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April 1993

Common sense guide to cost control and greater corporate profits. (CPA in Industry)

by Fleischer, Stuart F.

    Abstract- The prevalence of consolidation, downsizing and debt reduction during the 1990s necessitate cost-controlling measures. Common-sense procedures that financial officers can take in identifying wasteful practices and containing costs are suggested. These include purchase of only needed services and materials, solicitation of bids from other suppliers, saving 'hard' dollars by offering 'soft' dollars, taking advantage of cash discounts and testing for mathematical errors in invoices. Moreover, financial executives are encouraged to negotiate or question a billing, recruit specialists for certain contracts, utilize internal labor and materials, and appropriately assess buy-lease decisions. It is stressed that in most cases, common sense is enough to minimize costs and increase savings.

Corporate financial officers are often asked to describe the key elements and procedures used in cost cutting. Minimizing costs is not a science but rather an art. However like a painter or a composer, the financial artist needs to use the senses (especially sight and hearing) and keen imaginative and creative skills.

While each industry and entity has its nuances, there are common sense techniques that financial officers in large and small companies can apply in discovering corporate waste and poor cost containment.

Buy Only What You Need

A typical company purchases countless services and materials. However, in many instances, little consideration is given to determine exactly what is needed. The purchaser orders and pays for a complete dinner instead of buying from the a la carte menu.

Generally, the supplier will attempt to push the "fully loaded" product or service contract because it maximizes profits and requires little, if any, customization. Peripheral options usually contain the greatest profit margins, just as restaurants make excellent profits on bar orders.

To prevent unnecessary expenditures for useless services or product, some homework is required prior to procurement. Interview the user(s) to determine such key factors as to:

* Specific needs;

* Time frame goods or services are needed;

* Quality needed; and

* Frequency of use.

Only after these factors have been evaluated, can the company's purchaser properly search for the products or services to fulfill the need.

Before procuring a facsimile machine, an entity must evaluate the anticipated daily use, the length of a typical document, the size of the paper being transmitted, whether documents are sent to numerous locations, confidentiality requirements, the clarity of the transmissions documents, etc. The type and cost of a facsimile machine required by an architect who transmits detailed blueprints should differ drastically from a local coffee shop that receives luncheon orders. However, it is amazing how many times a slick salesman can sell both of these customers the "top of the line" machine with numerous costly and useless options in addition to an extended service contract.

Bid Periodically

Too many times, managers reorder products or renew service agreements without spending time to evaluate whether the supplier is charging a competitive rate. The excuse offered is always something like "Why rock the boat? I have always been satisfied with the vendor's product or service."

Maintaining continuity of product or service is admirable and usually an attainable goal. However, a conscientious manager keeps the vendor "on his toes." Often vendors will charge their best customers list prices because the user never balks and is unaware that others are paying less for the same product or service.

Periodically, the astute manager will solicit bids from competing vendors and will ask current vendors to meet any lower quotes. It is not uncommon for the current vendor to reduce the price to meet a legitimate quote and keep a valued client.

For example, a company's air conditioning maintenance contract was up for renewal. The landlord's suggested vendor offered to continue his services at $3,000 per year. By making a few telephone calls, three bids in the $1,800 per year range were received. Almost immediately after being informed of the discrepancy, the current air-conditioning company not only met the other offers but agreed to guarantee that rate for at least the next three years.

When the incumbent supplier will not meet the lower prices, do not be afraid to switch vendors. Beside reducing costs, you may be pleasantly surprised with the quality of the new supplier.

In this economic environment, a financial manager must be prepared to spend a good deal of time soliciting competitive bids and negotiating in a tough but fair manner with all current suppliers.

Save "Hard" Dollars by Offering "Soft" Dollars

A company's financial profit/losses are measured on a "hard" dollar basis (i.e., based on dollars received less dollars expended). Often, a creative financial manager can reduce the outflow of cash by offering to substitute "soft" dollars (i.e. services or products that cost nothing or relatively little but are perceived by the other party as having a high value) for all or part of a cash liability.

One clever chief financial officer used his sense of hearing to save his company over one-third of the monthly house-keeping costs. While returning from lunch he overheard a conservation between the building's landlord and a supplier, who was expressing his desire in securing some housekeeping service contracts from the building tenants. By contacting the landlord, a meeting between the housekeeping company and the tenant arraigned. The new housekeeping company agreed to provide the usual daily housekeeping services at $6,000 per month for three years, including materials and bathroom supplies versus the normal going rate of $9,000 plus materials and supplies. In exchange for these substantial savings (with the costs of the materials, a three year savings of about $125,000), the chief financial officer promised to assist the housekeeping company in obtaining additional contracts by serving as a reference. Subsequently, the housekeeping firm contracted with three other tenants in the building.

Another interesting illustration of a soft dollars/hard dollars swap occurred at a large privately owned indoor/outdoor tennis facility. A severe winter storm caused major damage to a pressurized bubble covering four tennis courts. The courts were unusable for three weeks. The courts are rented on a seasonal basis and in excess of $30,000 was owed to the contracted players due to lost court time. Even though the loss of revenue was reimbursed by its insurance carrier, the club explored alternatives to merely returning such monies to the players. The players were offered 1 1/2 hours of tennis time at off hours or open hours at the end of the contracted indoor season for each hour of lost time in lieu of a refund. Virtually all club members accepted this plan. The club saved the insurance proceeds and only had to pay for the additional utilities (electric and heat) that were necessary to operate the courts for the extended period of time.

A third example has been effectively used by a leading mail order company for many years. Whenever a customer returns an order from a prior purchase, he or she is given a refund check. In order to induce this customer not to cash the check, the mail order company offers the customer a 10% discount on future purchases that are paid fully or partially with the uncashed refund check. Amazingly, this incentive has resulted in less than 10% of the refund checks being cashed. In addition, the vast majority of the replacement orders exceeded the original credits (i.e. an added revenue source).

From these three situations, you can see how other parties can be enticed to accept items that cost far less but have a high intrinsic value for a hard dollar savings to the business that makes the offer. This area of savings is vast and is limited only by the financial manager's imaginative and creative skills.

Take Advantage of Cash Discounts

Since, interest rates are lower now than they have been in many years, cash discounts have become more valuable. As the following illustration highlights, it makes sense to borrow funds to take advantage of a cash discount.

In this example, let us assume a company receives a $100,000 invoice with payment terms of "2 - 10, net 30" (i.e. the debtor has the option to take a 2% discount or $2,000 if payment is made within the days of the invoice date or to pay the full invoice amount within thirty days). Also, let us assume that the company has no current cash nor will it have the $100,000 until the final invoice due date. However, it does have a $100,000 bank line of credit with an annual interest rate of 10%.

If the company borrows the $98,000 from the bank on day 10 and repays the loan plus interest on day 30, it will cost $540 in interest. Hence, the financial professional has saved $1,460. Imagine how many thousands of dollars could be saved if this borrowing program were extrapolated to an entire year on all eligible purchases.

Even if a supplier does not offer cash discounts, there is reason to aggressively negotiate a discount. With cash being tight these days, you can tempt a vendor into giving a cash discount by promising to pay immediately for a new purchase. Should the supplier refuse the offer, it is neither illegal nor unethical to stress the fact that the vendor will absolutely not get paid until the due date.

Check the Accuracy of Invoices

Common sense dictates checking an invoice for mathematical accuracy before paying it. However, you would be astonished by the number of companies that do not perform this procedure faithfully. Even if the invoice is computer generated, all footings and extensions (number of units multiplied by the price per unit) should be recomputed prior to disbursement. Also, make sure that sales tax is correctly charged or not charged (i.e., utilize resale and manufacturer's exemption certificates properly). If you do not detect a mathematical error during the approval process, the odds of catching the discrepancy at a later date (through an audit, etc.) are remote.

Another essential procedure to be performed is to agree the invoice to contracted rates or the supplier's price list, rate card, or other relevant price information. In many instances, similar goods have drastically different unit prices (due to color, size, quality, etc.). Thus, special care by both the receiving and the accounting departments is needed to ensure that the company pays the appropriate amount for what was received.

A corollary step in guaranteeing the accuracy of an invoice prior to payment is to compare the quantities invoiced with the quantities received. Many suppliers prepare and mail the invoices at the time of shipment. However, goods can be lost, stolen, or damaged in transit. It is the responsibility of the company's invoice processor to adjust for any discrepancies between quantity received and quantity received and quantity invoiced.

The bottom line of this cost savings tip is to check all invoices carefully and conscientiously. While the vast majority of vendors do not purposely misstate their invoices, errors of all types and degrees of materiality do occur.

Do Not Be Afraid to Negotiate or Challenge a Billing

Most people will ask the waiter in a restaurant to take back a meal if it is inedible or improperly cooked. The same goes for the products or services purchased. If the goods or services do not meet promised standards or are not received on a timely basis, the company's financial department is perfectly within its right to challenge the billing. Do not pay the billing until you are satisfied because you will lose much of your leverage once the vendor receives payment.

Remember you are the customer and most vendors aim to please their customers. They rely on repeat business and usually will be amenable to reasonable requests for a billing adjustment or substitute products or services. Should a vendor's billing department not agree to an appropriate adjustment or substitution, do not be afraid to communicate your unhappiness with a top official at the vendor's company. If that attempt fails, maintain your negotiating advantage by withholding payment of the bill. Once the vendor's receivable from your company becomes sufficiently overdue, the pressure to settle the dispute will heighten. Unless the billing and the dispute are extremely large, it will not pay for the vendor to begin a collection suit.

Whenever a company contracts with a vendor to perform a large construction assignment and agrees to pay installments on a percentage of completion basis, the financial officer should make sure that the percentage paid does not greatly exceed the work completed. If there are delays in the work, the company should likewise postpone the contracted payments. Should there be an unforseen bankruptcy, at least the lost monies can be minimized. Also, the greater the percentage that is owed the vendor, the greater the ability to ensure that the contracted work is completed on a timely basis.

Seek the Assistance of Experts

Much of the art of negotiating is fairly standard and does not vary drastically. Notwithstanding this generalization, certain contracts like real estate leases or insurance policies require the assistance of specialists.

Traditionally, real estate leases are long term (i.e., only negotiated every 10 to 15 years) but are usually a material monthly corporate expenditure. Typically, a smaller enterprise has no internal expertise in negotiating such leases. Therefore, before entering into a real estate lease, heavy reliance should be placed on the enterprise's attorney, broker, accountant, and interior decorator. While the base rent is the major component of the monthly payment at inception, escalations (e.g., real estate taxes, inflation based on a CPI index or the standard porter's wage rate) and other hidden costs can become a large percentage of the monthly payment in future years. An expert's ability to slightly change a definition in the lease could save a company thousands of dollars over the lease term.

In addition, the expert might be very helpful in interpreting the lease's "gray" areas. Generally, landlords will appease contesting tenants and/or their representatives in exchange for the tenants not publicizing the contested discrepancies to other tenants.

Negotiating insurance policies can be unusually technical. Failure to employ an insurance expert knowledgeable in both your company and industry is not a good business practice. The chief financial officer must utilize the insurance specialist to:

* Determine coverage needed;

* Determine policy limits and desired deductible amounts;

* Evaluate the financial soundness and claim settling record of the potential insurers; and

* Negotiate the annual premiums.

A perfect industry to emphasize the need for an insurance specialist is promotional marketing. Companies in this industry manage numerous sweepstakes, and contests which require errors and omissions insurance. One such marketing firm obtained a quote for $1,000,000 of errors and omission coverage with a $50,000 deductible at a cost of $46,000 per year. The company used an insurance professional more familiar with the risks and nuances of the promotional industry to negotiate a new $1,000,000 errors and omission policy with a $25,000 deductible at an annual cost of $12,500. That was an immediate annual corporate savings of $33,500 or 73%.

Negotiating real estate leases and insurance policies are only two areas which require a high degree of expertise. The company's financial professional should utilize specialists whenever deemed necessary. Do not be "penny wise and dollar foolish."

Use In-House Labor and Materials

Just as there are times when outside specialists are needed, there are other instances where using outside labor and materials are a major waste of money. A firm should attempt to utilize its workforce and materials as completely and thoroughly as possible. Unfortunately, numerous times funds are spent unwisely due to internal cost accounting pricing structures and the need to meet projected budgets.

The following series of events took place at a professional golf tournament televised by a major network. The network needed six television monitors for four days. The unit manager rented the television sets from a local supplier for $360 (a daily charge of $15 per set).

The network has numerous television sets in its central equipment warehouse. Had the units been transported with the other equipment in the network's trucks, the golf broadcast would have been charged an internal fee of $1,500 ($25 per unit for each of the ten days that the six television sets were "rented" from the warehouse). The network should have reprimanded the unit manager for wasting $360 of actual monies. Instead, he was praised for saving $1,140 ($1,500 internal cost accounting charge less $360).

Many companies' cost accounting systems cause managers to fall into the same trap. The cost system should be designed so that it differentiates real funds from "funny money" (i.e. internal charges).

Properly Evaluate Buy/Lease Alternatives

In most organizations, the financial executive will be presented with several instances each year when he or she must decide whether a piece of equipment, vehicle, or machinery should be purchased outright or leased. If it is to be leased, the lease term must be determined.

To arrive at the proper conclusion for the given set of circumstances, the decision maker must evaluate:

* Useful life of the asset versus the expected lease term;

* Estimated purchase option versus the projected fair value of the asset at the end of the lease term;

* How future technological advances will affect the value and usefulness of the asset in the organization;

* Tax ramifications of owning versus leasing the asset; and

* Whether there are additional costs to be borne because of specific lease covenants (e.g., increased insurance coverage or expensive maintenance contracts).

Besides quantifying the above criteria, the financial professional needs to understand how this decision will affect the company's future credit needs. Typically, the implicit interest rate in a lease is greater than the interest rate charged by a bank on a straight demand or term loan. However, for the growing company, it might be wise to attempt to lease all equipment because of the limited bank borrowing ability of the entity and the future necessity to use the limited borrowings to finance greater inventory levels. Through leasing, the financial officer has increased his borrowing capacity by the amount that the lessor is "lending."

Common Sense is Key

As the demands for cost containment and savings continue to increase, the focus will be on the corporate financial "artist" to implement various techniques and controls to achieve the aspired goals. A good financial professional can eliminate many areas of corporate financial waste by merely observing and using his or her common sense.

Stuart F. Fleischer, CPA, is a senior vice president and the chief financial officer of Communications Diversified, a promotional marketing company.

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