How To Reduce Cost Of Goods Sold

Whatever product you or your company makes, the cost of your materials is probably one of your largest expenses, directly affecting profitability. But how do you reduce material costs without impacting the quality of your final product and altering what your customers have come to expect and rely on?

Like most effective business cost-cutting measures, reducing the cost of goods starts with a thorough analysis of the various direct and ancillary ways in which your base materials consume cash flow.

How to Reduce Materials Cost

1. Substitute Lower Cost Materials Where Possible

Products can usually be manufactured utilizing a variety of different materials, depending on marketplace requirements and the practices of the manufacturers. Technology is constantly improving older materials and creating new ones, prices move up and down due to political goals as much as supply and demand, and processing methods change.

When considering a change in the materials used in your products, be sure to recognize all factors involved. For example, substituting a carbon steel for a higher-cost stainless steel will save money, but will also reduce corrosion protection, which may be a valuable product feature for buyers.

In addition, different materials may require changing your method of manufacture by increasing cycle times, as well as labor costs. And in some cases, changing the composition of a product may be worthwhile, even when the material costs are higher due to a simplified production process.

2. Reduce Waste

Product engineers typically design products without considering the production consequences, particularly how non-standard purchase units of size, volume, or weight must be modified to create the final product. Production methods are usually established to minimize the costs of the highest component of production, either labor or materials, at the time the method is established.

If, for example, the cost of the raw material is low, the volume of excess material or "scrap" may not be considered to be important relative to the labor cost. Over time, however, prices for materials and labor may shift. This alters the ratio between the two elements and their related expense, so that the cost of scrap material becomes excessive. Modifying product designs and altering production methods in order to utilize standard raw material units may reduce excessive scrap and its associated costs.

3. Eliminate Unnecessary Product Features

Custom products cost more to manufacture than mass-produced products, and any non-standard feature requires an additional step in the production process, increasing the expense.

Examine your customers' motives for purchasing your products: Do they buy your products because of their low cost, high quality, unique look, or some other reason? By determining what is important to your customers, you can selectively attack elements which are not as important to reduce cost.

4. Negotiate, Negotiate, Negotiate

The level of your profit depends upon your ability to receive the highest possible price for your products and pay the lowest possible price to your suppliers and vendors. Every participant in the supply chain is looking for business and will take unusual, often extraordinary steps to make or save a sale – this is especially true in a poor economy.

Ask for a discount every time you request an estimate or place an order, and keep asking until you actually place the order. If you do not get a reduction in price, ask for favorable financing terms, prepaid freight, or other freebies. By negotiating, you can maximize your position as a buyer – as your buyers do to you.

5. Leverage Suppliers

In many cases, a little research will turn up alternative suppliers of similar products available to you. Determine whether there are any different features between suppliers and whether these differentiating features benefit you or your customers. Is it worthwhile, for example, to have a faster delivery time or favorable financing at a slightly higher price? If not, purchase from the supplier offering the product at the lowest cost.

6. Buy Need, Not Potential

Toyota Motor Company of Japan is considered the father of the "just in time" (JIT) production system. Requiring suppliers to make frequent deliveries eliminates excess inventory and carrying costs. While JIT has been criticized in recent years due to the pressure placed on suppliers and the need for an accurate sales forecasting model, it remains one of the more popular cost-cutting methodologies around the world. The lesson for a small business here is to not buy inventory or equipment until you need it or can determine an immediate benefit in either lower costs or improved customer benefits.

7. Trade Time for Discounts

The opposite approach to JIT is to purchase and receive materials on the supplier's schedule, rather than when you will use the material. This means you will incur additional associated costs in excess inventory. However, allowing vendors and suppliers to deliver materials on their cycle times, rather than on your production schedule, may result in a lower price.

In order to decide which method is most beneficial to you – JIT or the supplier's schedule – consider the final delivered costs of the material, your carrying costs, and the impact of each delivery method on your internal production processes and schedule. If the discount using the manufacturer's schedule is greater than the expenses you'll incur, use the manufacturer's schedule. But be sure to confirm the delivery schedule with the vendor and the lower cost before placing an order.

8. Buy Bargains

From time to time, unbelievable bargains appear in the market. A vendor may need to dump inventory due to his or her banking relationship, for funds to fill other contracts, or because the company is going out of business. Whenever such opportunities arise, take advantage of them – many times the price will be less than the seller's actual manufactured cost.

9. Transform Buyers Into Suppliers

If your finished product is a component of an end product, ask the buyer of your component to contract directly with the raw material vendor to furnish raw materials to you for the processing of the component. In all likelihood, your profit margin on the raw materials is considerably less than the margin on your processing labor and overhead. Transferring material supply responsibilities to your buyer will eliminate a significant cost for you without substantially reducing your profit margin.

10. Barter Finished Goods for Raw Materials

If your products or services are used by any of your vendors, selectively approach them about a non-cash trade between your two companies. Usually, the exchange rate for two different products in a barter is the standard retail price of each. If the gross profit margin on your product is considerably higher than the gross profit margin of the exchanged product, it is to your benefit to make the exchange.

Remember: Bartered goods and services must be fully and accurately reflected in your company books and financial statements.

11. Provide Warehouse and Distribution Services

Manufacturers minimize their costs by volume purchasing, assembly line production, and concentrating operations in a single location. As a consequence, shipping and handling become more expensive when they are required to ship long distances to their customers.

If you have excess space, offer your main suppliers a regional warehousing capacity in return for reduced prices on your purchases. For example, a local custom upholstery firm became the regional warehouse for its main supplier, an Australian firm that manufactured Teflon membrane material, in return for a reduced price on materials, as well as a nominal payment each time the firm shipped an order to other companies in the region.

The upholstery firm was also able to eliminate over $100,000 of inventory which it had previously carried, and the Australian firm benefited from a shorter supply schedule to those companies in the region, which helped its sales. And the cost of the arrangement was less than they would have incurred by setting up a company-owned distribution center.

12. Offer Quick Payment for Lower Prices

For many companies, cash flow is more important than profits, particularly in the short-term. During periods of financial stress, companies simply cannot afford to keep excess inventory or allow the payments of accounts receivable to be delayed.

Inform your suppliers that you are willing to consider cash purchases in return for low prices. If your operation is financially capable of holding the inventory until it is needed, the use of cash is justified.

For example, a Texas shade structure manufacturer in 2010 produced a large number of prefabricated structures for a remodeling/rebranding program of a national food chain. Due to the economy, the remodeling program was delayed and extended from one to five years. Needing the cash tied up in the fast food inventory for other contracts, the company sold the prefabricated structures at-cost to the construction company responsible for the remodeling. The cost per unit to the construction firm was less than half of the initial price paid for each unit.

13. Enter Into Cooperative Purchase Agreements to Gain Buying Muscle

It is a truism that the larger the purchase, the more attentive the seller. Higher volume buys respect and discounts. Contact other companies that use your suppliers to combine orders, thus increasing the per-order quantity for the supplier. Since most suppliers treat sales and logistics separately, requiring the seller to ship different portions of the order to separate locations should not be an obstacle.

If necessary, team with your competitors to gain leverage with the supplier (or suppliers). Since you and your competitor will be paying the same price for the same material, neither will gain or lose an advantage over the other. It is a win-win for each company.

14. Negotiate Long-Term Supply Agreements

While a single order might be small, the total volume of material used over a period of time – a single quarter of the year, multiple quarters, or a full year – will be significantly larger. Offer to use a supplier exclusively for a specific period in return for a set lower price and better terms. While you will lose the opportunity to change suppliers during the contract term, the offsetting benefits of a lower price and a firm supply should compensate for your loss of flexibility.

Final Word

Small companies can feel overlooked and unwanted when dealing with larger suppliers. As a consequence, some small companies grudgingly accept the terms and treatment dictated by the supplier. But you don't need to fall into that trap – suppliers are just as interested in sales as you are. In fact, many suppliers prefer to work with a number of smaller purchasers than a single large account on which they become dependent.

Cutting costs is important and should be a perpetual effort in every small company. If you work with a supplier that will not work with you to reduce your costs, find another one.

What other tips can you suggest to save money on material costs?