About procurement importance or “the golden rule of doing business”

Imagine for a moment that you are General Manager of transnational corporation, say acting in more than 20 countries. Field of functioning is characterized by high domestic and foreign competition, certain legislative barriers and extremely demanding consumers. Try to agree that in these circumstances it is getting more and more difficult to cheer the shareholders up with income from dividends. Nevertheless, you are full of aspirations and you are determined to maximally grow the profit of your enterprise. How you would do that?

Saying straight, you are facing three alternatives:

- lead an aggressive marketing company aimed at the sales growth;

-  increase the price of the production of your company;

- reduction of costs for conducting business

Let’s have a look at these alternatives in more details. The first one is costly enough and labor intensive. Just look at such gigantic companies as Uniliever, P&G, L'oreal , etc spending billions of dollars on advertisement! And this is made just in order to ‘stay afloat’ on highly competitive and glutted market.

Even on rapidly growing market (IT-segment, for instance) a company might fail to achieve necessary sales growth due to high resource cost, legislative barriers, me-too products, demanding purchasers, etc. 

 The increase of prices for the company production is not an efficient method at all times due to various demand elasticity. It should be noticed that transnational companies are not approachable to the growth of prices on highly competitive market. As a rule, the necessity of this measure is based on the growth of production cost, legislative changes influencing expenditure budget of a company ( it may be, in particular, the entrance duty of feedstock, the growth of costs for licensing and certification, growth of taxes and levy, ecological requirement strengthening), growth of staff costs.

Taking the above said into account, the third option seems the most appealing in terms of reduction of business costs. It is rather difficult to reach regarding the high level of automation of this branch. Reduction of costs in marketing, especially in advertising, is very unwelcome, as it often results in loss of the market share. Considering this we should mark that it is the prime cost reduction which is the most efficient activity direction in terms of cost cut. Massive cost reduction in this field makes much more essential impact on equity return than the sales growth.

In the expenditure cross-section related to sales the biggest ratio is the one of logistics costs and prime cost of production on market. Considering this, it is not a good idea to think that the gain in sales by $1 would lead to profit increase by $1. Let’s raise in mind quite well-known example taken from an excellent book by James R. Stock and Douglas M. Lambert “Strategic management of logistics” (p.16): 

 Leverage of profit growth due to prime cost reduction

If the net income from sales per $1 is 2%, then…

 Savings                    is equivalent to increase of total revenue from sales by

0,02                           1,00

2,00                          100, 00

200, 00                     10 000, 00

2 000, 00                  100 000, 00

20 000, 00                1 000 000, 00

200 000, 00             10 000 000, 00

2 000 000, 00          100 000 000, 00

In the example given above where total revenue from sales excluding taxes comprise 2%, the company gains sales revenue 2 cents per $1 before tax charges. Meanwhile, every dollar saved by your purchasing office is not followed by need of sales increase or marketing costs,for instance, in order to bring this economy to action. Consequently, $1 saved by your purchase executives lets you gain $1 profit! In this regard, prime cost reduction is much more efficient than growth of sales. The described exampe is basically ‘the golden rule of business’ and means that the actual amount of profit of your company depends on acquirement, skills, experience and professional competence of your purchase office employees.

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