An efficient businesses is agile; not burdened by the overhead of paying for components that don't add any value to the bottom line. The more lean and efficient a business the more options that business has open to it in terms of controlling its future.
If a business is able to produce a product for $1 and sell it for $5 while its competitor can produce the same product for $3 this efficient business has two wonderful options:
While there are many ratios that explore efficiency I think there is no better in this regard than looking at a simple comparison of Sales to Cost of Goods and Selling, and general and administrative expenses.
We can start by taking a sample income statement:
Next calculate the percentage that C.O.G. and Selling Expenses form as a percentage of the total sales.
So this means that 41% of the gross sales go towards the direct cost of creating the finished item, and that 47% of our gross sales goes towards the marketing and sales of the item. So, in total, 88% of the gross sales goes to producing and selling the item; meaning at most 12% of the gross sales could be available as net profit. 12% isn't a great sum especially if it turns out the competition is running with a much lower COG%.
It is worthwhile and very important to spend the time to find out how your prospective company lines up in this regard, are they the most efficient in the industry? If they aren't then there is a good chance that the two options described above are being toyed with in the competition's boardroom.
It is so simple to do this equation, why not run it against the business your are analyzing and all of its competitors and see how they stack up
If a business is able to produce a product for $1 and sell it for $5 while its competitor can produce the same product for $3 this efficient business has two wonderful options:
- Driving the competitor out of business by pushing retail lower say to $2. The business is still profiting meanwhile its competition is loosing massive amounts of capital if it wants to stay competitive.
- Build a huge war chest by picking up an extra $2 of profit on every sale.
Finding Efficient Businesses
While there are many ratios that explore efficiency I think there is no better in this regard than looking at a simple comparison of Sales to Cost of Goods and Selling, and general and administrative expenses.
We can start by taking a sample income statement:
| Category | Value |
|---|---|
| Sales | $190,554.00 |
| Cost of Goods Sold | $77,741.00 |
| Gross Profit | $112,813.00 |
| Selling, General, and Admin Expense | $90,377.00 |
| Operating Income Before Depreciation | $22,436.00 |
| Depreciation | $6,316.00 |
| Operating Profit | $16,120.00 |
| Interest Expense | $0.00 |
| Non operating income/expense | $2,930.00 |
| Pretax income | $19,050.00 |
| Total income tax | $7,811.00 |
| Net income | $11,239.00 |
Next calculate the percentage that C.O.G. and Selling Expenses form as a percentage of the total sales.
| Category | Value | % of Gross Sales |
|---|---|---|
| Sales | $190,554.00 | |
| Cost of Goods Sold | $77,741.00 | 41% |
| Gross Profit | $112,813.00 | 59% |
| Selling, General, and Admin Expense | $90,377.00 | 47% |
| Operating Income Before Depreciation | $22,436.00 | 12% |
| Depreciation | $6,316.00 | 3% |
| Operating Profit | $16,120.00 | 8% |
| Interest Expense | $0.00 | 0% |
| Non operating income/expense | $2,930.00 | 2% |
| Pretax income | $19,050.00 | 10% |
| Total income tax | $7,811.00 | 4% |
| Net income | $11,239.00 | 6% |
So this means that 41% of the gross sales go towards the direct cost of creating the finished item, and that 47% of our gross sales goes towards the marketing and sales of the item. So, in total, 88% of the gross sales goes to producing and selling the item; meaning at most 12% of the gross sales could be available as net profit. 12% isn't a great sum especially if it turns out the competition is running with a much lower COG%.
It is worthwhile and very important to spend the time to find out how your prospective company lines up in this regard, are they the most efficient in the industry? If they aren't then there is a good chance that the two options described above are being toyed with in the competition's boardroom.
Final Thoughts
It is so simple to do this equation, why not run it against the business your are analyzing and all of its competitors and see how they stack up
