Business leaders always spend a lot of time thinking about costs and how they can reduce them, free resources for investment and improve the bottom line. The pressure to reduce costs is normally driven by cash flow position, shareholders, uncertainty, investments and the need to improve business performance. In light of the aftermath of 2008 global economic crisis, there has been increased pressure on business leaders, especially financial executives, to achieve more with less. The finance function has had to transform itself in order to improve productivity and efficiency.
If not managed properly, cost-cutting exercises may prove to be an unnecessary enemy that the company does not want to deal with. In some organizations, cost-cutting exercises have taken precedence resulting in the business becoming weak and more limited. On the contrary, if managed properly, cost reduction using activity-based costing and management techniques leads to better performance.
Cost-cutting measures should not be considered in isolation. Instead, cost-cutting should form part of the organization’s overall strategy because every investment, whether good or bad, is important. If the organization is not able to contain unnecessary costs, the impact will reflect in lower profits and cash flow problems. It is therefore important for managers to understand that no strategic planning process is complete without a close analysis of costs. At the same time, no cost or strategy project is complete without a closer look at its impact on the company’s capabilities system.
As Paul Leinwand and Cesare Mainardi clearly state in their book, The Essential Advantage: How To Win A Capabilities-Driven Strategy, the management’s approach to cost control is a key indicator of how coherent the company is or is not. Cost-cutting is meant to free up resources for strategic investments that are aligned with the organization’s capabilities system and way to play. If managers have no clear way to play and are cutting costs randomly, this fuels incoherence.
Unfortunately, some business leaders are still using the conventional approach of cutting costs with the hope of achieving positive results. So many at times, these leaders receive satisfaction only in the short-run. Adhoc across the board cuts, where a percentage of cost reduction is shared equally between functions, normally fail to free up the much needed investment. This is so because adhoc across the board cuts negatively impact some parts of the company that are strategically aligned by stripping them off of the resources they desperately need to perform better. Also, most of these exercises are a benchmark of the competitors’ cost levels which by far are not linked to the company’s strategic priorities.
Using ABC/M techniques can help managers avoid the mistake of focusing on the short term. ABC/M helps identify cost drivers of different processes, activities, products, channels, customers etc. and this in turn help reduce waste by eliminating non-value adding activities. In 2008-2009, many companies across national borders implemented across the board cuts which were misaligned with their capabilities system and way to play. They instituted adhoc layoffs and cost reductions without considering the long-term implications on business performance and competitiveness.
As the global economy started to rebound, these companies found themselves in not so favourable positions of lacking the capabilities and skills essential to drive growth. In turn, they were forced to embark on massive recruitment sprees at huge costs to replace those skills lost during the downturn. On the contrary, those companies that implemented talent management strategies aligned to their overall strategies have managed to come out of the economic slump much better and stronger. This just shows that if the root cause of unnecessary costs is not identified and dealt with properly, they will come back again as if nothing was learned.
To cut costs and grow stronger, the conversation about costs needs to change to a more productive one. The starting point requires you to categorize your costs into costs you need to incur to keep the business running; costs you must incur to maintain your industry position even though your business might run without them; costs that support your capabilities system and way to play and lastly all other costs which are those that do not specifically fit into the first three categories. This distinction of costs helps evaluate the downside that the business would face if it makes cuts or changes in either one of these categories.
Today, many managers are facing the challenges of huge overcapacity and steep loses. The best way to react to these challenges is start looking at their businesses with fresh eyes. For example, to reduce operations costs, they need to start looking at operations as a single network and reconfigure production flows as needed to more flexibly serve customers.
Having eliminated unnecessary costs, the challenge for leaders is to deal with expense creep. It is important to ensure that cut costs do not come back because if these costs manifest again, this is a sign of strategic incoherence. The best way to avoid expense creep is to continuously evaluate costs relative to the organization’s capabilities system and way to play. Only by assessing costs regularly and consistently can the organization become aware of the relationship between its capabilities system and other expenses. In the long run, this will ensure a viable good cost position.