Strategic Cost Reduction
Author:
Tim McCormick
Recession offers an impetus to cut costs but businesses must be strategic in their approach to ensure their survival and to position themselves for the future, explains
Tim McCormick.
Over five years ago, the Irish Management Institute in a survey of a hundred chief executives found that the biggest single issue they faced was cost reduction. While this was, at the height of the Celtic Tiger era, somewhat of a surprise, it would surprise nobody today. Businesses which fail to address their costs in a recession adequately may well not survive. Similarly in the public sector, with a deficit heading towards an unsustainable 10% of GDP, there is no alternative to cost reduction in 2009.
Sadly for many organisations the onset of the recession has been both faster and deeper than expected, leaving them ill prepared for the change. In these circumstances they have little option but to cut costs indiscriminately. Organisations fail, not because they run out of profit, but because they run out of cash. Discretionary expenditure on areas such as research, training and marketing are usually first to feel the knife. Capital expenditure and dividends are cancelled, while the attention of the CFO is focused on working capital management, forcing down debtors and stocks, while negotiating longer terms with creditors.
In a short term emergency such remedies may be unavoidable. Nevertheless they may be disastrous in the medium term. The areas where cuts have been applied may well be the keys to future growth. A business with no new products or services, devoid of the necessary skills and equipment may also fail once the recession has passed.
BUDGETING AS A REMEDY
Many CFOs will look to the budgetary system as the best way to reduce costs. Every year the annual ‘game’ commences and can continue for many months. The departments submit their plans which get rejected by the Controllers until eventually, through haggling typical of an oriental bazaar, a final deal is agreed. The trouble is the skilled player will often end up with a soft budget with comfortable padding, so that the inefficiencies remain.
Some businesses have periodically resorted to zero based budgeting, a system brought to prominence by the Carter Administration in the US. Instead of starting from the last year’s expenditure, all costs are considered from scratch each year. The process is necessarily more time consuming, but it can lead to serious reductions. However, the cuts may still not be strategic, leading to eventual problems down the road. Nevertheless many organisations may be forced down this somewhat unfashionable road in 2009, as crises unfold.
For those fortunate organisations which only need a small loss of corporate weight, the skilful use of budgeting may provide the answer.
But practitioners should be aware of the traditional pitfalls. Too often ruthless cutting may sever a corporate artery, while indiscriminate slashing may result in corporate anorexia, where the patient finally collapses, suffering from one thousand cuts. Sometimes also, the random use of the knife may indeed yield the short term results, but before long the patient has put back the weight, as the inevitable crises are addressed and additional manpower or resources taken on.
VALUE FOR MONEY: THE 3 ‘E’S
The traditional method of achieving cost savings, espoused in theory particularly in the public sector, if not always applied in practice is to seek ‘Value for Money.’ In practice this is approached by questioning expenses under the 3 ‘E’s:
• The first ‘E’ is economy or traditional good housekeeping: Can we use less of the resource?
• The second is efficiency or doing things ‘right:’ Can we obtain more output from less input?
• The third is effectiveness or The Value Chain doing the ‘right’ things: Can the objective be achieved in a better manner?
The tests might yield interesting results, if applied, say, to the Government scientific ‘Challenger Programme’ in Florida:
Economy: Could the programme have been run with fewer trips?
Efficiency: Could the goals have been achieved by lower cost flights and cheaper entertainment, using budgeted per diem limits?
Effectiveness: Could the overall aims of the programme be achieved, without the doubtless arduous and onerous trips being undertaken in the first place, through maybe greater use of video conferencing?
Good managers are by nature people who seek value for money and avoid unnecessary waste. So in any functional area cost reduction should be taking place as a matter of course. In some areas it may be more obvious than others. Operations mangers, purchasing or procurement managers as well as financial controllers are constantly engaged in cost reduction. But in well managed organisations it happens also in human resources, information technology, engineering, logistics and sales & marketing. The trouble with such a piecemeal approach is that it tends to be undertaken in individual silos, often missing the greater cross-functional possibilities.
STRATEGIC COST DRIVERS
A more comprehensive approach to cost reduction is based on the overall strategy of the organisation. Few organisations in Ireland compete for business primarily on the basis of low cost. Ladas may be cheaper than other cars, but they are not the most popular, since consumers are concerned with many other features, such as safety, speed, comfort, styling etc. Similarly in hotels it is possible to reduce cleaning. But if cost reduction focuses on the features most valued by the customers, then failure is probable.
Cost reduction should also take cognisance of corporate values. The cheapest way to reduce the labour force may be to sack people on the basis of statutory redundancy. But such a course of action may make it more difficult to attract people when growth resumes, as well as transgressing important core values.
A good starting point is to benchmark the organisation with a suitable peer or group of peers. If the results show that your organisation has a higher cost base, ask what the broad drivers of these higher costs are. Sometimes these causes may be more amenable to change than others. Nevertheless without understanding the root cause great macho cost reductions are unlikely to be effective.
Sometimes the higher cost base may be attributed to the smaller scale of the organisation. Economists have traditionally argued for the benefits of specialisation made possible with greater size. Similarly there can be learning effects. The more times a lawyer performs a certain task or a garage mechanic undertakes a certain repair the quicker and cheaper it should become. Conversely large organisations may suffer from diseconomies of scale due to bureaucracy or other forms of inefficiency.
On other occasions the cost disadvantage may derive from the situation in which the organisation finds itself. The current location may bring its own costs. These in turn may originate in extra transport costs, higher wages or other costs imposed by Governments or trade unions. Unfortunately Ireland with relatively high wage costs struggles to remain competitive for mobile multinationals organisations. In other cases unit costs may be high due to idle capacity. The hotel with many empty rooms will also have difficulty competing.
Yet again some organisations may find that costs can be reduced by working on various linkages. The cost of stocks may be reduced by careful coordination of purchasing, sales and operations. Others will take advantage of group membership to buy more cheaply or avoid replicating expensive functions like treasury. Others again may integrate vertically to access cheaper raw materials or service sales outlets.
Finally costs may be high as a matter of policy. If competition is based more on quality than price, higher costs are part of the business. Innovations, servicing and branding comes at a price, but they may be integral elements of the deal or business proposition. Once the strategic cost drivers are fully understood the challenge is to tackle the problem areas and target those specific elements which can sensibly be reduced.
THE VALUE CHAIN
A significant barrier to strategic cost reduction may be the accounting system itself.
Costing systems need to perform many tasks. They act as the basis of budgetary control and may help in the profitability analysis of products, services and customers. But rarely do they help in identifying better ways of conducting processes, where the true savings are to be found.
Splitting costs into fixed and variable costs has its uses, but in the short run
many costs may be fixed and the long run most costs are variable. Work forces may not reduce readily to a downturn in demand, while rent may be reduced by relocation. The split between direct and indirect costs too is of limited help, since an arbitrary allocation of indirect costs does little usually to obtain cost reduction. Activity Based Costing possesses advantages in this respect, but its take-up has been limited.
A better approach may be to consider the organisation through the elements of the value chain (illustration omitted from web article).
The value chain separates businesses into 5 Primary and 4 Support activities. Consider how a grain farmer, under prolonged cost pressure, as a result of falling cereal prices might cut costs to survive. He orders seed which he probably collects himself (‘Inbound Logistics’). He sows, sprays and harvests using the minimum amount of inputs, both material and labour, possibly outsourcing some activities to contractors (‘Operations’). The grain merchant collects the produce (‘Outbound Logistics’) and pays an agreed formula, based on quality and moisture. Servicing does not apply.
Both operating inputs and capital expenditure will be kept to a minimum and keenly negotiated (‘Procurement’). The internet may be used to provide information on prices and products (‘Information Technology’). The labour policy will be to minimise the full time workforce (‘Human Resources’). Infrastructure may be the farmhouse kitchen with accounts possibly outsourced to a professional.
Some businesses find economies in every element of the value chain. For example Ryanair has taken the low fares airlines to ever new ways of reducing each element. Because other businesses may have a different strategy, particularly around customer and employee values, many of their savings may not be readily transferred. But an examination of their management of the value chain provides some fascinating lessons to those both within the airline industry and further afield. It is also not a bad starting point for the businessman, facing new competition as a result of the 30% devaluation of sterling against the euro over the last year.
THE STRATEGIST’S TOOLKIT
Many businesses have found ways to fundamentally reconfigure their value chains. Operations specialists may use ideas from World Class Manufacturing, drawing on the role models of companies such as Toyota or Motorola to discover the secrets of ‘Lean’ manufacturing and ‘Six Sigma.’ They may use Business Process Re-engineering to radically re-examine the basic processes. They may also look at the decision of what to outsource in a far more sophisticated way than the accountant’s crude ‘Make or Buy’ decision.
Human resource experts may find ways of restructuring the workforce. Many builders have only a small core workforce, relying on subcontractors and casual labour for any given project. Other businesses might wish to emulate this particular approach to the labour force.
There is evidence that accountants are occupying an increasingly important role in current strategies for survival. Their training and numerical skills equips them singularly well for this arduous and often unpleasant task. There are no easy quick fixes and accountancy does not provide all the answers. What may be useful is an understanding of the tools and techniques employed by leading companies, as well as seeing how they fit into the broader strategic framework. With this understanding accountants should be well equipped either to lead the team or at least make a key contribution in the difficult search for solutions.
Tim McCormick is a Chartered Accountant who has spent his career in financial training after a long spell in investment banking. He is coauthor (iwith Dermot Duff, who has a strong, practical and diverse background in Operations) of Strategic Cost Reduction or How to Radically Slim Down your Organisation, while Staying Fit and Surviving published by ICAI (2009).