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ITW # 3 – a guide to cost reduction

ITW # 3 – a guide to cost reduction

by alexander roan

Welcome to the third edition of ITW – ‘Interesting Things this Week’ 🙌🏻

This weeks newsletter is dedicated to cost reduciton. In the news; the independent wrote about cost cutting in UK retail, the BBC wrote about layoffs for aviation workers and UK job cuts in general. HSBC were also in the headlines as they decided to continue with their plan to lose 35,000 employees. The OECD reported that global economic activity is expected to fall by 6% in 2020 and OECD unemployment to climb to 9.2% from 5.4% in 2019. A theme of 2020 for many companies will be the need to cut costs as a way to mitigate reduced income.

With this as a backdrop I’d like to talk further about the approach to cost reduction.

1) Cost reduction and CSR

Whenever discussing cost reduction it’s important to consider corporate social responsibility as a starting point. Ideally companies can find the right balance between reducing costs and thinking about employee and business partner (e.g. supplier) impacts. Employee layoffs can have a devastating effect on individuals. Business partner changes can put companies out of business. When planning and executing cost reduction these impacts should be considered. In real life this might mean trying to offer employees other options (reduced hours / different contract terms / new profit generating roles) or business partners a revised agreement.

2) A model for cost reduction

A good starting point for cost reduction is to consider the type of costs incurred within the business. Accounting provides a consistent way to look at this. Costs are either tied directly to production or not. For example; in a manufacturing environment there are factories with machines, operated by people to produce products. Cost accounting is used to calculate ‘cost of goods sold (COGS)’. This is the cost that can be directly tied to converting the input materials to the finished product. In this case by adding the raw material, labour and utility costs.

figure 1: cost structure

In addition to COGS there are operating expenses. They include the entire cost of departments such as accounting, human resources and IT. They also includes the costs of headquaters or sales offices. The majority of operating expenses are sales, general and administrative costs (SG&A). This is sometimes further broken down to sales costs (S&A) e.g. advertising campaigns and general and administrative costs (G&A) e.g. rent and utilities.

In service industries there are no COGS so SG&A is even more important.

This structure will be useful in planning cost reduction initiatives. Each cost area can be considered in turn. Typically SG&A is seen as one of the top priorities of cost reduction as it’s somewhat independent of production and sales volume.

Approach to cost reduction

A basic approach to cost reduction that many organisations follow is to set blanket cost cutting targets across the entire enterprise. Why? – perhaps because identifying the best place to cut costs requires a lot of analysis, thought and difficult decisions. Setting blanket targets across seems to be an easy way out and hands the responsibility to individual budget owners.

Costs are normally managed as part of annual budgets. This annual budget settting process is complicated. It can take as long as 6 to 9 months to set budgets. Typically the executive set high level targets on sales, margin and costs. These are then filtered down through management layers to individual budget owners. There is then a back and forth that can continue for several months to agree the budgets. The targets are often moving during this process.

Budgeting is often based on previous year actuals. If the executive takes last years budgets and asks each team to cut costs by 5%, each budget owner will try to negotiate a lower % cut. This leads to an allocation of investment based on the individual budget owners ability to justify and negotiate. The company might make it’s 5% target, but at the cost of reducing investment in the wrong areas.

A better approach to cost reduction would be to start from strategy and think carefully about the right areas to reduce costs.

During this strategy review the executive can carefully consider the products / services and markets and the different cost categories present across the business. An approach would be to build a matrix by cost category and product / service and answer some questions:

  • How closely tied is the cost to sales and production;
  • Has cost been challenged or reviewed in that area previously;
  • Is that department a key dependency for high volume or highly profitable products / services or customers segments;
  • How easy is it to make changes to the area in question;
  • etc.

This kind of analysis would be useful for deliberating the right focus areas for cost reduction. These will differ based on industry / market etc. Another useful tool is to apply zero-based budgeting. This will move away from assuming previous year budgets are the right starting point.

A word on benchmarking

Benchmarking is a common tool which helps to reduce costs. Ratios of different cost to revenue factors are often used to get a broad idea of whether a particular part of a company is efficient and shows value for money. The cost of the finance function as a percentage of revenue is an example of this.

But benchmarking can also be used in more granular ways. Two examples:

  • Checking salary rates against competitors – easier than ever with the advent of online comparison tools;
  • Internal benchmarking of departments / functions against one another, this can be done with sales offices, manufacturing sites etc. Where the benchmarked areas have slight differences complexity measures can be identified to adjust the benchmarks.

Ten ways to cut costs

Over the years I’ve seen or been involved in several cost related programs. Here are ten areas where I’ve seen good results.

1. Focus on core products / services

My first employer; Procter & Gamble, is a good story of the importance of focussing on core products and services. Around 2000 P&G were struggling. They had become ‘fat’. Too many new products and services and a large unorganised support function (high SG&A costs). A.G. Lafley joined the company in 2000 and two key strategies helped with the recovery:

  • Focus on core brands / products;
  • Build an efficient back office (simplify, standardise, centralise).

This needs to be carefully planned and will results in a high degree of mid and long term benefits.

2. Cancel projects

The success and cost rates of projects is rarely a focal point of strategy. Every company should have a central PMO that monitors the benefits to cost ratio for all programmes. This is a low effort / light touch PMO. Projects can be expensive, the key is to carefully control project budgets and stop or re-direct them quickly.

3. Create a central procurement organisation

For large organisation scale can be leveraged by procuring centrally. This goes for everything from raw materials to pencils. Rather than individual facilities / locations / teams making their own purchases, all purchases can be handled by a central team. This is an opportunity to buy at scale and also build a procurement and negotiation centre of excellence.

4. Centralise operations – finance, IT, HR, legal, marketing etc.

If staff are decentralised across locations there will be an opportunity to improve rent and utilities costs as well as reduce overall management effort by centralising teams. This can be done for all staff not directly tied to production or field sales. Centralisation has a lot of additional benefits for culture, quality and controls. Centralising functions will also have a knock on effect by simplifying requriements from IT, HR and property services.

5. Offshoring

Offshoring whether based on a captive or outsourced model can massively reduce laboour cost. I’ve seen savings off over 50% on labour, this can be a huge proportion of SG&A, particularly in service industries. This does require detailed planning and very careful execution. However it’s easy to calculate potential savings. First calculate a blended fully loaded cost for the functions you are considering e.g. finance staff, and then calculate the equivelant for any target country of interest. The information to calculate this is easily available freely online.

Outsourcing has somewhat of a bad reputation. Based on my experience this is normally due poor execution. Most of the time the companies squeeze the outsourcing supplier to far on price and hence receive poor service levels. Cost reduction should always be balanced with quality.

6. Review IT licensing

One of the patterns in IT over the last decades has been an ever increasing number of technology products, services and suppliers. It’s worthwhile to consider rationalisation in this space. Is each application needed? Do we have the right number of licenses? Can terms be renegotiated?

7. Deep dive into sales costs

For companies with field sales there may be opportunities to reduce costs. The key factor is to figure out what costs drive success in sales. Travel, events, conferences etc. should be carefully analysed to understand how much they impact sales. Moving events online, or reducing budget for entertainment can result in significant savings.

8. Deep dive into employee costs

Layoffs are one option to save on employees, but there are also opportunities to reduce labour costs. Is the salary banding simple and efficient? Are the package related costs (benefits) good value? Is there an opportunity to change contract structures? Would employees consider a 4-day week?

9. Discounts

Discounting can easily be overlooked on cost reduction initiatives as it happens at the point of sale. Discounts can total up to have a large impact on margin. This is true especially in industries like Pharmaceuticals where complex pricing structures are used.

10. Process improvement

Methods such a Lean culture and tools such as automation (RPA) can be key drivers of effort reduction, however these do not reduce costs on their own. There must be layoffs or re-assignment of people to revenue generating roles.

What the experts say

I’ve taken a look at some of the leaders in strategy and management to see what they have recently published on cost reduction.

McKinsey

McKinsey recently wrote this article about cost reduction, noting that it’s a top priority for most corporations and observing that cost targets seem to be fairly unfoccused. The following diagram is a useful illustration of how organisations normally set blanket targets:

Source: McKinsey

Bain

Bain currently have a webinar that looks at zero-based budgeting and five key themes of cost reduction. They also have an insight article that covers the less widely focussed on fixed product costs together with sustainability. It’s interesting to consider how a move to more sustainable packaging can cut costs. This is a good example of considering cost and CSR together:

Bain also have an article focussing on where to cut costs. They recommend focussing strategically on the right areas of the business. The ‘where to play’ and ‘how to win’ diagrams are useful and are normally an effective way to structure the discussion about the products / services and market segments to focus on and invest in vs. the ones to consider downsizing or as they note below divesting.

Source: Bain

Strategy& (PwC)

One of the first insights posted on Strategy& includes a downloadable PDF where they share a fairly comprehensive plan and approach to tackle cost. At a glance this includes a starting point of thinking clearly abot strategy and the market and then moving onto action. I like the categorisation of short term, mid term and long term actions.

And finally..

With this being the third edition of my newsletter I decided to try something a little different by focusing on a specific topic. Would you prefer future newsletters of this type or a more general format? What would be useful to include; theory, case studies, analysis / links to expert views?


I’ll also be sending this newsletter via e-mail in future, if you would like to receive it in you inbox please subscribe:

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