TagCost Transformation

Achieving True Cost Transformation

Suppose your business is facing significant competition from traditional and non-traditional competitors. Demand for your company’s products and services is tepid and customers are deserting you. Revenues are in sharp decline and the impact is beginning to show in shrinking margins.

To increase revenues and alleviate shrinking margins you try to cross-sell and up-sell your products and services, but all your efforts are in vain. You ultimately decide to embark on a company-wide cost transformation initiative.

Do you cut back on equipment investments, reduce marketing and IT spend, sell some of your business assets, lower inventory levels, lay off certain employees, freeze salaries, shrink transactional administrative costs or eliminate all cosmetic travel and training?

Although the above cost reduction measures are all necessary, they are basically short-term wins which are difficult to sustain in the face of new technologies, changing customer expectations and increasing competition from new entrants and other disruptors.

Cutting costs for the sake of it

Many organizational cost transformation initiatives fail to deliver lasting gains because they are often implemented in isolation without the context of the broader strategy of the business. You need to understand that cost transformation is not simply a matter of cutting costs randomly.

Rather, gainful cost transformation is linked to strategy and drives the effective execution of that strategy. In my experience, I have realized that majority of cost initiatives are more inward focused and less outward focused.

It’s all about increasing the bottom line as opposed to making sure the business remains competitive. More backward-looking and less forward-looking.

Because cost management is misaligned with business strategy, there is little focus on generating capital to fund strategic growth initiatives or diverting resources from low performing business units or unviable markets towards higher value and return opportunities.

Partly to blame for this misalignment is lack of understanding of strategy by employees across the organization. As a result, employees are unable to distinguish necessary costs (essential to meet customer expectations and deliver the organization’s value proposition) from unnecessary costs.

That is why it is important for employees across the organization to have a clearer understanding of the strategy of the business, its objectives and how these will be achieved, including the costs.

The devil is in the detail

Given that there are necessary and unnecessary costs, implementing across the board cuts will only yield marginal gains. Ultimately, high performing business areas or markets end up badly impacted because of such mediocre management decisions.

Instead of channeling resources towards investments, projects and markets which matter, or customers who matter, lackluster business performance areas tend to receive the limited resources.

To obtain customer, product or channel profitability visibility and optimize costs, you need to understand the key drivers of each. Implementing activity-based costing principles and techniques can help you answer any cost transparency and visibility questions you might have.

For instance, basing cost reduction decisions on consolidated gross margin alone obscures the reality that your business is actually making losses on particular products, customers or in certain markets.

You therefore need to drill down and understand the costs-to-serve each customer, service line or product and their drivers. This will in turn help you explain why costs are unnecessarily higher in certain business areas and make informed decisions.

Thanks to advances in technologies, companies are now able to leverage advanced analytics to analyze customer, product, market and channel data and generate insights into costs and where savings opportunities exist.

Use it or you will lose it

This culture is prevalent in organizations that are yet to break free from the shackles of the traditional annual budgeting process. During the financial year, business unit managers underspend their budget allocations.

However, towards the end of the year, to avoid losing the unused budget allocation in the forthcoming year, they willy-nilly spend the funds resulting in unnecessary costs. These funds could have been deployed somewhere for profitable return.

Unfortunately, such scenarios do little to transform the cost structure of the business and transition to a value-based model.

To avoid the culture of “use it or you will lose it” spreading over, leaders need to foster a culture of accountability, performance reporting and continuous improvement.

Hence the need to align cost transformation initiatives with strategy. Cost reduction targets must clearly be defined, both at enterprise and business unit levels, then hold leaders accountable for achieving performance improvement goals.

It’s therefore imperative to educate employees on the future financial needs of the business. They need to understand the costs that really add value in your business, and those that don’t.

Cost transformation is not a one-time initiative. Instead, it is a continuous improvement approach for leaders seeking to transform the cost structure of their companies and deliver a sustainable business advantage.

This does not necessarily mean that leaders should entirely focus on cost reduction efforts. You need to maintain an appropriate balance between achieving cost reduction targets and supporting necessary innovation and process improvements that drive effective execution of strategy and the ultimate success of your business.

Prioritizing cost optimization initiatives with only short-term goals in mind can cause unanticipated problems.

The Role of Finance in Pricing Decisions

One of the key financial metrics constantly measured and monitored by the business is the level of profitability growth.

For any company, profit and positive cash flow, are both critical and with a company that does not initially have investors or financing, real and not paper profit may only be its capital. Without sufficient capital or the financial resources used to sustain and run a company, business failure is imminent.

The bottom line is that no business can survive for a significant amount of time without making a profit. That being the case, the measurement of a company’s profitability, both current and future, is critical in the evaluation of the company.

In an environment where competition is intense, customer loyalty is diminishing and business growth is not a guarantee, the scramble for the profit pie is far from over.

Faced with these mounting challenges, businesses embark on cost transformation initiatives to boost profit margins. Normally, the exercise starts by looking at the company’s Profit and Loss historical spend, analyze the cost drivers, justify the spending and then make the decision to wield the axe or not.

Sometimes an across the board approach is pursued whereby an equal percentage cut is applied to all business areas. The drawback of such approaches is that they only allow you to extract limited savings that are not sustainable in the long term.

Also, business areas that have future potential for growth and require continual attention and investment are sacrificed for short term gains.

In other cases, the focus is more on increasing revenues, either through new business development, growing the existing product line, up-selling or cross-selling. Provided there is demand for your new offerings and recurring costs are not significantly high, the results could be different.

However, there is another focus area, in my experience, I have noticed is often not granted adequate resources and effort despite its massive potential to grow both revenues and profitability.

Effective Pricing

Pricing has a substantial and immediate effect on company profitability and any significant price changes in either direction can have unexpected effects on the bottom line. Managing pricing is therefore a vitally important lever to increase profitability and generate funds for investment.

With margins increasingly getting squeezed due to costs escalations, using the wrong pricing model for your business increases the risk of losing money on some customers or contracts by applying the same pricing approach and margin across the board.

Although companies differ noticeably in their approach to price setting, the goal should always be to get the price right across all customers, channels, segments, products and service lines. The challenge today, especially for B2C businesses, is meeting the constantly evolving needs of consumers at a reasonable profit.

Consumers are increasingly demanding quality, immediate availability and superior after-sales service at a much lower cost than before. On the other hand, input costs are not declining. In such an environment, the effectiveness of traditional cost-based and competition-based pricing approaches is challenged.

Since these approaches are reactive in nature, perhaps the competition has raised prices or perhaps the COGS has increased, can you afford to raise prices without losing business to a competitor?

Finance and Sales & Marketing Collaboration

In a number of organizations, pricing decisions are the remit of sales personnel in the field. The absence of robust pricing processes in these organizations often result in sales personnel basing pricing decisions on gut feel.

Additionally, because of the pressure to bring in new deals and reach the sales quota, heavy discounting is widespread and chaotic.

Working hand in hand with sales and marketing teams, finance can help fix the broken system and bring transparency and discipline to pricing decisions.

  1. Clarity on customer sensitivity to price variations: With so many factors affecting a company’s profitability, it can be difficult to determine the best way to price your products and achieve the desired profit levels and customer loyalty. However, disciplined pricing execution is highly dependent on the specific products’ price sensitivity, or customers’ willingness to pay a different price for a product without affecting demand. Leveraging their commercial acumen and analytical strengths, finance personnel can help develop business rules and sophisticated tools that quantify customer price sensitiveness and willingness to pay and improve price levels.
  2. Document and implement new processes: In the absence of robust processes to ensure discipline in price setting and prize realization, the organizational consequences of not following pricing guidelines are too big to ignore. As process improvement specialists, finance can help put into practice processes and tools to document, monitor and communicate incentive systems, acceptable discount levels and price variances to sales and marketing teams and other decision makers. As a well-run business, you want to ensure that the price the company gets is a close as possible to the price the company wants. Thus, any price changes have to be justified and documented for approval.
  3. Define pricing boundaries: Companies usually use historical heuristics, such as cost information, to set prices. At the anniversary of each contract and during pricing review, very rare do most of them calculate the customers’ costs-to-serve. A standard increase is applied to previous pricing rates with the objective of getting a certain ROI or a certain markup on costs. This simplistic approach ignores the customer’s perceived value of the product as a critical factor for determining the final price. Finance can look to see whether or not the price points are too low, too many, or are at least profitable and value-based enough to be implemented. Through scenario planning practices, finance can run test-and-learn plans that help define pricing boundaries. New approaches are piloted, and prices are then optimized based on what works and what doesn’t.
  4. Drive change throughout the company: Evolving from pricing based on cost or competition (me too) to pricing based on customer value is a continuous learning process that requires a shift in culture. The process requires top management buy-in, sponsors and change agents who are committed to improving the organization’s pricing capabilities and overall system effectiveness. Finance business partners are well positioned to act as change agents, internalize value-based pricing and motivate the organizational changes required to support it. They are able to help colleagues understand the value reflected in prices. In turn, sales teams are empowered to address customer or client questions related to price variances and walk away from unprofitable deals.

Customer Experience and Customer Perceptions

It is vital for businesses to develop a deep understanding of their customers’ needs, perceptions of value for money and how any shifts in prices alters their willingness to pay. At the core of value-based pricing is having the ability to balance costs and the benefits attributed to your product or service.

One of the grave mistake you could make as a business is falsely assume that customers will immediately recognize and pay for your innovative and superior product. Today, rather than base their purchase decision solely on price, customers first want assurance that your product is the right one to fulfill their Jobs-to-be-done.

Instead of asking, “How can we achieve higher prices in spite of strong competition?” you need to start asking, “How can we generate additional customer value and increase customer willingness to pay, in spite of strong competition?”

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