Maximize profit through savings: Why Saving $1 on Expenses Can Be Worth $2 (or $20) in Revenue
- Originally Published: October 22, 2024
- Last Updated: October 22, 2024
Table of Contents
In the current economic environment, principled cost control is more important than ever, and most businesses are looking for ways to maximize profit and insulate themselves against a potential economic downturn. Before launching Perfect Fit, I worked in the startup and tech world, where it’s common to hear the refrain “revenue can fix any problem.” While growing revenue is a goal for nearly every business, it’s not the most efficient way to improve your business’s resiliency. In this post, I’ll explain why saving $1 in expenses can be far more impactful when trying to maximize profit than generating $1 of additional revenue, with a specific focus on why background checks are an easy and ideal expense to reduce.
Essential Terms
Before diving deeper into why saving on expenses is a more effective method to maximize profit than an equal increase in revenue, let’s define some terms that will be essential to understanding the mechanisms that make this fact true.
Profit
The amount of money left over after all expenses and taxes have been paid. This is ultimately what most businesses care most about. This post explains how the leftover profit is different when increasing revenue by $1 versus decreasing costs by $1. Learn more >>
Revenue
Total income generated by sales of goods and/or services. This is the money your customer pays you.
Expenses
Every business incurs expenses to create the product or service that they sell. This includes costs to produce your goods like materials and labor (often called COGS – Cost of Goods Sold) as well as other operating expenses (OpEx) like rent or marketing.
Earnings Before Tax (EBT)
Earnings Before Tax is the amount of money that is left over after subtracting total expenses incurred from total revenue earned, but before you pay taxes.
Cost Ratio
The cost ratio (or cost-to-sales ratio) measures the proportion of Revenue that is consumed by Expenses (COGS + OpEx). This is a similar measurement to profit margin, but focuses on the expense side of it instead of profit.
Formulas
All of these key terms are related to each other, and it’s the way they interact that makes savings more impactful to a business than new earnings of the same amount. Let’s put these key terms into formulas to illustrate how they are related:
Revenue – Expenses = Earnings Before Tax (EBT)
EBT – (Tax Rate x EBT) = Profit
Cost Ratio = Expenses / Revenue
Example 1: Adam’s Snow Cone Stand
Now let’s talk about this with some real numbers in an example. While accounting in the real world is going to be more complicated, these examples still illustrate the mechanisms that make changes in savings and revenue different, even when the change itself is equal.
Let’s say Adam owns a snow cone stand. He sells snow cones for $5 each, but spends $2 on materials (cups, ice, syrup), $1 to pay his employee, and $1 on other miscellaneous expenses (like rent and electricity), making for $4 in expenses for each snowcone. He is set up as a corporation in the US that pays 21% in taxes. If in a typical day he sells 10 snowcones, then he makes $7.90 in profit. Here’s how we get there:
$50 in Revenue – $40 in Expenses = $10 in Earnings Before Tax (EBT)
$10 in EBT – (21% x $10) = $7.90 in Profit
His Cost Ratio is $40 in expenses / $50 in revenue = 80%
Two Scenarios: Earning $5 More vs. Saving $5 on Expenses
Now let’s compare two different scenarios where revenue or expenses are changed by $5:
- Scenario A: Adam earns $5 more in revenue by selling one more snowcone than normal (11 instead of 10).
- Scenario B: Adam saves $5 in expenses by finding cheaper ice that reduces his costs from $4 to $3.50 per snowcone, but still only sells 10 snowcones.
| Adam's Snow Cone Stand | Previously | Scenario A | Scenario B |
|---|---|---|---|
| Revenue | $50 | $55 (+$5) | $50 |
| Expenses | $40 | $44 | $35 (-$5) |
| Earnings Before Tax | $10 | $11 | $15 |
| Tax (21%) | $2.10 | $2.31 | $3.15 |
| Profit | $7.90 | $8.69 (+$0.79) | $11.85 (+$3.95) |
You can see that the change in profit is dramatically different, depending on whether you shift the revenue by $5 or the expenses by $5. In this case, the change in profit is 5x greater when reducing expenses than when increasing revenue. While Adam would ideally like to increase revenue AND decrease expenses, in the real world we’re often constrained by time and other factors. If he wants to maximize profit and only has time for one project, saving on expenses would be the more impactful choice on a per-dollar basis.
So will expense savings always produce 5x more impact than increasing revenue for all businesses? No.
The difference in impact will depend on your business. Specifically, it will depend on your business’s cost ratio. Remember that from the formula section? Businesses with a higher cost ratio (smaller profit margins) will see greater impact than those with a lower cost ratio (larger profit margin).
The example above with Adam’s snow cone stand had a cost ratio of 80% ($4 in expenses / $5 in revenue). Let’s look at two more example businesses to see how cost ratio impacts the results.
Example 2: With A Lower Cost Ratio (40%)
Let’s take a look at another business, Peggy’s Paintings. Peggy is a talented painter and is able to sell her paintings for well more than the cost of the canvas and paint. She sells tiny art pieces at her local craft market for $5 each, and only has $2 in expenses to generate each. From this, we know her cost ratio is 40% ($2 in expenses / $5 in revenue). In a typical day she sells 10 pieces, and we’ll analyze the same two scenarios that we did before:
- Scenario A: Peggy earns $5 more in revenue by selling one more painting than normal (11 instead of 10).
- Scenario B: Peggy saves $5 in expenses by finding a cheaper paint supplier that reduces her material costs from $2 to $1.50 per painting, but still only sells 10 paintings.
| Peggy's Paintings | Previously | Scenario A | Scenario B |
|---|---|---|---|
| Revenue | $50 | $55 (+$5) | $50 |
| Expenses | $20 | $22 | $15 (-$5) |
| Earnings Before Tax | $30 | $33 | $35 |
| Tax (21%) | $6.30 | $6.93 | $7.35 |
| Profit | $23.70 | $26.07 (+$2.37) | $27.65 (+$3.95) |
For Peggy, the cost savings were only 1.67x more impactful than increased revenue because she has a lower cost ratio.
Example 3: With A Higher Cost Ratio (95%)
Let’s take a look at another business, Wilfred’s Waffles. Like most restaurants, Wilfred runs a tight operation with only a 5% profit margin. He has $4.75 in expenses for every $5 waffle he sells, giving him a cost ratio of 95% ($4.75 in expenses / $5 in revenue). In a typical day he sells 10 waffles, and we’ll analyze the same two scenarios that we did before:
- Scenario A: Wilfred earns $5 more in revenue by selling one more waffle than normal (11 instead of 10).
- Scenario B: Wilfred saves $5 in expenses by purchasing his ingredients from a distributor instead of his local grocery store, which reduces his material costs from $4.75 to $4.25 per waffle, but he still only sells 10 waffles.
| Wilfred's Waffles | Previously | Scenario A | Scenario B |
|---|---|---|---|
| Revenue | $50 | $55 (+$5) | $50 |
| Expenses | $47.50 | $52.25 | $42.50 (-$5) |
| Earnings Before Tax | $2.50 | $2.75 | $7.50 |
| Tax (21%) | $0.53 | $0.58 | $1.58 |
| Profit | $1.97 | $2.17 (+$0.20) | $5.92 (+$3.95) |
Cost Ratio: 95%; Savings worth 20x new revenue
For Wilfred, the cost savings were a whopping 20x more impactful than increased revenue because he has such a high cost ratio. To maximize profit, it would be wise for Wilfred to seek out all opportunities to reduce expenses.
Tighter Margins Mean Savings Are More Impactful
As we’ve shown above, businesses with a tighter profit margin stand to gain more from cost-cutting measures than businesses with larger profit margins, with our examples ranging from 1.67x impact to 20x impact.
But why is that?
Because more money is lost between revenue and profit than between expenses and profit. If we combine our formulas from above, we can write one formula that describes the entire path from revenue to profit:
Revenue – Expenses – (Tax Rate x EBT) = Profit
When you add $5 of revenue, you subtract both expenses and taxes, but when you reduce expenses the only step left before profit is to pay taxes on those new savings.
Identifying Cost Reductions to Maximize Profit
Where do you go from here? In reality, reviewing your business’s expenses involves weighing multiple factors. For example, if Wilfred cuts costs by switching to a cheaper brand of ingredients, it could lower the quality of his waffles and negatively impact sales. It’s crucial to ensure that short-term savings don’t lead to long-term losses.
The key is to find expenses you can reduce without compromising quality, efficiency, service, or value. In some cases, you’ll need to weigh whether the savings justify the potential trade-offs in these areas.
Savings on recurring expenses offer the most long-term impact because they compound over time. The initial cost of adopting a new platform or process can be far outweighed by the ongoing savings compared to the higher fees from entrenched vendors. Regularly price-checking your suppliers can significantly improve your bottom line.
Why Background Checks Are a Smart Area for Cost Savings
Background check vendors pull the same data from the same courthouses, so if they’re running identical searches, the reports should be virtually the same. This makes background checks an ideal area to explore for cost reductions.
While factors like the quality of customer service or software integrations (if needed) might vary between vendors, the actual reports are generally consistent across the industry. This consistency makes it easier to compare vendors and find savings without compromising on quality—the most critical factor when evaluating expense reductions.
At Perfect Fit, our customers save an average of 38% over their previous vendor and we get glowing reviews for our customer service. If you’re a small or medium sized business running fewer than 300 orders per year, this presents a fantastic opportunity to save on a recurring expense without making any sacrifices in product or service quality.
Maximize Profit by Checking Your Background Check Pricing Today
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About the Author
Travis Reiter
Owner-Operator, Perfect Fit Background Checks
Travis has co-owned Perfect Fit Background Checks with his wife Rachael since 2021. With a passion for helping small businesses, Travis specializes in providing affordable background check services with unrivaled service. When he’s not helping customers, Travis is actively volunteering around Austin, Texas, exploring new destinations, or enjoying board games with friends.
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