Incremental Improvement in ROAI - Lower Variable Costs - Part 4
- greenwoodphilip
- May 10, 2024
- 3 min read
The impact of increasing prices or sales volume on a critical number like Return on Assets Invested (ROAI) can be significant. In each case, changes (if not unrealistic) were required to raise ROAI from 12.5% to 20%. In this post, we'll illustrate the effect of Variable Costs on the bottom line targets. First, we'll examine the impact using the same example how much variable costs need to be reduced in order to see that dramatic improvement in ROAI. Second, we'll examine the practicality of such tactics.
Strategy - Lower Variable Costs to Get Higher ROAI
Using the same parameters, how much does volume need to increase ROAI from 12.5% to 20%? Recall that:
ROAI = (EBIT / Asset Investment), can be restated as ROAI = (EBIT/Sales) x (Sales/Asset Investment), which is Operating Margin x Asset Utilization.
Dividing Operating Margin further Operating Margin or EBIT/Sales is comprised of:
(Sales - Variable Costs - Fixed Costs)/Sales.
Sales $ can be split into (Price per unit x Volume) and Variable Costs split into (Variable Cost per Unit x Volume)
Using the data from a previous blog post:
Revenues $500,000 (Price per Invoice $250/Invoice x 2000 Invoices)
Cost of Goods Sold $240,000 (Variable) or 48% of Revenue ($240,000/500,000)
Other Variable Expenses $60,000 (Variable) or 12% of Revenue (60,000/500,000)
Contribution Margin = Revenues - Variable Costs = 500,000-300,000 = 200,000, 40% of Revenue
Operating Expenses $150,000 (Fixed)
EBIT = $50,000
Assets Invested $400,000
ROAI = 12.5%
Variable Costs in this example are 60% of Sales (300,000/500,000). If volume decreases, the amount of variable costs will decline with the change in sales but on a relative basis (assuming all else remains constant), the variable cost percentage will remain constant. If the price changes, for each 1% change in price, variable costs will change 0.6%.
How much do variable costs need to be reduced to obtain the target 20% ROAI used in previous examples? Again, assuming all other variables remain constant:
EBIT = 30,000 Increase needed to get to 20% ROAI.
Contribution Margin = 500,000 - 300000 = 200,000
Contribution Margin % = 100% - 60% = 40%.
Since Revenue (Price x Volume), Fixed Costs, and Asset Investment remain the same in this example, the only variable that changes are Variable Costs or it needs to decline $30,000
Increase in Contribution Margin = (New Sales - New Variable Costs) - (Original Sales - Original Variable Costs)
30,000 = (500,000 - X) -(500,000 - 300,000)
30,000 = 500,000-X-200,000
30,000 = 300,000 - X
-270,000 = -X
X = 270,000 in New Variable Costs
New Contribution Margin % = (500,000/500,000) - (270,000/500,000), New Contribution margin % = 100% - 54% = 46%. Thus, variable costs need to be reduced from 60% of sales to 54% to obtain a 20% ROAI or EBIT of $80,000/Asset Investment of $400,000.
Effective Strategies for Reducing Variable Costs to Boost ROAI
In today's competitive business environment, managing costs effectively is crucial for enhancing profitability and improving the Return on Assets Invested (ROAI). One of the most impactful ways to achieve this is by strategically reducing variable costs.
1. Negotiate with Suppliers: Building strong relationships with suppliers and negotiating better terms can lead to significant savings on raw materials and other necessary inputs[2][5].
2. Optimize Production Processes: By streamlining operations and utilizing technology such as automation and robotics, companies can increase efficiency and reduce labor and production costs[2][4].
3. Invest in Technology: Implementing advanced software and systems can help in reducing costs associated with manual processes and enhance operational efficiency. For example, cloud computing can reduce the need for expensive hardware and maintenance costs[4].
4. Energy Efficiency: Investing in energy-efficient machinery and tools can significantly reduce utility costs, which are a substantial part of variable costs in manufacturing and production-heavy industries[4][12].
5. Waste Reduction: Applying lean manufacturing principles can help minimize waste in materials, time, and resources, directly decreasing variable costs[2][5].
6. Outsource Non-Core Activities: Outsourcing activities like transportation, payroll, or IT services can reduce costs by leveraging the expertise and economies of scale of third-party providers[5].
Challenges and Considerations
While reducing variable costs is beneficial, it is not without challenges. Investments in technology and training can lead to an increase in fixed costs. Moreover, drastic cost-cutting measures might affect product quality and employee morale. Therefore, it is crucial to balance cost reduction with long-term sustainability and quality assurance[1].
Conclusion
Effectively managing and reducing variable costs is a powerful strategy for improving ROAI. By implementing the strategies outlined above, businesses can not only enhance their profitability but also strengthen their competitive position in the market. Continuous monitoring and adjustment of cost management practices are essential to adapt to changing economic conditions and maintain a trajectory of growth.
Citations:
[2] https://fastercapital.com/content/Cost-reduction--Implementing-Strategies-to-Lower-the-Variable-Cost-Ratio.html
[3] https://meshpayments.com/blog/how-to-reduce-variable-costs/
[4] https://fastercapital.com/content/Variable-costs--Controlling-Variable-Costs--Maximizing-Profitability.html
[5] https://report.woodard.com/articles/everything-you-need-to-know-about-variable-costs-oimwr-katwr
[6] https://happay.com/blog/variable-cost/
[7] https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/how-reduce-business-expenses
[8] https://dealavo.com/en/fixed-costs-vs-variable-costs/
[9] https://www.investopedia.com/terms/v/variablecost.asp
[10] https://www.bench.co/blog/accounting/fixed-vs-variable-costs
[11] https://logikalprojects.com/insights/interactive-cost-reporting-in-construction-projects/
[12] https://www.caminofinancial.com/en/blog/business-managment/reduce-manufacturing-costs/
[13] https://www.cubesoftware.com/blog/variable-expenses-examples
[14] https://study.com/academy/lesson/avoidable-costs-in-accounting-definition-examples.html
[15] https://fastercapital.com/content/Cost-Factors--Cost-Factors-and-How-to-Consider-Them.html
[16] https://www.fool.com/the-ascent/small-business/accounting/variable-costs-examples/
[17] https://www.projectmanager.com/training/basics-project-cost-management
[18] https://www.bill.com/blog/reduce-fixed-costs
[19] https://www.fool.com/the-ascent/small-business/accounting/fixed-cost-vs-variable-cost/
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