The changing nature of business (pt 4): sources of profitability
Posted by Vinny Patel on Thu, Oct 18, 2012 @ 06:53 AM
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Our research shows that in the FTSE-350, labor consumed on average 12.9% of revenue in 2011. In contrast, non-labor costs consumed 68.3% of revenue. The difference between these two percentages suggests that bringing non-labor and third-party costs under greater control represents an opportunity for leaders to make more meaningful improvements to their profits than the traditional focus on labor cost.
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The table below highlights that the disparity between labor and non-labor is widening, suggesting that the trend, driven in part by organizations increasingly outsourcing their cost base over recent decades, continues.
| Year |
Labor cost as a % of revenue |
Non-labor cost as a % of revenue |
| 2009 |
15.7% |
65.6% |
| 2010 |
14.3% |
66.8% |
| 2011 |
12.9% |
68.3% |
| Average |
14.3% |
66.9% |
Even modest reductions in non-labor costs could generate significant increases in profitability. Any savings that are made, if captured, go straight to the bottom line. And these are not just one-off savings: they are removed from the cost base permanently (as long as effective management of the cost base continues).
Averaging all sectors over the three year period, our research suggests that just a 1% reduction in non-labor cost produces, on average, a 3.6% increase in EBITDA. The equivalent reduction in labor costs produces, on average, only a 0.8% rise.
Certain sectors present greater opportunities for profit enhancement than others.
The below table (click the image to enlarge) breaks down labor and non-labor costs as percentages of revenue for each FTSE 350 sector and the impact on profit of a 1% reduction in both labor and non-labor costs, to illustrate the scale of the opportunity.
As you can see from the table, there are certain sectors that stand to gain the most from a 1% reduction in non-labor costs. These sectors are core economic barometers. For example, the UK’s GDP figures for the second quarter of 2012 highlighted a notable impact on the construction industry, with output down more than 5%. Against this backdrop, improving non-labor costs can provide a compelling answer to the question of how companies can protect the value they deliver to shareholders when conditions are challenging.
Ultimately getting non-labor costs under control has a far greater impact on profitability than labor cost reduction. So why aren’t senior executives (and shareholder activists) paying more attention to non-labor and third-party costs?
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Our latest research reveals that businesses spend, on average, two-thirds of their revenue on non-labor costs – 68.3% in 2011. This far outstrips their collective labor costs, which averaged just 12.9% of their revenue. Yet headcount reduction is traditionally seen as the best way to tackle cost. This raises a number of questions:
- Are businesses ensuring that their non-labor cost base is being effectively managed?
- If not, why not?
- And what are the potential benefits of making that investment?
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