In these times of economic downturn, businesses are concerned about managing their margins and conserving their cash. Firms are trying to focus on controlling costs. The question is, whether your
firm is cutting costs in an effective manner? Are your cost cutting measures creating sustainable benefits or are simply knee jerk reactions?
Finance 101 would tell you that there are two broad classes of costs- the costs directly associated with manufacturing of a product or providing a service (also known as "Cost of Goods Sold") and indirect costs like marketing expenses, administrative costs etc . For a manufacturing firm, a major cost maybe the cost of raw materials used. Such a firm should focus on ways to reduce these costs. The firm should analyze its sources of raw materials- are there many suppliers supplying the same materials? Can the firm look at procuring supplies from a couple or few big suppliers? That may help it get better discounts. If the firm ends up being a big customer for a single supplier, it can negotiate a better deal. Another area to focus on is direct labor costs. How can productivity of labor be improved? Employee rationalization may appear to be an obvious option, but negotiating with strong unions can always get messy. Maybe reducing employee hours is a better alternative than job cuts? How about launching schemes that motivate employees to increase their productivity and reduce idle hours?
Let us now also look at other expenses like marketing & selling costs, research & development expenses, and general administrative expenses (not directly related to production or service being rendered). Many times, this cost bucket is the first one to bear the cost cuts. But businesses need to be smart about thinking what costs they should really cut and where cost cutting may actually be counter-productive. You may have heard doctors talk about good cholesterol and bad cholesterol and how one needs to cut down on bad cholesterol and keep healthy levels of good cholesterol. Just as all cholesterol is not bad for the heart; for a business, not all costs are the same. Firms need to identify areas which are key to a firm's long term success and temper the tendency to make major cost cuts in those areas. For example, Research & Development costs are critical for a firm to stay innovative and competitive. So a short term temptation to cut R&D expenses could cripple the firm's innovation capacity in the medium and long terms. Irrespective of economic conditions, marketing is important for a firm, especially for FMCG and consumer durables manufacturers. A business needs to evaluate what is the optimum reduction in spend, which while saving some costs, doesn't start having negative impact on sales. You would have heard the saying - "Out of sight, out of mind". A business cannot afford to loose consumer mind share, as that inevitably leads to loss of market share. Businesses looking at reducing selling and distribution expenses, should do a systematic analysis to evaluate what sales and distribution channels are bringing the lowest return on investment. Also, consider, if those channels present any long term opportunity. Maybe it makes sense for the business to exit a particular channel totally. That presents a better approach to cutting costs than an across the board cut. There may be other areas which present opportunities for cost reduction. Shifting office from expensive downtown locations to less expensive locations could be an option. Consider allowing certain employees to work from home once a week. The cost impact may seem small (in terms of office facilities utilized, use of office transportation), but small things add up. Also, encourage use of modern networking and teleconferencing tools instead of avoidable face to face meetings. That could help cut down on travel expenses.
As the economic downturn forces businesses to reduce costs, businesses need to carry out cost reduction in a wise manner. Firms should avoid those short term cost reduction measures, which may be counterproductive in the long term.
Harshdeep Jolly is a management consultant and author of the book Everything You Desire- Journey through IIM
