APPROACHES FOR CUTTING COSTS: A THOUGHT-STARTER

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1 APPROACHES FOR CUTTING COSTS: A THOUGHT-STARTER There are many techniques that a company can utilise to cut costs and improve performance. Whichever you use, the key to success lies in how well they are managed and implemented. You will need to establish a program that ensures attention is maintained on delivering the savings without compromising other factors such as production, sales, service and morale 1. The purpose of this paper is two-fold: to provide some background on what you need to consider before starting a cost-reduction effort and to give an overview of possible approaches. FIRST, UNDERSTAND THE ISSUE Before considering cost-reduction approaches, you should first make sure that you fully understand the issue, so that you can focus your efforts in the right place. This means that the first step should typically be a diagnosis of the problem. Some of the questions that may need to be asked include: - How do your costs compare with competitors? Are you facing a problem (or an opportunity) because your costs are higher? Or are you comparatively efficient, but facing an industry-wide issue that affects your competitors as well? - Are there particular functions where your costs seem to be behind the competition? For example, Operations? Marketing & Sales? Technology? If so, this can help you to establish different targets for cost-reduction in different areas. - What is the root cause of any competitive cost differences? Is your business at a disadvantage because it is smaller than competitors and lacks economies of scale? Is it that your product range is more complex? Is there some fundamental difference in your business system or strategy compared with competitors? - How urgent is the problem? Do you have time to wait for long-term, fundamental changes or do you need to find some improvements more quickly? Benchmarking and other forms of competitive economic analysis can be useful tools at this stage. They can help you and your management team to better understand the need for change and to focus your efforts on the areas of greatest potential. Keep in mind, however, that you can waste time at this stage over-analysing the problem. If you are not careful, your managers will spend the time justifying their current cost levels, rather than looking for areas of improvement potential. 1 This subject is discussed further in a separate paper The Key to Success in Cutting Costs. 1

2 REMEMBER: COST CUTTING MIGHT NOT BE THE BEST WAY In practice, an effective performance improvement program often includes elements of cost reduction together with other types of improvement initiatives. In some cases, it may even be better to leave costs alone and focus your attention elsewhere. So before jumping into a cost-reduction program, it is worth remembering that cost is just one of the ways to improve performance. There is no doubt that cost reduction is often an effective way to increase profits, since cost savings flow directly to the bottom line. But there are other areas of improvement that are often just as powerful and sometimes more so. One example is pricing. If you need to improve profits quickly, a small increase in price can have a major impact on the bottom line and often there is more flexibility in pricing than managers realise. You could increase the price of some of your products or add-on features, for example, and increase revenues without increasing the price for your basic product. Or you could restructure terms to make the offer look more attractive. The Australian mobile phone industry, for example, has developed some wonderful ways to complicate their pricing structures so as to support their revenues. Depending on your industry, there could be other areas that you can focus on. In the insurance industry, for example, claim payments are a much bigger item than expenses and might warrant more attention. In banking, there could be opportunities to reduce credit losses. Sometimes especially in capital-intensive industries it will be better to focus on productivity (increasing output for a given level of inputs), rather than focusing directly on costs. However, once you have confirmed that you do need to cut costs, the next step is to identify, quantify and select specific cost-reduction opportunities. IDENTIFY AND CAPTURE THE OPPORTUNITIES There are many approaches and tools that you can use to identify and capture cost-reduction opportunities. Some of these focus on quick results while others involve long-term fundamental change. Some companies focus on one main approach, others will combine a range of approaches. The following checklist is not intended to be a comprehensive record of every approach. It is intended to act as a thought-starter, allowing you to consider which approach, or approaches, might be best for your situation. Cut the Headcount and Let the Work Sort Itself Out It is not uncommon for companies to cut headcount or cut budgets and then expect managers down the line to decide how best to cope. This is certainly the quickest approach in a crisis but it comes with big risks. It does nothing to clarify where the inefficiencies really are and it will usually appear arbitrary and illogical. The result could be unintended damage to 2

3 production, sales, service and/or morale. Some managers may even do this deliberately, cutting out important activities to reinforce their case that their area is already efficient and cannot cope without more resources. Good Old-Fashioned Brainstorming Sometimes the simplest approach is the best. Experience suggests that there will be a huge number of cost reduction ideas lurking around every company. Simple brainstorming sessions might be all that is required to surface them and generate more. Of course, you will need to follow a systematic and vigorous process to capture the ideas and to evaluate and refine them to make sure that they are effective. Some ideas might be simple and easy to implement. Others could lead to major projects in their own right. Many of the cost-reduction approaches mentioned below also rely on basic brainstorming and a systematic evaluation of ideas as an integral part of the process. (Most of these approaches, however, focus on different aspects of the business as a starting point for the brainstorming. These different ways of viewing the business enable you to highlight different types of opportunities and to develop new ways of working.) Activity Value Analysis (AVA) This approach involves systematically identifying the costs of different activities, allocating those costs to end products, and then assessing the costs against the value of the end products. Brainstorming is used to identify ways of cutting the costs of each end product. The key to success here is to analyse these costs systematically and then ask the end users of the outputs from each activity, together with the people engaged in the activity, to evaluate the costbenefits and explore cheaper alternatives. This approach is well suited to cutting costs in overhead functions, such as Finance or Marketing, where there are lots of separate activities, each involving a relatively small number of people. Project Value Analysis The concept of value analysis can be applied in other areas, such as projects. In the IT function, for example, software development costs can be reduced by systematically reviewing the cost of each project relative to the quantifiable benefits (value) of each project. Here the end users, not the IT function, should prioritise the projects and drive the decisions to cut costs. This type of review can also be applied to other types of projects, such as R&D projects. In areas where projects are the normal way of working, this approach can be used to review costs that might be missed in a traditional AVA process. 3

4 Product Redesign or Rationalisation Depending on your industry, a great deal of overall cost is determined by product design decisions the range and features of your products and services. There could be important cost savings available from standardising, simplifying or reducing the product range. Design for cost is an important concept that many manufacturing companies are using to improve their results. The concept is also applicable to service companies. Business Rationalisation In some cases, the answer to improving performance goes beyond rationalising the product range to rationalising the business as a whole. This could include discontinuing or selling whole business units or sets of activities that generate disproportionate cost or complexity. It is important to remember, however, that you will only eliminate the marginal costs of any business you close. You will lose its contribution to company overheads unless you can also reduce overheads proportionately. In reviewing a business portfolio, you might also consider acquisitions, joint ventures or alliances to reduce unit costs for example, by providing better economies of scale or scope. Process Redesign or Reengineering Another important approach, particularly in operational areas, is to systematically examine the steps and flows along end-to-end processes. One technique involves quantifying the inefficiencies throughout the process (such as levels of rework and wastage) and focusing on how to eliminate them. Other techniques focus on the cost or timeliness of each activity in the process, and look at each task to see if it can be eliminated, re-sequenced or made more efficient. Yet other techniques focus on the bottlenecks in the process. These techniques for improving existing processes can be classified as process optimisation. Redesign can also take a clean sheet approach going back to basics to rethink what the organisation is trying to deliver and how it does so. Frequently, one of the most important ways to improve processes is through the use of technology, either by automating existing process steps or by creating new ways to do things. Supply Chain Management Some of the biggest improvement opportunities can come from looking beyond the traditional boundaries of the organisation and considering the whole supply chain. More and more, technology is permitting companies to eliminate costs at their boundaries by linking suppliers and distributors directly with the company s systems and processes. This in turn leads to reduced transaction costs, including, for example, reduced inventories. 4

5 Beyond this, there can be opportunities to work with suppliers and/or distributors to improve the efficiency of the supply chain as a whole for example, through better coordination of product and process design decisions. Benefits can flow to a company directly through lower operating costs or, indirectly, through better supply deals or better value for customers. Purchasing Even without restructuring the supply chain, there are often opportunities to reduce the cost of purchased supplies and services including accommodation, telecommunications, technology as well as raw materials and other direct inputs. Over the last decade or so, many companies have consolidated their purchasing functions and realised large savings from consolidating orders, reviewing specifications, reviewing suppliers and exploring different terms. Sourcing Decisions The ability of most companies to manage their commercial relationships with other companies is getting better. Transaction and coordination costs are declining everywhere as a result of new technologies and increasing experience. This helps to explain why outsourcing is a continuing trend. Companies can look at each of their non-core internal functions to see if they can save costs by sourcing them from another company. Alternatively, if your company has the scale, and is efficient in a particular function, you could consider providing it as a service to other companies through insourcing. In principle, this can provide further scale and help to reduce costs. In practice, a lot of attempts at insourcing have failed because companies overestimated the value that they could provide to others. Shared services - effectively insourcing from other parts of the same company is a more common practice. Shared Services An important cost-saving opportunity might come from consolidating a function across different parts of an organisation and setting it up as a shared service for example, shared administration, processing or legal services. One potential benefit here is economies of scale. Another potential benefit and often more important comes from leveraging the best skills. An even bigger benefit can come from forcing the service function to cover its costs by charging for its services. This makes the costs of those services transparent to their users, and encourages better decisions about when and how much to use those services. Organisation Restructuring Changes in organisation structure can lead to savings by consolidating different parts of an organisation structure or by refocusing management on different areas of cost. Shared services are a specific example of organisation restructuring. 5

6 Human Resources Management Not many companies try to save costs by cutting wages and salaries although it has been done. However, there could be potential savings from reviewing employee benefits, or from restructuring incentive plans to better link payments to results. In some cases, outsourcing functions or moving them (for example, to other countries) can be used as a way of accessing cheaper labour. Capacity management can also be an opportunity for example, using part-time or casual staff to cope with peaks and troughs in service workloads. Measurement Systems and Incentives The objective here is not to identify cost-reduction ideas directly, but to give managers the tools to highlight ideas at the micro level and the incentives to get costs down. Work measurement systems come into this category, helping managers to identify areas that are more or less efficient. There are many different tools, such as Activity Based Costing, or simple time sheets, that can be used to clarify the costs of different activities so that managers can make better ongoing decisions about the value of those activities. Ken McLeod March 2003 KEN BRINGS THE SKILLS AND PROCESSES TO ADDRESS YOUR ISSUES OF STRATEGY, PERFORMANCE IMPROVEMENT, ORGANISATION AND FINANCE WITHOUT THE OVERHEADS OF THE MAJOR CONSULTING FIRMS. This work is copyright, Apart from any use permitted under the Copyright Act, no part may be reproduced by any process, or any other exclusive right exercised, without the permission of Ken McLeod, 3/192 Lt. Collins St., Melbourne. 6

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