How to cut costs in a recession

MANILA, Philippines — TECHNICALLY, YOU DO NOT CUT cost; you cut wastes or “unnecessary cost.”

Unnecessary costs are due to excess capacity and inefficient use of resources. There will always be necessary “costs of doing business” you would want to keep — unless you plan to close shop.

These are mission-critical costs that create value and assure quality, service, safety and compliance to regulatory standards.

“Cost-cutting” is therefore a misguided, if not dangerous concept that should be replaced by the more pragmatic “waste cutting.”

The challenge is how to quickly and accurately distinguish the necessary from the unnecessary costs. Cost reduction programs without this roadmap are doomed to cut necessary costs while maintaining the unnecessary ones.

It follows that companies with continuous improvement programs are more recession-ready since they are adept at separating value-adding from nonvalue-adding processes.

The typical cost cutter in the company is like the cynic described by the Irish writer Oscar Wilde (1854-1900) as one who “knows the price of everything and the value of nothing.”

Unless he knows what is wasteful and what is valuable in the company, in spite of knowing all the costs, he will not be able to quickly and deeply cut costs. Chances are, he will be cutting the wrong costs.

We are familiar with a cost reduction program that instructs an across-the-board slashing of costs (e.g., budgets, head count) by a fixed amount, which has absolutely no basis. For example, “all divisions must cut their respective operating costs (or manpower) by 10 percent within six months or else …”

This mindless mandate serves no purpose but to terrorize all unit heads into scrambling for sacrificial lambs, among which some golden geese may inadvertently be included. On the other extreme, this order from the top may allow unit heads to perpetuate their wasteful ways, which may account for much more than 10 percent of operating costs.

An effective and informed cost reduction scheme is neither conservative nor aggressive. It is effectively appropriate, customized and opportunity-seeking in nature. It is about cutting the right cost at the right amount at the right place.

For instance, if a unit has 40-percent waste, a 10-percent cost reduction goal will be deficient. When time is of the essence, as in an economic crisis, you would want to immediately and decisively slash 40 percent of costs — not by trial and error or long-term installment.

Indiscriminate surgery

On the other hand, for a business unit that is already lean, with, say, a two-percent idle capacity or inefficiency remaining, a 10-percent cost reduction would be tantamount to an indiscriminate surgery that removes and kills both the healthy and diseased organs.

Let us take, for example, two departments with 10 and 100 staff respectively. A mandatory 10-percent head count reduction means they are downsized to 9 and 90 staff. After the exercise, the first department, which was already lean and just meeting its service level targets, ceases to function or serve its clients.

The second department suffers no loss in output, since its excess personnel was actually 30. In general, the larger the department, the larger the relative waste because of the larger hiding places.

The cost reduction targets must not be uniform company-wide, but be based on the waste content or savings potential of each business unit.

But this task is easier said than done.

It requires a profound knowledge of the process, and a “deep dive” process and product cost analysis. It cannot be implemented and led by just accountants and the finance staff. It requires teaming up with those with hands-on process knowledge such as industrial engineers, process engineers and production staff.

In one study, when a call center tried to reduce its agents from 34 to 30 or by about 10 percent, the number of callers waiting to get through jumped exponentially from 0 to more than 250. Unless cost cutters are thoroughly familiar with the process and particularly queuing theory in this case, they may exceed the critical process thresholds and reach the tipping point that will jeopardize the entire business.

Unarmed and dangerous

Typical cost cutters, mostly bean-counting finance types, are “unarmed and dangerous.” They may act too fast or too slow.

A cost accounting report, known as cost variance analysis, measures the difference between actual costs of products and their standard costs — consisting mainly of standard labor costs and standard material costs. Cost variance analysis has weak spots when it comes to crisis-mode cost reduction.

First, reduction or elimination of unfavorable variances may not be sufficient to offset recession-induced losses or shortfalls. Second, unit heads of budget-driven companies may think that the ultimate and maximum cost reduction goal is the achievement of standard costs or elimination of unfavorable variances. Variance analysis favors cost containment, rather than the cost reduction needed in a recession.

Third, the company may have embedded inefficiencies in standard costs and budgets, effectively hiding and standardizing wastes. Process owners will think that having favorable variances (or spending less than budgeted) is just an option or a “nice to have,” rather than an urgent “must do” which would be the case had their wastes been more visible from accounting records. In a recession, it is urgent to cut both actual costs and standards costs.

Fourth, a cost variance component may be used to offset another, thus discouraging solutions to the inherent deficiency or inefficiency. For instance, material cost variance is a composite of price variance and usage variance. Any unfavorable material cost variance from excessive usage due to low yields and poor quality can actually be erased or hidden by a favorable price variance through the discovery of a cheaper supplier.

Cost accounting tool

A more recent cost accounting tool is ABC or activity-based costing. Originally, ABC was conceived to improve the accuracy of the allocation of fixed cost among different product lines by basing the allocation on the actual activity or cost driver that determines individual product usage of the fixed cost.

Conventional fixed cost allocation, usually based on direct labor content, has led to mistakes in costing and pricing of products. ABC has greatly solved this issue and improved pricing, product mix and profit planning. However, if we use ABC as originally intended, i.e., to improve accuracy of costing, rather than to cut cost, it will be just as useless as cost variance analysis during the recession. It doesn’t help much if ABC will just accurately tell you that all your products are losing money during this economic downturn.

At most, it will tell you how your business will collapse. If used as a cost reduction tool instead of just an allocation tool, however, ABC can be your life-saver. Remember in a recession, demand drops rapidly and you would want to quickly lower your break-even sales and fixed costs, so you can profitably survive protracted low sales levels.

Since ABC has determined the drivers of fixed costs, you can go straight to these cost drivers and reduce them systematically.

ABC can save you precious time: Instead of reducing the fixed costs themselves in panic, you right away attack their root causes like defects which drive up quality control costs. In short, you don’t cut costs, you cut the drivers of unnecessary costs.

A simple but powerful metric of efficiency to guide the cost reduction program of a labor intensive company is the ratio of direct labor to indirect labor which many Japanese companies use.

Essentially, work done by direct labor is presumed to be value-adding since it is directly applied on the product and become part of product cost, while indirect labor which does not touch the product but merely supports direct labor in doing its task is presumed to be nonvalue-adding.

Therefore, the higher the ratio, whether labor is expressed in costs or head count, the better or the more efficient the process is.

You can benchmark your scores with those of world-class companies, or if you can’t, just make sure your company’s direct/indirect labor ratio continuously goes up, and not down. An increase in this ratio means you are overstaffing or overhiring relatively to your value-added activities.

Excess capacity

Usually, in reducing labor cost, it is better to look first for waste and excess capacity in indirect labor. Wastes are easily hidden in indirect labor simply because it has no direct accountability to business volume. You may go beyond the production-oriented accounting definition of direct and indirect labor.

In sales, the relevant ratio you want to increase is direct sales manpower/indirect sales manpower. This index recognizes sales people as value-adding and all other staff in sales and marketing as nonvalue-adding. In general, consider everyone in the company who is doing indirect work or those who are neither producing nor selling as nonvalue-adding. This includes management, the most expensive indirect labor. This is where you begin your labor cost reduction and search for wastes.

With or without a recession, continuous cost (waste) reduction must be done as a strategy to make your business model robust. Even during normal times, cutting costs early helps to cope with the inflationary increase in material and labor costs, anticipated supplier price increase, customer price discount request, competitive pressures on price and cost increase due to expected product proliferation demanded by your marketing department.

Remember if you lose cost leadership, you lose price leadership and then market leadership.

Finally, what is the mother of all waste? It is cutting cost in a business that is not viable in the first place. It is better to shut it down than spend time making it more efficient in producing unsalable, uncompetitive products or services.

Never waste your time cutting operational waste in a business that is strategically wasteful.

(Rene T. Domingo is a professor and management consultant. Please send comments to rtd@aim.edu.)–Rene T. Domingo, Philippine Daily Inquirer