Cost Reduction Analysis (#103)
/In this podcast episode, we discuss the best ways to reduce costs in a manner that negatively impacts the organization the least. Key points are noted below.
Let’s say your company wants to reduce expenses. The simplest method that we’ve all seen is to order the same percentage cut in expenses in all areas. The CEO will say that this is the only “fair” way to make reductions.
Problems with Cost Reduction
The trouble is, some departments are better managed than others and the good ones operate pretty lean. Those managers can have a really hard time figuring out where to cut expenses. On the other hand, if a department is being managed poorly, then that manager has probably let some excess fat build up in his budget, and he can more easily meet the reduction target. So if you implement the same cuts everywhere, the bad managers look like heroes, and the good managers struggle to keep their operations going.
And another problem is that when a manager is told to cut a certain amount of expense, he does it – and then he reallocates the work load around the remaining people, so you have to expect a period of reduced productivity, while everyone learns the new parts of their jobs. And, at least for a while, some things will be done poorly, or late, or not at all – and what if those things are in critical areas, like customer service?
In essence, you cannot cut deep into an organization and expect to keep everything running properly. If you try, then everything is stretched too thin, and at some point you start seeing fallout, like losing burned out employees, or poor customer service.
The Binary Approach to Cost Reduction
So, the better way to handle cost reduction is black-and-white. Literally. Either you decide to continue doing something, or you don’t. There is no middle ground, where you shave away a few expenses here and there.
For example, your company operates a bunch of retail stores, and it has to cut expenses by some large percentage. It could do this by reducing store hours at all of its stores to save money on payroll, but that cuts into revenues. Or it could cut the staff at every store. But that reduces customer service. Or, it can look at the profitability of each store, and close the ones that aren’t producing.
The last option is the best one. The reason is, that store profitability is on a bell curve. That means there’re always a few bad ones. So, do you take resources away from the profitable stores to support the bad ones? Because if you do, you’re effectively driving down the profits of the good stores, and that means you’re essentially driving the whole company into mediocrity.
And, you can move the concept up a notch, and review the profits of an entire region of stores, to see if you should drop the entire region. This may make sense if they’re all serviced by the same distribution center, since it wouldn’t make much sense to pare back to just one store in a region that’s being supported by a big warehouse somewhere.
Not everyone is in retail, of course, so let’s look at it from the perspective of the business unit. Let’s say you have a flight operation that does aerial photography. This should be tracked as a complete profit center, which means that you’re offsetting the cost of the airplane, and the flight crew, and fuel, and sales staff, and operations manager against revenue. If the entire unit is losing money, then the decision is really whether you should drop the entire business unit, and not trying to get by with one less pilot, which brings up other issues with flight safety.
So let’s change the example and talk about functionality instead of stores or business units. What if the company focuses all of its expertise on marketing, and its losing its shirt trying to operate a distribution warehouse? The question is not how to reduce expenses at the warehouse; the real question is why the company is in the warehouse business at all, and how can it outsource the entire operation.
Customer Profitability Analysis
Or let’s change the example to a customer. Which ones generate all kinds of revenue volume, but requires so much support staff time that the company actually loses money on them? The decision here is to either jack up prices to that customer, or drop the customer. And by the way, this is a difficult analysis, because if you decide to drop the customer, your assumption is that all of the support expenses vanish – and that may not be the case. Customer support tends to be spread around among a lot of people, so if you drop a customer, the offsetting expenses you were hoping for tend to be reabsorbed back into the company.
And that means that if you’re looking at the customer base to cut expenses, your best bet by far is to raise their prices. If you can’t raise prices, then know in advance exactly who’s being laid off when you get rid of the customer.
Impact on the Accounting Department
So this is all very nice, but how does it impact the accounting department? You may have noticed that these analyses all involve giving information to senior management about the profitability of just about every aspect of a company.
These reports aren’t something that the accounting staff suddenly scrambles to assemble when the company is in a crisis. It isn’t like you should be handing over these reports to management, and they say “whoa, I didn’t realize we were losing so much money doing that!”
If that’s the case, then accounting is not doing its job. Instead, you should be preparing these reports well before there’s a crisis, so that management is well aware of the expenses, and which profit centers are having issues. If management has this information in hand all the time, and the CFO drives an ongoing cost review process, then hopefully there’ll never be a need for more drastic action.
Parting Thoughts
And another point. When I say these decisions are all black-and-white, go or no go decisions, I’m doing so to make a point that it’s generally the best way to reduce expenses. Now in reality, sometimes a business unit or a store or some other function is so badly managed that you can send in a good manager and fix it. So I’m not saying that as soon as something goes south, you dump it. However, I am saying that you shouldn’t spend forever trying to fix it. If it’s clear that something will at best be a marginal performer, then – yes – the decision should focus on eliminating the whole thing.
So, why is this extra level of cost reduction analysis better than across-the-board cuts? I’ve listed a lot of points already, but another one to consider is that the impact on the company as a whole is massively reduced. You completely cut out those (hopefully) few pieces of it that’re really losing money, and leave the rest entirely alone. Depending on how you handle it, people elsewhere in the company may not even release that there’s been any cost reduction at all.