Cost Reduction Analysis

Tools and Strategies

Steven M. Bragg

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470622476
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Betriebliches Rechnungswesen

Discover the tools for knowing the costs your company should cut, without impacting its ability to deliver goods and services

New from Steve Bragg, this book provides the tools for determining which costs a company should cut, without impacting its ability to deliver goods and services. It explains how to use throughput analysis in order to locate bottleneck operations in a company, which in turn dictates where capital investments should (and should not) be made.

• Delves into process analysis, to determine where excess resources are being used in a business process
• Describes the total cost of ownership, showing how a single purchasing decision actually snowballs into a variety of ancillary costs
• Shows how to create and use a spend management system to reduce procurement costs
• Shows how just-in-time systems can be used to eliminate inventory costs

Cost Reduction Analysis: Tools and Strategies provides examples to show how much cost can potentially be eliminated to avoid drastic action later that can imperil your corporation's direction and future.

PART I

Primary Areas of Cost Reduction

CHAPTER 1

The Cost Reduction Process

Introduction

The reason for having an active cost reduction program is quite simple. A company can work extremely hard to obtain one extra incremental dollar of revenue, which will yield a net profit of perhaps 5 percent. Gaining that extra revenue dollar will be uncertain, and it may be difficult to attain the targeted profit. Alternatively, and using the same profit percentage, a cost reduction of one dollar would have required 20 dollars of revenue to generate. Further, a cost reduction is entirely within the control of a company, whereas a revenue increase is not.

The calculation for the equivalent amount of revenue needed rather than saving one dollar of cost is:

1/profit margin = Equivalent amount of sales

The next table shows the equivalent sales that would be needed at various profit margins in order to equal one dollar of cost savings:

Net Profit	Equivalent Revenue
1%	$100
2%	50
5%	20
10%	10
15%	7
20%	5
25%	4

Thus, even a spectacularly profitable company having 25 percent profitability would have the choice of either creating four dollars of revenue or reducing costs by one dollar.

Also, assume that a cost reduction is not a one-time event but rather is a continuing cost reduction that otherwise would have been incurred in every future year. By eliminating this type of cost on an ongoing basis, a company can achieve compounded gains that keep piling up in the future.

Given the obvious economics of cost reduction, why do companies not practice it more often? They typically ignore it until they get into financial difficulties and then impose a sudden across-the-board cost reduction. The better approach is a long-term, ongoing analysis of every part of a company, with an emphasis on maintaining full funding of the overall strategic direction and a careful paring of other costs with surgical precision. This chapter describes the advantages, disadvantages, tools, and process flow of a successful cost reduction program.

Need for Cost Reduction

An ongoing program of cost reduction is not really an option for a company that wants to remain competitive over the long term, since it is subject to many issues that can negatively impact its profits, as the next subsections reveal.

Revenue Declines

The need for cost reduction starts with revenue: If a company’s products and services are subject to significant price declines, then costs have to also drop to keep pace. It is useful to stress test the sales forecast with a variety of worst-case scenarios to see what would happen to profitability in the event of a major price decline. Another option is to watch the results of other companies located in the same industry or tangential ones to determine the extent of price elasticity.

Rapid price declines are a particular problem when there are low barriers to entry, so that new competitors can easily enter the market and drive down prices. Price declines can also occur when fixed costs are a large part of the product cost structure, so companies have an incentive to fill their available capacity by driving down prices (see the next subsection). On a more short-term basis, prices also drop when there is a great deal of unsold inventory flooding the market.

In all of these cases, revenue declines can be so severe that a company that was initially awash in profits may very suddenly find itself in a significant loss position.

Fixed Cost Base

A company may have an exceptionally large fixed cost base, perhaps due to a fixation on high levels of automation, or simply because the market requires a great deal of equipment in order to compete. A high fixed cost base means that a company has to operate at a relatively high percentage of capacity in order to turn a profit. This is a major problem in industries where everyone has a large fixed cost base, since an industry slowdown means that prices will drop dramatically as everyone tries to keep their capacity levels high.

A determined and ongoing cost reduction campaign is an excellent way to avoid this trap. With a lower fixed cost base than competitors, a company is much more capable of riding out an industry downturn and may even be able to snap up any competitors that have not had the prescience to similarly engage in an active cost reduction campaign.

Creeping Costs

If there is no active campaign to reduce costs, then by default costs will increase; they will not hold steady. The next factors all work in parallel to increase costs:

• Complexity. Processes always become more complex over time, as they expand to encompass new products, services, and situations. Complexity increases a variety of expenses, but in particular requires more staffing. See the next subsection for an extended discussion of this topic.

• Entitlements. Benefits increase over time—they rarely decrease. Once a benefit is granted, it is very difficult to reduce it but quite easy to add to it.

• Inflation. Costs will naturally increase with the rate of inflation, but this is not acceptable if a company’s revenue increases are not keeping pace with inflation.

• Tradition and inertia. In general, if an expense has always been incurred, then a company will continue it. There is rarely a discussion of reducing an expense, only of adding to it.

For these reasons, cost creep is an insidious and ongoing issue that slowly reduces a company’s profitability at a pace that is barely recognizable over the short term. Since it is not a sudden event, management is not motivated to take action for a long time, at which point a great deal of effort will be needed to revert to the earlier level of profitability.

Complexity

One of the chief causes of excess costs is the presence of too many layers of management. Each manager requires a separate set of reports to monitor his or her area of responsibility (which takes time to create) and tends to acquire support staff. It is better to flatten the management structure of an organization, so that fewer managers supervise the activities of quite a large number of employees. Not only does this approach eliminate the complexity that comes with too many layers of management, but it also brings top management closer to a company’s operational levels.

An excessive quantity of reports also contributes to complexity. Each one requires some data collection as well as aggregation into a report. Even if a report is automatically generated and distributed from a computer database, it may still waste the time of the reader, who no longer needs it. Further, an automated report may draw on information that was originally added to the database specifically to create the report, and which is now still being collected.

A report may originally have been created as a one-time report and morphed into an ongoing one. Or it may be associated with a process that is no longer used. Alternatively, it may have been created for someone who is no longer with the company, and it was inherited by her successor. All of these reasons can explain the presence of reports that are no longer needed but that continue to plague employees.

Quite a serious form of complexity is customized systems. A company will find that it can acquire commercial, off-the-shelf (COTS) software that is perfectly acceptable for most of its operations. However, these systems will not exactly match the company’s underlying process flows, so there will be pressure from employees either to modify these packages or to create entirely new ones in-house. These customized systems are difficult to maintain and are much more expensive than COTS systems, so they introduce a significant amount of costs that are probably not necessary.

These examples show that complexity can arise in a variety of places in an organization—in its organizational structure, reports, systems, and so forth. Each type of complexity brings with it an increase in costs that can only be reduced through a considerable and ongoing change effort.

Acquisitions

The cost of complexity arises in particular when a company starts acquiring other businesses. An acquiree rarely serves precisely the same markets or has the same corporate structure or offers the same products. Consequently, an acquirer must somehow create an overall corporate structure that integrates two disparate businesses, which generally results in a combined entity that is less optimal than the original business. If these issues are expanded to a large number of acquisitions, then the cost of complexity becomes even more widespread.

However, there is one case where an acquisition strategy can lower costs. This is when an acquirer specifically searches for target companies that have lower costs than the acquirer and buys them specifically to spread that low-cost knowledge throughout the rest of the organization. This requires an excellent ability to force change throughout an organization.

Partnerships

A company may have a variety of partnerships, such as for research and development, or for production distribution, or for independent salespeople. Each of these partnerships requires some time by management to monitor and so increases costs to some extent. These partnerships may have been in existence for a long time and so may be continued more because of tradition than due to their profitability.

Because of their associated costs, all partnership agreements should be reviewed regularly to ensure that a company is earning a reasonable return. A major warning flag for these reviews should be any partnership that is characterized as “strategic,” especially if it has not generated a return since its inception. Strategic partnerships typically have the support of a senior-level manager and so are not easily discarded, but their ongoing cost should be noted.

Advantages of Cost Reduction

Cost reduction is the easiest and most certain way to increase profits in the short term. It can also be a major driver of long-term growth, if handled properly. Why is it easy? Because cost reduction is entirely within the control of the company. Simply determine an area for cost reduction and implement it. It is completely unlike the uncertainty of trying to increase revenue, where one must be concerned about pricing, margins, the actions of competitors, and governmental regulation. Cost reduction is the simplest road to increased profitability and enhanced cash flow.

Cost reduction also works well for long-term profits, so long as the process becomes a core belief of the entire company and is constantly readdressed. The selection of cost reduction targets is key, since cost reduction over the long term cannot undercut a company’s profit-making capabilities. Instead, the focus should be on constantly paring away unnecessary expenses, increasing efficiencies, and streamlining processes. In addition, it helps to continually reinvest some portion or all of the cost reduction savings back into the company’s people, processes, and technology.

A company that publicizes its continual efforts to reduce costs is effectively signaling to potential market entrants that they will have a very difficult time competing on price, since the company can likely weather any such attacks with ease. Conversely, a low-cost company has a powerful tool available for undercutting companies in new markets and so can aggressively pursue its more bloated competitors.

Disadvantages of Cost Reduction

Cost reduction sometimes can earn a bad reputation if it is handled incorrectly. The worst form of cost reduction is the blanket percentage cost reduction that is imposed throughout a company. This arises when senior management suddenly realizes that the organization will not achieve its targeted numbers and decides that everyone will share equally in the pain of a cost reduction.

The blanket cost reduction has three bad effects.

1. Any department that has already voluntarily reduced its costs substantially must now find a way to cut expenses farther, probably to the point where it cannot complete its assigned tasks.

2. Managers who have experienced multiple rounds of these imposed cost reductions then realize that their best hope of survival is to pad their budgets with extra expenditures, so that they will have enough fat to cut from their budgets the next time a cost reduction mandate arrives.

3. A blanket cost reduction tends to result in the elimination of “soft” expenses that are needed for long-term growth, such as employee training or new investments in business development, additional salespeople, and fixed assets. If these expenses are trimmed, then a blanket reduction tends to harm a company’s long-term growth prospects.

The effects noted here can be eliminated through the use of a more targeted cost reduction program, as noted later in the “Process Analysis” section. Even a well-run cost reducti...