Expense Management: The Shortest Path To Profitability

The number one difference between the average bike shop and a high-profit shop is not its size, margins, employee productivity, or wages. It’s expense management. Here we lay out how to think about expense management, and give you a step-by-step guide to getting started in your shop.

Sometimes you see expenses coming, like those improvements to your building that you just can’t put off any longer. Sometimes you don’t, like emergency repairs for the shop vehicle. Whatever the situation, whether you see them coming or not, increased expenses may be inevitable, but you can control how you handle them and how they impact your shop. Every day you have the opportunity to increase the profitability of your business.

Expense management is an essential concept that will affect all areas of your business. Today we’re going to use two examples to illustrate four key concepts of expense management. The first example is rooted in personal finance: the cost of a daily cup of coffee. While the scenario is basic, it introduces four tools for managing expenses. The second example is rooted in the shop: the increasing cost of a weekly rag service. Using these examples, you’ll see how you can use the following tools to deal strategically with increased expenses, thereby boosting the profitability of your business.

The Tools

If the expense is non-essential, you can try to eliminate it.

To decide if an expense is a good investment, you need to make the business case.

You can increase sales.

You can decrease profit.

You can increase gross margin.

Each of these tools can stand alone, but realistically, you’ll use a combination of all of them. It’s also important to distinguish between the first option and the last three. The first can be used to eliminate new or increased expenses, while the last three are how you pay for new or increased expenses that can’t be eliminated.

Before getting into any of them, however, it’s important to remember the old adage “you can’t improve what you don’t measure.” Expense management is only possible if you already have a good understanding of your expenses. Step one is to establish your baseline. If you’re familiar with your business’s profit loss statement, you’ve got a good start. Once your expenses are all in front of you, there are a couple of ways of organizing them. You might list them from largest to smallest, or you may list them by “low hanging fruit,” meaning those expenses you feel will be easiest to reduce. The important things are to make sure they’re comprehensive and to track them the same way from month to month and year to year. To that end, you’ve got plenty of options in bookkeeping software, or if you’re a whiz with a spreadsheet, you can make your own.

We’ll wrap up with a recap at the bottom of the article, including a step by step guide to getting started in your shop and how to track changes so you know if what you’re doing is working.

Eliminate the Increased Expense

While it’s true that the overall cost of business is more likely to increase over time, it should not be a foregone conclusion that every expense category is going to get more expensive. For our coffee example, let’s assume the role of a production mechanic who likes a good cup of coffee. He’s got a good relationship with the coffee shop just up the street, but notices that his favorite beans have gone up $0.50 a pound. What are his options for eliminating this potential increase in expenses?

There’s no rule that says he has to buy that variety of beans, so he could just find another roast that’s cheaper than the new price of his favorite. He could shop around to see if there’s another shop that sells his favorite beans for cheaper. Finally, he could try to sweet talk the manager of the coffee shop into giving him a deal. Simple, right?

In our second example, let’s assume we’re the service manager of a shop that uses a weekly rag service. After a few years of good service from them, it’s time to renew the service contract and the rates are going up. What are the service manager’s options? They’re actually exactly the same as the mechanic’s whose coffee is getting more expensive: stay with the same vendor but switch to a cheaper service, find a new laundry service who can match the old price, or negotiate for a better rate. Many potential expenses can be reduced or obviated through negotiation. If it’s an expense that could potentially be increasing, negotiation is essential. You owe it to your business, your employees, and yourself to make sure you’re getting the best deals possible. That said, there are many resources on the art of negotiation, so we won’t dig too deeply into the nuts and bolts of it here.

No doubt at this point, you’ve also identified another option: switch to disposable rags and get rid of the service altogether. Assuming you’ve carefully penciled it out and the annual cost of disposable rags is significantly less than the rag service, it’s a no brainer. However, most decisions will not be so simple, and the second half of this expense management tool becomes critical: the business case.

The Business Case

How do you decide if an added expense is going to pay off in the long run? Even in our rag service example, for which the options are straightforward and easy to understand, the financial benefit isn’t immediately apparent. Let’s say the rag service costs $500 annually. If you calculate that disposable rags would cost you $100 annually, it’s a no brainer, but what if you calculate they’ll cost $450 a year? Does that $450 include the cost to ship them, or if you’re going to be buying them locally, the cost of gas to pick them up? Does it include opportunity costs, which are the costs of missing out on the benefits of the choice you didn’t go with? An example here is the convenience of having the rag service come to the shop. How much time will you spend weekly or annually picking up rags for the shop? A seemingly simple, straightforward choice is actually more complicated once you consider all the financial variables.

There are many resources out there for writing business cases, so we won’t lay it out step by step here.  Our point is that even a seemingly small change, such as changing from a rag service to disposable rags, must be quantified and tracked, or your expenses could go up a point or two each year, until you’re losing money.  As potential costs increase, the business case becomes more important, and beware the tendency to rationalize expenses that appeal to your emotions.  We all have areas of the business that are going to be weak spots.  Maybe you’re a merchandising junkie and want to make sure your display cases and fixtures are always fresh, or a mechanic who wants every new tool, or a web guy who wants a new computer every six months.  Spending money on those things will make you feel better, but are they sound business investments?  Write the business case, and if it’s not a true investment, don’t do it, no matter how it “feels.”

This kind of thinking should permeate your operation, and you should consider the financial impact of every decision you make.  A good manager may not write a business case for every decision, but I promise you she’s thinking about the financial impact of every decision, from the point-of-sale software she chooses, to the kind of lube the shop uses on its tune-ups, to the payoff of buying the sales team pizza for lunch on a crazy Saturday when nobody had time to sit down.

Once you’ve used the business case to establish that an increased expense will be a good investment, you need to figure out how you’re going to pay for it.

Increase Sales

At the most basic level, finance is a function of money in (wages or revenue) versus money out (expenses).  In our coffee example, on the income side, our mechanic’s got his wages and on the expense side, he’s got rent, maybe a car payment, food, clothing, etc.  In the best case, when that equation is balanced every month, the difference is positive so he can keep himself in new bike parts.  If his coffee expenses go up $25 per year, he can figure out how to make $25 more per year and it’s a wash.

The rag service example is obviously more complex.  If you’ve decided to stick with the rag service and weren’t successful negotiating a better rate, and that expense is increasing $500 annually, you just need to sell $500 more next year than you would have otherwise and it’s all even, right?  Well, not exactly.  In accounting terms, what we’ve been talking about are selling, general, and administrative (SG&A) expenses.  These expenses are the cost of doing business, or what it takes to pay rent, keep the lights on, pay employees, etc. (it’s important to note that inventory is not an SG&A expense).

In order to figure out how much more you need to sell each day, week, or year to cover a new or increased expense, you need to know what your total SG&A expenses are as a percent of your sales.  Let’s say your shop has $95,000 in annual net sales, and your total annual SG&A expenses are $37,050.  Your SG&A expenses are 39% of your annual net sales.  To figure out how much more you need to sell annually to cover the new expense, divide the annual cost of the new expense by your SG&As as a percentage of sales: $500/0.39 = $1282.05.  Suddenly, selling more stuff isn’t as simple nor as easy as you may have thought, although as we mentioned above, it is likely to be part of your overall strategy for dealing with increased expenses.

Decrease Profit

If our mechanic is doing well, he could just decide that he’ll continue to pay the increased cost of his favorite beans, and at the end of the year, he’ll have $25 less to spend on other things like new bike parts.

If your shop is doing OK, and the cost of the rag service is increasing $500 a year, you could just take home $500 less this year, and it’s all good, right?  You may already be thinking of the reasons to be careful using this strategy.  First, we know there are shops operating on shoestring budgets, and eating into profit simply isn’t an option (although we hope that implementing some of these recommendations will change this over time).  Second, while this strategy can be effective as part of an overall plan, too many shops do this without realizing they are.  The result is less money in your pocket and less money in the pockets of your partners or shareholders if you have them.  Unless you’ve demonstrated via your business case that this is going to pay off, nobody is going to be comfortable with reduced profits for long.  Finally, decreased or decreasing profits are something that banks are going to notice.  It can be indicative of improper planning and/or a lack of focus on your return on investment, and if you owe money or are looking to borrow, they’re going to start asking questions about your strategic expense planning.  None of these alone are reason enough to decide against investing in your business, as long as you make sure it’s a sound investment and is part of your plan.

Increase Gross Margin

Our coffee example stumbles a little as a demonstration of this tool, but bear with us.  Coffee is a ratio of water to beans, the result of which is a cup of coffee.  If our mechanic was unable or unwilling to use any of the other tools to manage this expense, he could simply adjust his brew ratio so he’s using fewer beans per cup of coffee.  The result will be a cup that costs the same despite using more expensive beans.

In the shop, rather than brew ratio, what we’re talking about is gross margin. Gross margin is a simple thing, dependent on only two variables: revenue and cost of goods sold (COGS).  If you want to move your margin, you need to move one or both of those variables. The revenue side is dependent on how well you control your prices. Do you or your sales staff habitually offer deals or need to close out inventory at a discount? While a good deal is a necessary tool in the back pocket of all sales people, it’s imperative it be used appropriately as part of your overall selling strategy. For closeouts, make sure you have a plan, by category, for when it will be necessary to close out those products, and hold them to MSRP until then. If yours is a shop that likes having some discounted product as a means of attracting customers, make sure anything discounted was purchased on closeout so you can maintain your margin. On the COGS side of the equation, make sure you’ve negotiated to get the best deal you can, and take advantage of incentives for paying early whenever possible.

Review

Let’s bring this full circle and do a little review:

  • Start with your current expenses and establish a baseline. 
  • Make sure they’re comprehensive and track them the same way from month to month and year to year. 
  • Identify the low-hanging fruit, or expenses that would be easy to reduce and/or will have the biggest impact on your expenses.
  • Never assume that any single increase in expenses is a foregone conclusion – an effective way to manage your expenses is to keep them from getting more expensive! 
  • When it does come time to invest in your business, write the business case to make sure you really are investing and not just spending money. 
  • The bigger the expense, the more thorough the business case needs to be.
  • Beware the decision that’s not supported by the business case. 
  • Determine the annual cost of implementing the change.
  • Use a combination of increased revenue, decreased profit, and increased gross margin to pay for it as part of your overall strategic plan for expenses. 

Tracking Your Changes

Remember how you can’t improve what you don’t measure? You need to track the financial impact of the changes you’ve implemented to make sure they’re performing as expected. If the expense is big enough, you may want to include an exit strategy in the business case, including a timeline by which, if things aren’t going according to plan, you’re ready to cut your losses. The unexpected happens, but with a sound plan, you can reduce the impact it has on your business. Remember to plan your changes, implement your plan, track the impact, and be ready to change tack if necessary.

If you’re still not convinced, consider this: every two years, the National Bicycle Dealers Association (NBDA) conducts its Cost of Doing Business survey. As part of that study, they report on a variety of variables and report on them in two categories. One category is the average bike shop, and the other is the high-performance shop, identified as being in the top 25% of the industry with regard to profitability. According to this study, the difference between the average shop and the high-performance shop is not its size, margin on bicycles, inventory turns, average wages, or employee productivity. All those variables are similar between average and high-performance shops. The biggest difference? Expense management. According to Fred Clements, former Executive Director of the NBDA:

“Expenses are clearly the biggest difference-maker when it comes to profitability. The average store pays 42.2 percent of gross sales in overall expenses, compared to 34.9 percent for high profit stores. This means that while some fail to cover their costs when they sell a bike for a 36 percent profit margin, others make some money on a similar transaction.”

And the number one recommendation by Industry Insights, the firm that conducts the study? Manage and stay on top of expenses.  

We hope reading this isn’t the first time you’ve considered strategic expense management, but even if it is, that’s OK. Just as you have the opportunity every day to improve the profitability of your business, it’s also never too late to bump that bottom line in the right direction! The first time you put all your expenses in front of you, it’s going to be overwhelming. Take a deep breath, and start to look for the easiest place to start. Once you’ve experienced some success, and felt the satisfaction of seeing the profitability of your shop improve, you’ll feel the momentum shift and it will get easier.  If you’ve already got a plan for expense management, push yourself a little and see if there are any opportunities to take it to the next level. The result will be an efficient business that performs for you, your employees, and your community.

References

Fred Clements, “A Formula for High-Profit Bike Stores” http://www.bicycleretailer.com/opinion-analysis/2013/06/14/blog-formula-high-profit-bike-stores#.VdvLd_lVhBc, 14 June 2013

Industry Insights, Cost of Doing Business for Bicycle Retailers 2012-2013 Financial Survey (National Bicycle Dealers Association, 2013), 8.

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