Strategic operating expense reduction. A primer

Operating expense reduction should be a strategic enabler for a business if you have full context over the entire context of the operation. However, too little focus on strategy and on effective change management sees many operating expense reduction initiatives going horribly wrong, most often as a result of reduced staff morale emerging as a consequence of poorly communicated cost reduction plans.

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I have been involved in various operating expense reduction projects over the last decade. Some have involved the trauma of headcount reductions - with and without change management - as a hardcore means of expense reduction, while others have resulted in reduced expenses and increased effectiveness by looking at more obvious things such as tactics (core business), people performance measurement, processes, automation, and internal innovation, sometimes in the strategic context of the business, but most often in relative isolation of it. 

While I don't want to cover staff in this particular article, note that people, constituted both as individuals and teams, are a critical part of the value-adding jig-saw puzzle in any enterprise. Given this, you should always be prepared to confront poor people performance, and you should know that not everyone can be turned into people productive enough for your business. There are often tough people calls that need to be made, but those are a story for another day.

Before we begin, it's important to understand 'productivity'. In a nutshell, it means that the business is doing exactly what it needs to be doing (effective), and it's doing it well (efficient). Hopefully the difference between what it is actually doing and what its strategy is are not too dissimilar! 

• If some parts of the business are doing things that are not aligned with the strategy of the business, then they are ineffective. These parts are knowingly or unknowingly working against the wishes of the board, of the shareholders, and of executive management, and in so doing, are wasteful operating (and perhaps even capital) expenses are being incurred 

There is an interesting branch of business theory concerning people working their own agendas instead of the agreed agenda of the board and executive management. Sound familiar? Yes, much of age old corporate politics is actually Agency Theory in action. 

• If some parts of the business are working in terms of the strategy of the organisation, but have low consistency of output (i.e. poor quality control), or have low throughput (bottlenecks), then they are inefficient and are wasting money

This is the area most likely to be the focus of short term operating cost reduction initiatives. However, be aware that the most efficient process doing the wrong thing is pretty darn useless in the corporate scheme of things! One cannot assume effectiveness in the pursuit of efficiency. Both need to be assessed simultaneously!

Given the above, it's also important to understand that there are different types of operating expenses:

• Fixed expenses are those that do not change as the productive (and hopefully sales) volume of the business changes. Stated differently, fixed expenses are those expenses that remain if your business stops doing what it does. An example would be leases and interest on loans. They are sometime the harder of the two operating expenses to reduce due to contractual or other obligations. A high fixed cost to total cost ratio can be dangerous for the sustainability of the business

These are often termed uncontrollable expenses, because they are difficult to effect in the short term. However, applying a strategic context to your cost cutting interventions is invaluable in the medium to longer term

• Variable expenses are those that change as the productive volume of the business changes, such as supply chain costs, materials, temporary staff, logistics, travel, stationery and marketing costs

Most expense reduction projects focus on the variable costs of production - ensuring that processes have few bottlenecks, that waste is low, that quality meets expectations. 

Now any intervention intent on reducing operating expenses must start by analysing the "as is" state of the business. The ability to do this effectively depends on how well the accounting department has been at record keeping. Assuming an awesome accounting department, this step includes:

• analysing cost trends over at least a 12-month cycle, but preferably multiple 12-month cycles
• determining which costs are fixed and which costs are variable
• determining the cost functions for the variable costs to determine baseline measures, and to understand why these baselines may have been exceeded historically

You will often find that costs exceed a baseline where quality control is not quite up-to-scratch, where processes are not flawlessly documented, followed and/or automated, or due to human error. Many opportunities for operating expense reduction can be found here, but it is not necessarily low-hanging fruit

• considering the nature of fixed costs, and how these can be reduced, for example by using low power drain electronics and lighting

Be aware of the potential myth of using low power equipment though, as the capital cost of changing some of your equipment may incur a depreciation cost you had not considered, which may result in accounting costs being higher than before the change. Do your sums

• considering the nature of variable costs, and how, when and whether these can be substituted, for example conference calling or Skype rather than driving/flying
• understanding the relationship between marketing spend and sales performance. The higher the marketing spend, the higher the sales performance should be

If it's not, then your marketing is ineffective. In spite of what marketing may say, marketing ROI / ROA can be assessed

• analysing working capital and understanding free cash flow, stock levels and stock turnover, debtors management and creditors management

As an example of how important working capital management is, as an example, it's very expensive if you give your debtors 30 days, while paying your creditors immediately... Old stock is an asset that negatively impacts your ROA and idle cash constitutes wasted opportunity

• analysing the balance sheet and considering the structure of debt and equity in determining the effectiveness of your capital
• determining which functions are non-core, and determining the efficacy of outsourcing them
• analysing customer profitability and the effectiveness of your channel management strategies
• analysing product profitability and your pricing strategies

Once an analysis such as the above has been conducted, a structured action plan can be compiled in the context of the overall organisational strategy, and presented to the relevant management and/or governance structures for approval (at the per recommendation level rather than as a whole).

The implementation of operating expense reduction initiatives is another story altogether, as many initiatives may require substantial change management interventions in order to be successful. This is because poor morale brought along by poorly executed cost reduction initiatives can do as much damage to an organisation as excess costs can!

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This article is a very introductory write up on the scope of the fascinating business of business productivity and operating cost reduction. Note however that in the context of total cost management, seeing operating cost reduction only as an occasional and undesirable event during lean times is not necessarily optimal. Total cost management requires a continuous assessment of the efficacy of your operations and of the productivity of your expenses. In other words, make informal productivity assessments part of the day-to-day operating culture of your organisation for best results. Also, be aware that operating expense reduction should be considered in the context of the overall strategy of your organisation, assuming that the strategy has been properly validated of course. 

In closing, operating cost reduction initiatives can be as painful and superficial as you wish, or as comprehensive and liberating as you wish. After all, it's not only the sustainability of your business that you need to worry about - it's also that every dollar wasted is a dollar of profit gone!