When economic conditions are good, companies may let their cost-cutting measures slide. But Tim Jones warns that they are seriously damaging their future competitiveness
The recent benign economic conditions have seen cost management take a back seat. When the economic cycle turns, companies tend to become more resourceful and focused on cost. They willingly consider tools such as outsourcing, shared service centres and process standardisation. But, with revenues up, cost-cutting measures slide. However, organisations need to manage costs to protect competitiveness.
When KPMG commissioned the Economist Intelligence Unit (EIU) to investigate corporate attitudes to cost cutting, it found that almost two-thirds of companies set themselves cost-reduction targets as low as three per cent. Yet, shockingly, only eight per cent manage to achieve or exceed these low expectations. It seems that as profits and revenues rise, companies increasingly lose control of costs. What is more, they allow it to happen.
The survey of 427 senior executives at leading companies around the world takes a detailed look at how companies address their cost structures. It found that costs are an issue – but, with revenues rising at a faster rate, they do not top the agenda. In fact, 42 percent of those surveyed admit that revenue growth has distracted them from cost savings.
Mind the gap
Corporates cannot survive on revenue growth alone. They have to manage their cost base at the same time as growing revenues, or risk leaving a gap for more cost-conscious and agile competitors to sneak in and steal market share. Look at how nimble-footed, low-cost airlines seized large volumes of the market from cost-bloated operators. But the good times will not last for ever. Steps taken now to manage costs mean that companies will not resort to less well-thought-out survival tactics when the tide of fortune turns.
Where increased profits and revenues mask a bloated cost base, companies leave themselves wide open to predators, especially when private equity (PE) buyers are on the lookout for deals. The multiples that PE buyers will pay indicate that they are increasingly looking at operational cost savings as well as financial engineering. Take the potential bid for Sainsbury's, where bidders almost certainly built substantial savings into their cash-flow projections.
The temptation to focus exclusively on revenue growth is possibly best illustrated by Asian firms. The survey shows that they are the most likely to let cost cutting take a back seat to revenue growth. Unlike their North American counterparts, they have seen faster rises in income over expenses.
This disparity has been the result of the rapid escalation of Asian GDP in recent years. The focus has been on revenue growth and the need to gain market share while it is available. Many of these businesses have not even had to consider cost management. However, history has repeatedly taught us that high-growth economies are most exposed to global economic downturn. Organisations that successfully balance the need to gain market share with building a solid and sustainable base will be the long-term winners.
Whose problem is it?
Accountability for cost cutting should be everyone's concern. While CEOs and CFOs may not involve themselves in the nitty-gritty of cost initiatives, they need to illustrate buy-in and leadership. Reducing costs that are built into a business model means changing embedded culture and practices. It takes clear leadership and communication from the board to alter practices so that they will deliver long-term benefits. It is advisable to delegate programme management for these initiatives, but sponsorship and leadership must come from the very top of the organisation.
However, the survey also revealed that 58 % of companies do not build cost incentives into employees' rewards. Cost reduction exercises can be difficult and painful for both the organisation and the individual. However, without some sort of mandate or incentive from senior management, why should individuals stick their heads above the parapet and court significant personal risk?
How to manage people costs
Over the next three years, according to 74% of companies, it is people-related costs that are most expected to rise. This comes at a time when companies are already increasing employee remuneration and benefits to attract and retain scarce talent.
There is an arsenal of tools that companies can use to manage their people costs. Initiatives such as offshoring and outsourcing onshore can help companies take advantage of the economies of scale available to specialist suppliers. Companies need to look at these tools as part of the mix of how they manage their people costs – and to recognise that they are not suitable for all.
A key challenge of managing people-related costs is that as our economies have developed, people costs have become less variable. Senior managers continue to look for ways to flex their costs in line with revenues.
Among professional services firms, where the cost base is substantively made up of people-related costs, there is a growing tendency to introduce a greater element of variable pay into reward structures. This not only ties the individual more closely to the performance of the organisation by giving higher bonuses to those who perform better, it also reduces the risk of mass waves of redundancy and hiring that characterised many firms in the early 2000s.
Other organisations 'variabilise' their wage bill by increased use of bought in or contracted labour. And, increasingly, they are looking at doing this in a more structured way, often via partnerships and alliances to buy specialist resources on tap when they need them. When demand declines the tap is turned off. This reduces the need to buy in expertise and to honour contractual employment conditions.
Rising revenues have had an analgesic effect and lured companies into a false sense of security. Like the fad dieter who cuts out crisps but not chocolate, cost-cutting exercises often target just one problem area, and the benefits are short term. An organisation that resorts to quick fixes and does not embrace a cost-cutting culture, risks becoming cost-bloated, ripe for takeover, or simply too cumbersome to react when a nimbler competitor steals an opportunity.
The point is that it is not a choice of raising revenue or cutting costs. Although the balance of attention may, at times, favour one or the other, both are imperatives. If you take your eye off the cost-management ball, expect to feel the pain in future years.
Those organisations which recognise that costs are driven by their operating model and that it can be turned to competitive advantage, can create a culture of cost ownership. In these organisations, the way things are done is challenged by all. Everyone feels a responsibility for cost management and recognises that it is a vital component of securing a better future for all. Until then, nine out of ten companies will, according to the EIU survey, miss out on major opportunities to boost profits.
Tim Jones is a global advisory partner, KPMG
Visit http://www.kpmg.com/Services/Advisory/Other/ RethinkingCS.htm to download a copy of the report
‘There is … widespread agreement on key cost pressures. In particular, companies think that the biggest challenge in the next three years will be people-related costs: 74% of companies expect this to be an area where costs increase. This is perhaps to be expected at a time when many companies are having to increase employee remuneration and benefits in a bid to attract and retain scarce talent.
‘Close behind are input costs (66%) and technology (64%), followed by marketing (62%). Although individual items rise and fall in importance based on corporate size and geography, these are very important to most enterprises, and people costs are of universal concern. Moreover, there is a consensus that costs will rise most slowly in production, financing and commercial property spending.’
‘A short sighted but common approach to cost reduction is to attack in isolation a single part of the business, such as procurement, people or systems through a single, finite project. Unfortunately, such efforts rarely achieve their desired goals; either they run out of steam or else the costs simply pop up in another part of the organisation. Even for those that do succeed, the benefits tend to be short lived, with the same problem cropping up again in the near future.’
‘Outsourcing and offshoring are still only being used by a minority of firms. Business, especially in Europe, continues to show a higher comfort level with keeping operations close to home. This is surprising given the cost advantages which respondents acknowledge outsourcing and offshoring offer. For those companies that had used the technique and where the respondent knew the results, offshoring has provided the highest cost savings of a number of strategies, including increased process efficiency or more cost effective service channels. Moreover, although pursuit of efficiency gains within business operations yielded the next highest degree of savings, outsourcing and shared service centres were not far behind.’
‘Organisations are often uncertain as to what they are getting in return for their investment in IT and view it primarily as an expense, when in fact many projects are designed to either cut costs or help the business to grow. It would help if IT leaders could drive home the message that the entire portfolio of IT programs has a business case, with firm financial benefits. Even for something as apparently unexciting as a systems upgrade, the value of the project could be highlighted by showing that an alternative 'do nothing' scenario would give a higher medium to long-term cost to the business.
‘By aligning IT more closely with the business you can build better risk assessment into the initial planning, and exercise tighter control over projects. Organisations also need to be less emotionally attached to existing systems; in many cases it is cheaper to replace them altogether.’