Cost reduction

Overview

Most companies are in business to deliver strong profits and hence need to increase revenues, whilst managing cost.  Taking cost out of your business is an important requirement for remaining competitive within your market sector and towards evolving your business into the future.

There are many reasons why you may wish to undertake cost reduction initiatives, including:

1. An unexpected deterioration to your market conditions;
2. Ongoing issues with your business performance;
3. Creating the right foundations for scaling up your operations;
4. Restructuring your group following an acquisition or divestment;
5. Generating funds to invest in your growth initiatives; and
6. A revised company strategy that requires you to change.

The purpose of this article is to cover ten important themes that will help you to manage your ongoing costs and to implement effective cost reduction programmes throughout your business journey.

Theme 1: Finance versus Economics

Your income statement tells you who is spending the money, but it doesn’t tell you why you are spending it and hence it is not giving you the right information.  You cannot take cost of your business without understanding your cost drivers.

Your starting point is to create an economic model and the key to this is Activity Based Costing (“ABC”).  ABC allows you to match costs to activities, so that you can properly understand why people are spending money.

Traditional costing tends to over cost the simple activities and under cost the complex activities, which leads to bad decision-making.

It is essential that you fully understand your economic engine and what drives cost.  After detailed scrutiny, many people discover that your simple activities actually drive more underlying profit than you previously realised.

Customers buy products and services that are generated from processes and activities, which consume resources.  Some of this is product cost, however typically around 90% of costs sit within your overheads.  Therefore, it is crucial to properly understand your overhead costs.

Activity Based Costing looks at the cost of processes and activities, and how these are driven by products, services and customers.  This provides a better understanding of your overall cost base than traditional costing:

ABC differs from traditional costing, which looks to allocate costs to outputs.  ABC looks at everything that your organisation carries out and starts by considering the activities incurred due to outputs.  Outputs require activities that consume resources.  It is crucial to understand what your people are actually doing by performing detailed activity analysis.

Once you fully understand what people are doing, you will then be able to determine which costs to take out of your business without significantly damaging it.

Theme 2: 80/20 Rule

Finance leaders should properly understand which customers and products drive your profit contribution.

Company research suggests that:

a) 20% of customers typically drive 80% of your profits:

This graph suggests that companies should focus more time on winning these types of customers and on maximising revenue opportunities from this segment of your customer base.

b) 80% of business effort is going towards customers who are driving only 20% of your profits.

The bottom 20% of your customers is often very interesting as it typically contains too many low volume customers with high costs.  You need to ask yourself whether these customers are your future profit generators, or whether they are draining your valuable business resources that could be better used elsewhere.  This will help you to determine whether you can walk away from your bottom 20% of customers, which needs to be juggled against other business considerations such as protecting your brand, generating product innovation and delivering your strategy.

Most businesses suffer from the 80/20 Rule and need to work more with the top 20% of your customer base, whilst getting rid of your bottom 20%.

However, in practice it is not quite that simple as you may need to exit contracts, remove employees and replace your bottom 20% of customers with more revenues from your top 20%.  This requires finance, marketing and other departments to all work together effectively, often in a different manner to the past.

Theme 3 – Take cost out in the good times

Most people typically only consider cost reduction when it becomes urgent.  This requires radical actions that could have been avoided if your changes were implemented over time.

Unfortunately, this will have less of an impact than if you carefully implement cost reduction initiatives over time due to the following reasons:

• When times are bad, the options available are far fewer;
• Many cost-saving projects cost money up-front and tend to be unaffordable during tough times; and
• In the very short term, nearly every cost is fixed and takes time to improve.

Finance leaders should focus on driving efficiencies at the right time, rather than waiting for a crisis.  This will allow you to take better actions and to benefit from improved profit over a longer period of time.

Theme 4: Zero based budgeting (“ZBB”) is your best friend

Go back to first principles and build your budgets on a bottom-up basis, whilst justifying why you need to incur each cost.  You start each cost item from zero, rather than using last year plus X%.

• Start with the absolute essentials of what you need to spend so that you can run your business. This forms your baseline cost.
• Next, add in the costs of your strategic imperatives.
• Then challenge everything else to determine if it is really needed and whether it fits with your strategic plan.
• Beware of building in contingency amounts.

Note that ZBB can be done any time and should not be thought of as a year-end exercise such as an annual budget.

Theme 5: Realising the benefits

Many people ask the following questions: “When can you claim that a cost has actually been saved?”

Experience suggests that you can only claim a cost-saving once it has been taken out of your budget.  Otherwise, there is a strong possibility that these costs will continue to be incurred.

A cost reduction programme should be focused on your business priorities.  You need to ensure that your existing initiatives and your new cost-saving initiatives are fully aligned with the strategic direction of your business.  This will result in a portfolio of aligned initiatives, some of which are strategic and some of which are operational.

Finance leaders should wrap these together into a change programme, representing a balanced portfolio of improvement projects that deliver the change required within your desired timetable.

These initiatives will fall into three categories:

1. Quick wins: Operational items that are easy to spot and can be solved within days or weeks, such as eliminating waste or bureaucratic drag.
2. Focused improvement projects: Streamlining processes within defined areas during the medium-term (3-5 months). For example, adopting best practice to reduce cost.
3. Major projects: Strategic projects lasting more than six months, which deliver significant performance improvements by addressing core processes.

A good change programme will have an element of all three of these categories.  However, you should avoid having too many competing projects taking place at the same time, otherwise your teams will suffer from initiative overload.

Theme 6: Align everything with strategy

Cost reduction initiatives such as Zero Based Budgeting (“ZBB”) will only work if you have a robust strategy.

Finance leaders need to ensure that your strategy and business plan are well thought out, are realistic and match the economic model of your business.  Cascade your business plan to your entire workforce and make sure that it is fully understood.

Your plan needs to be sufficiently clear for ZBB to work effectively.  The existence of each individual department needs to be clearly linked to your strategy.  Each project needs a business case to justify its existence and to avoid duplication.

The back office is a great place to find savings as it includes IT, HR, Finance and Procurement.:

Each of these areas cover a significant number of functional activities, many of which can now be automated to reduce cost.  Most back offices also suffer from a huge degree of duplication that can easily be removed.

Theme 7: Simplify, Standardise, Automate

The traditional finance function provides some decision support and accounting operations.  However, the majority of time was spent on processing transactions such as Accounts Payable, Accounts Receivable, Treasury and General Ledger processing.

The modern-day finance function looks very different and requires significantly more time dedicated towards decision support, whilst spending significantly less time on processing transactions.

Finance leaders should start by simplifying your processes and then standardising them across your business operations.  This will put you in a strong position to embed technology systems into your finance function that will automate your transaction processing.

You may wish to benchmark how much your transaction processing costs you as a percentage of your overall business expenditure.  Alternatively, consider how many transactions can be processed per full-time employee.

Many companies now outsource various activities to save costs and to free up time.  You should simplify your processes as much as possible prior to outsourcing them, so that you minimise cost and reduce issues arising from unnecessary complexity.

Theme 8: This isn’t just for the big firms

Many of the above activities were traditionally only feasible for bigger firms using shared services and expensive ERP systems.

However, there are now an ever-growing number of cloud-native finance software providers who are affordable to small and medium-sized companies.  Many of these affordable solutions have pre-built integrations with other technology providers.  These allow you to easily integrate your preferred selection of best-in-class applications, without the need to engage expensive software developers.

Theme 9: Continuous improvement

Finance leaders should always have continuous improvements in place.  These may include a combination of ongoing initiatives such as Lean, Six Sigma and Value Based Management.

You should constantly be using these methodologies to take cost out of your business.  This will avoid you having to implement these initiatives during an ineffective panic mode, when you suddenly experience an unforeseen crisis.

Theme 10: Look forwards not backwards

You will not find the information that you need for cost reduction initiatives within your accounts.  Your income statement will tell you what you have spent and who spent it, but it will not tell you why you have spent the money.

Finance leaders should monitor KPIs based upon your business plan to bring your income statement to life.  These will align your strategic objectives to your ongoing activities and resources.

A rolling forecast will help you to understand what is currently happening within your business and to better predict what will happen in the future.  A budget looks backwards and has limited use in identifying cost-saving initiatives.

Summary

Taking cost out of your business is an essential exercise for future-proofing your company and for remaining competitive within your sector.

Finance leaders should be implementing cost reduction initiatives on an ongoing basis to avoid having to urgently do this during an unexpected scenario, which will result in a less effective and efficient outcome.