Monday, June 11, 2007

Cutting Your Way to Prosperity? (part 1)

A long time ago, I was in charge of creating the advertising media budget for a retail company. I turned in what I thought was a reasonable budget.

A couple of weeks after I turned in my budget, I got a call from the budget department. They said that when the budgets of all the departments were rolled up, the expenses were too high. They asked me if it would be okay for them to cut the advertising budget by 25%.

I said, “Before I answer that, let me ask you a question. If the advertising budget is cut by 25%, are you planning on cutting sales by any amount?”

They replied, “No, the sales budget would stay the same.”

In response, I said, “Well in that case, why don’t you make advertising $0? Obviously, you do not think that advertising has any impact on sales, so I suppose we shouldn’t do any advertising at all.”

One of the hardest times to execute a strategy is when times get tough, such as in an economic downturn. To get through the tough times, there is often a need to cut expenses deeper than normal. There can be many problems if the cutting is done improperly. This is the first of a series of blogs on some of the pitfalls to avoid when cutting costs.

The first pitfall to avoid is in ignoring the interconnectivity of cost reduction decisions. If you cut costs in one area, it can make that area look good. However, due to interconnectivity, the impact of that reduction impacts other parts of the business. It may cause damage to other parts of your business which are worse than the benefits gained in the inital cuts, causing you to actually lose ground in your quest for profitability.

You may end up congratulating someone for their cuts, even though it is ruining the profit structure elsewhere. Take, for example, the story above. One could look like a hero for cutting advertising by 25%. It might cause the people in the advertising department to get a big bonus. However, if the reduction in advertising causes sales to drop too far, then you have rewarded people for destroying value.

In most cases, it is illogical to believe that one can just cut 25% of advertising and expect it to not impact sales at all. The overriding purpose for practically all advertising is to influence people to buy more from you. Advertising and sales are interconnected. To budget a huge drop in advertising without any drop in sales is to either admit that you are incompetent in your advertising or admit that your sales budget is an unrealistic lie.

The principle of interconnectivity needs to be considered when implementing cost reduction programs. There are three main areas where interconnectivity can hurt you:

1) Vertical Connections
2) Horizontal Connections
3) Customer Connections

These are discussed more fully below:

1) Vertical Connections
An income statement has many lines on it. If you focus on just one line on the income statement, you can achieve huge cuts on that particular line. However, it may just serve to move those costs up or down the income statement to a different line. The lines on an income statement are interconnected.

For example, let’s say one is focused on cutting a department’s payroll expenses. There are many ways to achieve this. For example, one can outsource work which used to be done internally to an outside third party. The payroll line goes down, but the outside services line goes up. It may even go up faster than payroll goes down.

Another way to reduce payroll is to increase the use of temporary services. The work didn’t go away…it just went to a different line item. If the focus is on cutting headcount, it may result in increased overtime for the remaining workers.

If the focus is on cutting capital investments, there may be an increase in repairs and maintenance in order to keep the old capital running. Or if the repairs and maintenance are cut too far, as appears to have been the case at some BP refineries, you may end up with serious disasters of entire businesses going out of commission for a long period of time. That raises costs on all sorts of other lines.

The moral of the story: When looking at a department’s cost cutting efforts, do not focus too narrowly. Look at the impacts that a cut on one line could do the increasing a different line on that department’s income statement. Cuts on one line rarely fall 100% to the bottom line. Some of it leaks back to other lines. Capture the leakage in your estimates.

2) Horizontal Connections
Vertical connections tend to be easier to address, because the income statement can be contained within a single department. For example, if you tell the legal department to reduce their total costs, then they do not gain much when shifting internal legal personnel costs to outside legal counsel. Since they have responsibility for both lines, they do not shift their total expense much in shifting the burden from one line on their income statement to the other. Hence, there is not much incentive for making the shift.

The more difficult problem is when the connectivity is horizontal—between departments. If one can improve their department’s expenses by pushing costs to another department, it can make that department manager look good, because his or her area has permanently reduced their costs. Even though the total company expenses did not go down, the department that shift costs to another department can get undeservingly rewarded.

Let’s look at how this might play out in a retail company. The merchants might be able to lower their cost on the good they buy by requiring less of the vendors. They could ask the vendor to stop doing certain tasks in return for a lower price. Those tasks could include:

A) No longer having the vendor put price tags on the goods.
B) No longer having the vendor sort the goods by store before shipping them.
C) Shipping the goods all at once, rather than holding onto the inventory and shipping it in more manageable quantities.

While this takes costs off the merchandiser’s books, it adds a ton of costs to the retailer’s distribution center, because now they have to do what the vendor used to do. They have to do the sorting and the tagging. At the same time, the warehouse gets clogged with extra goods, making processing at the distribution center less efficient.

Now the distribution center may want to escape some of this problem by shifting the burden to the stores. They could send the goods to the stores untagged. They could clog the stores with more inventory than they need. So now, someone at the stores has to do more work than before.

Moral of the story: Don’t just accept a department giving a commitment that they will reduce their costs. Ask them how they are cutting their costs, so that you can determine if their method of cutting is just shifting the burden to another department.

3) Customer Connections
Some cuts in cost are noticeable to the potential customers. If your cost cuts make your firm less desirable to customers, they could end up going somewhere else. It does little good to cut costs if it results in alienating customers and eliminating sales. Long after the tough times are over, customers will remember how you treated them in the tough times and may not come back when the times are good.

Using a retail example again, one can cut labor in the stores in a way that:

1) Makes the store visually less desirable, because there is less cleaning and straightening up.
2) Make the checkout lines longer due to fewer people operating the cash registers.
3) Create more out-of-stocks, because there are fewer people restocking shelves.

These outcomes can cause customers to no longer want to shop your store. The drop in sales could be greater than the drop in costs.

Moral of the story: Don’t forget the customer perspective when cutting costs. Do the reductions in expenses exceed their impact on reducing sales?

Just because one has a “successful” cost cutting plan put in place does not necessarily mean that total costs really went down all that much or that profitability of the entire company is better off. To really have success in tough times, one needs to check the interconnectivity of cost cutting actions, to make sure that costs were not merely shifted up and down a department’s income statement, or shifted to another department, or caused customers to stop patronizing your business.

I am not trying to imply that cost cutting is bad or unnecessary. Cost cutting is often necessary and good. We just cannot go around blindly believing that all cuts are good cuts. The next blog will address some of these issues around deciding what are good cuts.

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