Reduce costs
For a business, cost reduction should be a golden opportunity—almost literally so. But sometimes, the outcome can be very different: cost reduction initiatives that backfire, don’t deliver, or even harm the business.
Bear in mind the interaction between the business’s financial strategy and its commercial or business strategy. If the two are pulling in different directions, cost reduction can backfire.
Quite simply, random cost reduction is dangerous: it can damage customer relations, harm employee morale, create conflict and inhibit the achievement of strategic goals.
Take, for example, a magazine publishing company, the capital value of which is usually derived from its advertising revenues. Managing the business with a view to a trade sale, it’s clear that quick cost savings in advertising sales staff might improve the bottom line.
Equally clearly, by harming advertising sales, it could have a disastrous impact on the capital value of the business.
For this reason, I usually recommend that cost reduction exercises are led from the very top of the business, where strategic responsibility also lies, rather than being regarded as an operational detail.
This should be led capably, and convincingly. Remember: strong leadership won't guarantee success or support from the grass roots—but its absence will almost certainly guarantee failure.
Cost reductions must be sustainable, and not ‘window dressing’. All too often, I see businesses blindly slash budget headings such as training or marketing – which may produce the desired result on paper, but will either damage the business if carried through, or simply not happen in practice.
Just as unsustainable – not to mention damaging – can be cost-cutting based on budget variances, without considering what the underlying activity actually represents. All over-spends are not necessarily bad, and all under-spends are not necessarily good.
If a company finds itself in a position where more marketing spend will deliver more profitable sales, then an overspend on marketing in comparison to the original budget is sensible. Likewise, under-spending on health and safety looks good on paper – until there’s an accident.
Use reporting and management tools to make sure that target cost reductions actually happen. Many smaller businesses fail to use the reporting tools they possess when wanting to get a better handle on costs. These days, there can’t be a financial software package out there that doesn’t have an ‘actual vs. budget’ reporting capability, but it’s a fact of life that alarming numbers of smaller business either don't know that they have access to these facilities –or if do know this, fail to use them.
Put another way, for many businesses the answer isn’t to invest in new budgeting and reporting tools: instead, it’s to make better use of the ones that they already have.
It’s also important to bear in mind the behavioural aspects of cost reduction. How many times do we come across people who say: “I've got this budget, so I'm going to spend it—because if I don't, I'll lose it next year.”?
In businesses where this kind of thinking is prevalent, the budget has in effect become both the minimum and the maximum spend, rather than authority to spend up to a certain limit if circumstances warrant it.
Another common self-deception is changing the size of the budget ‘pots’ to reflect actual expenditure. It’s fascinating to see people move budgets around, within the overall budgeted expenditure, simply to produce a “we've met our budgets” feel-good factor.
Not only is this pointless, it hides over and under-spends and is actually misleading. Seeing an energy cost figure that’s 30% above budget might actually prompt some corrective action—seeing it miraculously within budget only disguises the issue.
Similarly, comparing actual figures to the previous year may give management a warm glow – “We're 10% up on last year,” for example – but comparison to an anticipated budget figure is usually more meaningful. Being 10% up on the previous year is fine, but not so good if your industry and your competitors are growing at 20% per annum.
Finally, good budgeting helps businesses understand the link between business activity, and cost. A business that sets a budget by saying, for example, that labour costs will be 5% more than last year, doesn’t really understand what that budget represents – it is just a pot of money. And if it subsequently over- or under-spends it is difficult for it to understand why.
Better by far to know what the budget represents: x people at y gross salary plus employer’s national insurance contributions, plus employer’s pension contributions of z.
That way, if the outcome is different from the budget, it is possible to identify why—and conversely, it’s possible to convert a desired cost reduction, of say 10%, into what that would actually mean in terms of the effect at the sharp end.
Cost reduction is never easy – but by following these five simple rules, you’ll at least be making sure that your hard work isn’t wasted.
By Donald Forsyth, partner, business advisory services, Scott-Moncrieff
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