Cutting Costs Without Losing Your Shirt
A Strategic Approach to Cost Reduction

by Derek F. Martin

Are you feeling the crunch? After years of heavy investment and expansion, businesses across the economy are feeling enormous pressures to reduce their costs. Such a tactical reversal is a difficult change in approach for managers mired by the "grow at all costs" mentality of the 1990's. But hold on a minute; despite the sense of urgency at achieving cost savings, it is vital that business managers apply strategic thinking to the reduction of their costs. A well-conceived cost reduction strategy enables managers to capture maximum value in the form of direct savings and the installment of a culture of efficiency while minimizing the destruction of company value resulting from cutting too much from core business activities. This article will outline some of the reasons that companies are feeling the pressure to reduce costs and then offer a five-step methodology for building a foundation of strategic cost reduction (SCR) in your organization.

Why the pressure to reduce costs?
Downturn, economic slump, or recession, whatever you call it the U.S. economy has seen a significant reduction of non-critical purchases across almost every sector. Orders for semiconductors, for example, have fallen roughly 16 % from last year as computer manufacturers adjust to shrinking demand. Couple the reduction of orders and its resulting overcapacity with market factors like a strong U.S. dollar and higher energy costs and you can imagine why many businesses are looking for ways to conserve vital cash reserves.

Pressures from the stock market are another reason companies are being pinched. Just compare the 45% devaluation of the NASDAQ since March of 2000 and you'll see why budgetary issues are of top concern. Burned from recent overvaluations, edgy investors are looking at companies with much greater scrutiny than previous years. Companies who modestly miss earnings expectations suffer swift and brutal backlash from the markets. Under the gun to deliver on earnings estimates in a stagnant market, managers have no choice but to reduce the cost side of the equation.

Finally, the Internet and e-communication can also be blamed for cost pressures on businesses. With all the increases in productivity that e-commerce provides, it has another, more quiet side that increasingly makes cost competitiveness a key in gaining competitive advantage. How can this be? At the heart of the matter we can see that electronic commerce and communication enhancements empower buyers and suppliers alike, removing the friction from business transactions. By friction it is meant anything that can slow down a transaction or cause inequality between the two or more parties involved. Examples of friction include costs resulting from ordering difficulties and delays, searching costs, or imperfect information that permits charging higher prices for an equal or inferior good. As e-commerce continues to proliferate few profit margins will be safe from competitive efficiency (Figure 1).

Where does this friction occur and how does its removal create cost pressure? Whole industries such as banking, insurance, retailing, and automobiles once relied on transactional friction and information asymmetries to provide wide margins from customers who couldn't shop around. The healthy APR's and markups companies within these industries once enjoyed are being squeezed by smarter consumers who use free comparison services such as getsmart.com, mysimon.com, and autotrader.com. Services like tax accounting, law and financial advice which benefited from knowledge arbitrage to pad their books are finding that the average consumer now has access to a host of information and automated service such as Quicken's Autofile.com and e-Schwab.com at a fraction of the traditional cost and processing time. According to Gary Hamel, co-author of the concept of core competencies, "For those companies who have grown fat on friction, inventing new forms of competitive advantage will be no easy task…in our hyper-transparent world, competitive advantage will increasingly rest on an ability to create products, services, and business models that are unique and utterly compelling." If a company is not continuously reducing costs to reinvest in people, process, and technology it will soon be at a disadvantage to its more fleet-footed competitors.

For many companies, the knee-jerk response to these and other pressures has been to cut costs wherever possible. From expense accounts to headcounts, many businesses are frantically slashing operating and overhead expenses in an effort to shore up cash. Witness truck engine manufacturer Cummings, Inc., who will cut 8 % of their employees or 2,000 jobs and close nine plants as a result of a 52% reduction in big truck engine sales in the fourth quarter. But in their rush to cut costs, many companies are also destroying company value. During several of the brief downturns of the 1990's, for example, investment banks such as Goldman Sachs, Salomon Brothers, and Merrill Lynch soon regretted their downsizing efforts as deals picked up and they were forced to hire back many of the same workers at a higher cost and with less allegiance. Today's complex and rapidly changing marketplace require winning companies to approach cost reduction more strategically in order to achieve efficiencies and lower costs while minimizing value destruction.

Consider Colgate-Palmolive, a company operating in the relatively low-growth oral care and hygiene industry and pitted against competitive goliaths like P&G and Gillette. And yet contrary to its competitor's lackluster performance, since 1983 when Reuben Mark began his tenure in the head office and instilled his cost cutting fervor across the company, Colgate-Palmolive shares have delivered an incredible 2,932% return, outperforming even high growth industry giants like GE (who returned an impressive 2,312% over the same period). How can Colgate continue to beat its competitors? A major component has been Mark's incessant crusade for the company to embrace cost cutting in everything they do. From the line worker's new packaging suggestion which saves $0.06 per item to the senior V.P's decision to discontinue unprofitable product lines, cost reduction is everybody's business. It is this type of focus that has enabled Colgate Palmolive to increase gross operating margin from 39.2 to 55% since Mark arrived on the scene - almost two years ahead of schedule. Applying the same focus on your business can achieve similarly impressive results.

Building Strategic Cost Reduction into your organization
Managers who wish to achieve SCR in their own businesses can do so by following five steps to introduce, position, and integrate SCR into the organization.

1. Generate buy-in with key stakeholders on the need and definition of strategic cost reduction. To avoid the negative connotations that employees may have with cost cutting, it is necessary to clearly communicate what strategic cost reduction is and is not. At its core, SCR eliminates waste and conserves resources in order to reinvest the savings in critical business assets like employees, technology, and R&D. Reducing costs does not mean unnecessarily reducing quality, skimping on service, or anything else that could undermine a company's longevity within a competitive marketplace. Instead, strategic cost reduction takes advantage of every opportunity to better leverage existing and new assets to bring value to customers and shareholders. Although this may result in some pink slips, it is in the interest of fortifying the company thus protecting the majority of jobs from future layoffs.

It is necessary to begin by speaking candidly about these issues with the company managers and supervisors to solicit feedback and generate buy-in. Since they will be responsible for extending the reduction effort across the company, building support for an unpopular initiative within this group is the first challenge. To build this support, management can employ combinations of activities such as chartering cross discipline cost reduction teams, including cost reduction goals in performance evaluations, and recognizing and rewarding employee cost reduction accomplishments.

2. Set your objectives: In broad terms, you should identify what you want this exercise to do for you in the form of a vision statement. Struggling companies, for example, might want to cease their cash hemorrhaging in order to survive until their next round of funding. More established companies use SCR in an effort to stay competitive, while healthy businesses can use SCR to strengthen their competitive position. During a January 17 TV interview, for example, John F. Welsh, CEO of General Electric, referred to rechanneling savings into a 12% increase in technology investment by saying "This is the moment to widen the gap as far as we're concerned." Whatever your situation, being clear up front about why you are implementing SCR is essential for achieving the best results and for communicating the vision to the rest of the company.

3. Align Cost Reduction with Business Strategy. It is vital that SCR initiatives be conceived and deployed in concert with the overall business strategy to ensure that cost cutting does not detract from the strategic vision or negatively affect company performance. This can be achieved by calibrating the company's vision/ objectives with its cash flow and budget, and then determining the financial gap between current capabilities and the future needs of the company. Armed with this information, managers can identify and prioritize areas that need to be strengthened and those to be rationalized.

In practice, this exercise is more difficult than it sounds and may require additional activities to ensure that the prioritization is based on a comprehensive view of the organization. These additional activities include:

· a future state vision if one does not already exist
· identification of mission critical operations and core competencies
· a competency gap analysis (between current state and future state)
· a high-level operational efficiency analysis

This is an extremely important exercise that ensures the cost reduction initiative does not weaken mission critical activities. It defines the business needs for the future, identifies areas that need resources, and locates the activities that will provide those resources through cost reduction.

4. Choose your approach. With these objectives in mind, the strategic manager will choose the cost reduction approach that best meets their objectives both from dollars saved and organizational impact. To oversimplify a bit, the approaches can be considered in two types: pervasive and surgical. Let there be no confusion as to the comparative contribution of the two approaches; even the most effective surgical cost cutting exercises can never create the kind of long-term value that is derived from the pervasive approach which infuses cost containment into the DNA of the entire company. In every factory, cubicle, and corner office, pervasive cost reduction is one of the best ways of maintaining competitiveness in today's hyper-competitive markets.

Sometimes, however, operating constraints or immediate cash crises require surgical cost reduction measures to bring more black into the balance sheets as soon as possible. By surgical it is meant that management pinpoints a specific business unit, activity or input as a candidate for cost cutting attention. It may be a process that is inefficient or an opportunity to leverage skills and information in a better way. Or it could be a single business activity or raw material that represents a significant proportion of total expenses where even a small reduction in cost would have a large impact on total expenses. In cases like these it is possible to isolate the savings candidate and customize the method of cost reduction to achieve bottom line savings relatively quickly and without disrupting ongoing operations.

5. Set Goals and Prioritize. Now that the process has been communicated, the objectives have been outlined, the priorities have been set, and the approach is chosen you can then develop detailed and measurable goals that will help you achieve the broader vision. You must resist the temptation to make an arbitrary % cut across the board, since this may incorrectly assume all of your operations are inefficient and will not suffer from the cuts. Instead, use the alignment insights from step 3 to identify and prioritize savings areas. Make a list of the top 10 savings initiatives and choose 3 to 5 based on cost and efficiency savings versus organizational impact over 1 and 3 years. Make sure each performance target is quantifiable and specific, such as "30% reduction in operating costs from non-strategic units" or "25% reduction in travel expenses."

Now launch the initiatives applying strong project management skills. Evaluate the results and get ready for the next project; this is just the beginning of the race to come.

Strategic Cost Reduction is something every business should be thinking about; past successes and technology cannot protect companies from shrinking margins and strong competition. Firms must start now by embracing the need for cost reduction and building a solid organizational foundation that promotes a culture of cost containment and efficiency. The five-step SCR methodology primes your organization to enact value creating and sustainable cost savings by ensuring that the cost reduction initiative has buy-in from company managers and employees, is aligned with the company vision, that it is applied in the right business area, and that the results are attainable and measurable. Ultimately, these are the success factors of any initiative.


Derek Martin is a consultant with The Pacesetter Group, a management consulting firm specializing in business strategy and organizational performance improvement within the pharmaceutical and financial services industries. For more information, contact Derek at dmartin@pacesettergroup.com and visit www.pacesettergroup.com .

See also Performance Improvement and Leading Change in The CEO Refresher Archives

   


Copyright 2001 by Derek F. Martin. All rights reserved.

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