Retail Real Estate (Lessors of Buildings) Software Publishers Waste Management and Remediation Services Source: Almanac of Business and Industry Ratios, 2002-2004

As is apparent, a cross-section of these companies must increase sales by nearly $4 million (Software Publishers) to over $70 million (Motor Vehicle Retail) in order to achieve an additional $1 million in profitability. However, regardless of the industry, a decrease in spending affects each of the industries in the same way. $1 million in savings that results from improved spend management practices and strategic sourcing practices creates a $1 million contribution to the bottom line.

Case in Point
The Canadian Pacific Railway (CPR) decided to embark on a strategic sourcing initiative in the late 1990’s. Cross-functional teams were established to analyze and gain a thorough understanding of CPR’s departmental spending. Once expenditures were understood, CPR realized savings through various strategic sourcing levers ranging from rate negotiations to long-term strategic alliances. CPR was able to realize one-time as well as recurring annual savings as highlighted in Table 2. As stressed above, these savings went straight to CPR’s bottom line.

TABLE 2: CROSS-FUNCTIONAL TEAM SAVINGS 1998-2001
Year 1998 1999 2000 2001 Annual Recurring Savings ($ Million Cdn) 10.4 15.2 30.2 29.7 Annual One-Time Savings ($ Million Cdn) 7.2 5.4 3.7 38.5 Total Annual Savings ($ Million Cdn) 17.6 20.6 33.9 68.2

Source: “Strategic Savings on the Right Track,” Management, February 2003

Baxter International (Baxter), a subsidiary of Cisco Systems, is a global company that develops, manufactures, and delivers critical therapies to people with life-threatening conditions. In early 2000, Baxter kicked off a strategic sourcing initiative driven in large part by an e-procurement system. The overall objective was to implement a widely accessible system that enforced compliance and provided visibility into spending on specific commodities and with specific suppliers. By the end of 2000, Baxter had saved over $30 million via this strategic sourcing

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initiative. Anticipated savings near the end of 2001 were approaching $40 million, all of which went straight to Baxter’s bottom line.

Good Times Ahead
Corporate spending increases, solid GDP and job growth, high business confidence, all signal that the economy is improving. New and growing companies will certainly continue hiring and tasking employees in order to boost growing revenues. The tendency for companies may be to shift assets away from the spend management and cost cutting priorities in poor economic times, to areas that traditionally boost revenues, such as operations, sales, and marketing. Prior to doing so, however, growing firms should consider two key questions: 1. Will the economy take a downturn in the future? 2. How can a company maximize impact on the bottom line with minimum resources? The answer to the first question, as history teaches, is obviously yes. In a future economic downturn, much of a company’s continued success will likely be determined by how well it is able to control spending during the growth period. Those that were disciplined will continue to maximize profitability and perhaps identify opportunities to further reduce costs through additional strategic sourcing efforts. Many new companies and those that have not been as diligent will be forced into the exercise of understanding their spend prior to taking any action. The answer to the second question points to the purchasing organization within a company. While the overall focus of a company may shift to other areas, the in-place spend management systems must remain effective. Trained personnel and adequate resources can help to ensure this effectiveness. Continued spend analysis and strategic sourcing must remain a priority, due to their impact on the bottom line, as well as the added benefit of providing stability for a company operating in a global economy where business cycles are a given.

Answer the Question
The profit margin example above was not intended to discount the importance of strong sales on profitability. Neither was the example intended to minimize the value and the need for a company to focus on operations, sales, and marketing. Rather, it serves as a reminder that systems put in place during an economic downturn should remain during a subsequent economic upswing. Industry Norms and Key Business Ratios describes Return on Sales (Profit Margin) as an indicator of a firm’s ability to withstand adverse conditions such as falling prices, rising costs, and declining sales. How can a company improve Return on Sales? By reducing costs via spend management. This answer leads to the question, why would a company shift focus away from strategic sourcing and spend management in an improving economy? The question rephrased; why would a company shift focus away from maximizing profit and increasing its security for a potential downturn in an improving economy? Perhaps now, the answer is a bit clearer.

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The Employment Situtation: August 2004, U.S. Bureau of Labor Statistics, September 3, 2004. Baxter International: A Prescription for Business Transformation, Cisco Systems Company Profile, 2001.

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