It’s a near certainty that businesses of any size or scope would seek to reduce costs if given the chance. And why not? Lowering costs is arguably the most direct way to increase profitability.
If only it were that simple. In reality, many businesses find that reducing costs is actually quite complex, given a host of variables unique to their business. Add to that competing internal priorities, as well as a general fear of cutting too deeply and trimming muscle and bone with the fat. It’s no wonder, then, that businesses find controlling core costs one of their biggest challenges.
While it can be complicated and time-consuming, the benefits of addressing costs are clear. Impacting costs directly relate to improving profitability. For many reasons, reductions in costs do not always translate dollar for dollar into profitability, and by cutting too deeply, you can inflict damage on the organization. But by cutting smartly, you can improve profitability.
So the easy question is, where do you start? In almost every organization, there are “Five Buckets of Costs.” While the order of these buckets varies somewhat from organization to organization and industry to industry, the general order from biggest impact to smallest is:
- Staffing-related costs: salaries, employee benefit plans/health insurance, HR services (payroll, search, training, and development), workers’ compensation, unemployment benefits, etc.
- Materials and supplies: direct materials (i.e., those related to production of products and services) and indirect materials such as office supplies and consumables
- Property, plant, and equipment (PP+E): land, manufacturing plants, office buildings, manufacturing equipment, etc.
- Contracts and contract services: outside services such as outsourcing, contractors, service providers, etc.
- Taxes and insurance: federal, state, local taxes and property and casualty, professional, directors and officers, and many others
Ultimately cost reduction serves to increase the gap between a business’ revenues and expenses. This, in turn, expands profit margin—even if revenue remains constant. As a result, the question arises what to do with increased free cash flow after the cost savings takes place. It can be returned to the owner/shareholder, or it can be used to reinvest in the business and fuel next-stage growth. New investments can include the development of new products and services, acquisition of new customers, or marketing-related investments to build brand awareness and equity. They can also focus on larger goals such as strategic acquisitions. The key is to unlock the cash necessary to move forward.
That’s where the five buckets come in.
Leadership should seize the opportunity to examine each bucket with a critical eye. How are costs managed? Are they necessary? If so, can they be reduced or streamlined – through negotiation or otherwise – in ways that don’t adversely affect operations or organizational capacity?
Consider some examples, bucket by bucket.
- Staffing-related costs:
- Move to a flexible/variable workforce (e.g., shift less critical/lower demand staff to a contractor status). The objective is to allow for slight increases in hourly rates while reducing overall costs.
- Outsource training and development, or implement an online learning academy.
- Renegotiate benefit plans and/or use a managed care organization for workers’ compensation
- Materials and supplies:
- Source and renegotiate materials and supplies. It is much easier to re-negotiate indirect, rather than direct materials, but savings can be found from either avenue. If you haven’t sourced materials recently, many organizations have found savings in the five to 15 percent range.
- Purchasing cooperatives serve a unique function to pool the purchasing power of multiple organizations to increase buying power and, therefore, reduce purchase costs.
- Acquisitions present an opportunity to discover whose purchasing contracts are better positioned. After an acquisition, examine all contracts to find the lowest price on all common materials and then drive all volume to the lowest-cost contract. If the volume change is significant, there is also an opportunity to re-negotiate price based on volume.
- Complexity reduction is a critical component of any organization. Identify duplicate parts or materials and identify opportunities to standardize on fewer parts. Then re-negotiate volume based on fewer parts with greater volume.
- Property Plant & Equipment (PP&E):
- If you’re a professional services organization or health care provider, what’s the value of owning an office building? While you can take the depreciation, you also bear the annual maintenance costs, and you lose the right to invest that capital in a higher return area. Can you sell the building, free up the capital and convert it to an on-going expense? It’s all about return on assets.
- If you’re a manufacturer, how often are you using that piece of equipment? Manufacturers and contractors often have a strong bias to own a piece of equipment, even if it is lightly used. Selling off that lightly used piece of equipment and then renting the same equipment when needed may be a better option. While the rental costs may be slightly higher than that of a proportional usage on owned equipment, the annual cost of that equipment should be lower.
- Sale and leaseback is another option to free up capital. While it will actually increase expenses, it will pour capital back into the organization. If you are over-leveraged and need to reset capitalization the business, look to sell off under-utilized assets and then either lease them back or rent comparable equipment only when necessary.
- Contracts and contract services:
- Much like re-negotiating material costs, the same strategy can be applied to contracts and contracted services. If you haven’t re-sourced your contracts in two to three years, it is time to go back to the negotiating table and identify opportunities to drive down costs.
- Purchasing cooperatives can also be used to source lower-cost contacted services.
- Examine opportunities to give contracted services to under-utilized staff—or even consider cutting them altogether.
- Taxes and insurance:
- While negotiating on taxes may not be feasible, engaging a trusted advisor to conduct a thorough tax planning strategy is. There are many opportunities to reduce taxes based on proper planning and by taking advantage of appropriate tax credits.
- Sourcing your insurance coverages should be done every three to five years as your needs and coverage options may change.
These are but a few examples of the many items that our Entrepreneurial Service group helps our clients evaluate in meeting their business transformation challenges. One final note: We find that far too many businesses view cost-cutting as a one-time initiative. On the contrary, when done correctly, cost-cutting should be a sustainable initiative that creates a recurring savings opportunity. It is also critical then to understand the opportunities of how the savings will be realized or invested in the business.
As for the notion that this is a one-pop challenge, the real goal here should be to create a sustainable process of cost savings enterprise-wide. Things all around your business – inside and outside – change constantly, and that impacts how your business must spend money to make money every day. It’s contingent on your company’s leadership team to identify those changes, understand how they impact business operations and do what’s necessary to leverage them in ways that fuel growth.
Do you have questions about controlling business costs or other business issues? Please contact your MarksNelson Smart Entrepreneurial Services Professional at 816-743-7700.