Recession is trying time for businesses. Revenues drop, costs seem to be unmanageable and the bottom-line becomes a bottomless pit. This is when the Finance guys, the ‘bean-counters’, are brought in to take charge and manage costs. Headcount is pink-slipped, travel budget is reduced, long distance calls are banned, stationery supply is curtailed and the free cups of tea are stopped.
Is cost management critical only during troubled times like recession? Is cost management less important during periods of high growth and prosperity? My experience shows that business leaders tend to focus on revenue growth during normal and boom times and allow costs to inflate beyond necessity. Then, during slowdown period and recession they switch back focus to cost management by letting loose the bean-counters, who then begin to cut back costs on an ad hoc and opportunistic basis.
This is a wrong approach to cost management. In a business organisation, which intends to run efficiently, costs need to be managed (not necessarily reduced) all the time – both prosperous and troubled times – and not with a stop-start approach. It cannot allow unhealthy accumulation of fat in any segment or type of cost at any time.
Let me now take you through my recommendations for cost management with a three-pronged approach. During recession period there will be a fourth point to consider as well. The three prongs are (a) Investment approach, (b) Variable Cost approach and (c) Opportunistic Savings approach. During recession period I will also consider Capacity Reduction approach.
All costs are viewed as investments and not as expenses. Therefore for every cost item, we need to evaluate the returns generated by that spend (with no distinction between capital and revenue expenditure). Returns generated from payouts on rent, utilities, travel, marketing spends etc will be evaluated. Yes, it will be difficult to evaluate returns on several types of spends. The alternative criterion in such cases will be the opportunity cost of that item – that is, the additional costs/losses likely to incurred, if we do not spend on that particular item. Avoidance of the opportunity cost can be considered to be the return on such spends.
There can be two types of investment in costs. Strategic investments are those where the returns happen over a longer term, where as in case of Normal investments the returns are quickly seen. Let’s take the case of Training – this is a strategic investment and the returns are not easily visible in the short term. Even in the long term, the returns from Training may not be easily measurable. But its strategic importance in creating an employee development culture might be critical to the business.
Variable Cost approach
In this approach the objective is to convert some part of the fixed costs into variable costs. When sales volumes are down, variable costs will go down. When volumes are growing these costs will increase, but the affordability will also increase with higher sales and consequent higher cash generation.
A popular example of this approach is the variable pay component in the salary package. It is not a piece rate system, but a performance based incentive system where at low volumes/profits the amount payable is small, but with higher volumes/profits the amount payable goes up. Another example is advertising agency remuneration where the agency can be paid a bonus based on sales performance of the business
Apart from payroll and agency remuneration, this approach can be applied to other costs of fixed nature as well, through innovative negotiations with vendors.
A word of caution – the approach can boomerang during periods of growth if used extensively. Costs will continue to increase for the business with growing volumes, where as competitors with costs of fixed nature will gain a cost advantage with decreasing fixed costs as percentage of revenue.
Opportunistic Savings Approach
This is the approach that most bean-counters follow normally. There is not much planning usually behind this approach, opportunistic short term savings are sought here. This will comprise mainly arbitrary budget cuts under most expense heads, essentially to take away part of the cushion that was allowed to be built into budgets in the first place.
We could follow in this approach a simple method of 3 Rs, for evaluating and managing costs – Reduce, Reuse and Recycle.
The positive side of this opportunistic savings approach is that short term savings can be quickly generated by this method. The negative side is that the arbitrariness generates demotivation within the system which can have a long term negative impact beyond the recession period.
Fixed costs are called capacity costs, because they are of fixed nature for a given level of capacity of production/sales. When capacity to do work or to produce/sell by a business organisation increases, fixed costs also increase but in steps. Variable costs on the other hand increase directly in proportion to increase in volumes.
During recession when sales volumes drop substantially, management might consider reducing capacity. Capacity reduction will mean giving up people, space, plant etc. If that is neither possible nor desirable then the excess items/space can be isolated as idle capacity, so that expenditure on related maintenance and utilities are not incurred.
Capacity reduction is not a short term opportunistic decision; it is at least a medium term decision of minimum 2 to 3 years. Rebuilding capacity once volumes pick up again will certainly be more expensive in the future. If the downturn is viewed to be of 6 to 12 months duration, capacity reduction will end up incurring more costs overall than what can be saved over that period, apart from significant impact in morale and client perception. This however remains a favourite method of most multinationals.Email This Post 0