How can we make cost cuts stick

54% of the executives surveyed by McKinsey in April indicated that they would take steps to reduce operating costs in the next 12 months, compared with 47% in February. In April, 2/3 of the respondents rated economic conditions in their countries as better than they had been six months previously, and another 2/3 expected further improvement by the end of the first half of 2010 (“Economic Conditions Snapshot, April 2010: McKinsey Global Survey results,” mckinseyquarterly.com, April 2010). Yet any successes companies have at cutting costs during the downturn will erode with time. Many executives expect some proportion of the costs cut during the recent recession to return within 12 to 18 months (“What worked in cost cutting -and what’s next: McKinsey Global Survey results,” mckinseyquarterly.com, January 2010) – and prior research found that only 10% of cost reduction programs show sustained results three years later (Suzanne P. Nimocks, Robert L. Rosiello, and Oliver Wright, “Managing overhead costs,” mckinseyquarterly.com, May 2005).

Why is it then so difficult to make cost cuts stick?

In most cases, it’s because reduction programs don’t address the true drivers of costs or are simply too difficult to maintain over time. Sometimes, managers lack deep enough insight into their own operations to set useful cost reduction targets. In the midst of a crisis, they look for easily available benchmarks, such as what similar companies have accomplished, rather than taking the time to conduct a bottom-up examination of which costs should be cut. In other cases, individual business unit heads try to meet targets with draconian measures that are unrealistic over the long term, such as across-the-board cuts that don’t differentiate between those that add value or destroy it. In still others, managers use inaccurate or incomplete data to track costs, thus missing important opportunities and confounding efforts to ensure accountability.

Some possible solutions:

Focus on how to cut, not just how much

Benchmarks matter. External ones on some measures may be difficult to get, but where they are available – for example, on travel expenses – they can enable managers to compare performance across different units and identify real differences, as well as trade-offs that may not be in line with the organization’s overall strategy. Internal benchmarks are easier to access and provide great insights, especially because managers are more likely to understand and adjust for differences among their company’s organizational units than among different companies represented by external benchmarks.

P&L accounting data is not enough to make lasting decisions

Unfortunately, few companies have the kinds of systems they need to track costs at a fine-grained level – and they face a number of challenges in establishing them. Multiple data systems may make it difficult to aggregate and compare data from different geographies. Inconsistent accounting practices between businesses or time periods may lead to significant distortions. Changes in organizational structure (as a result of acquisitions, divestitures, or even changes in the allocation of overhead costs) may similarly distort tracking.

Clearly link cost management and strategy

Strategy must lead cost-cutting efforts, not vice versa. The goal cannot be merely to meet a bottom-line target. Indeed, among participants in a November 2009 survey, those who worked for companies that took an across-the-board approach to cost cutting in the recent downturn doubt that the cuts are sustainable. Those who predicted that the cuts could be sustained over the next 18 months were more likely to say that their companies chose a targeted approach. (“What worked in cost cutting – and what’s next: McKinsey Global Survey results,” mckinseyquarterly.com, January 2010).

Yet, many companies do not explicitly link cost reduction initiatives to broader strategic plans. As a result, reduction targets are set so that each business unit does “its share” – which starves high-performing units of the resources needed for valuable growth investments while generating only meager improvements at poorly performing units. Moreover, initiatives in one area of a business often have unintended negative consequences for the company as a whole.

Aim at results for 2-3 years not just 12 months

Most companies treat cost management as a one-off exercise driven by the need to manage short-term profit targets. Yet such hasty cost-cutting activity typically goes into reverse once the pressure is removed and rarely results in sustainable changes in cost structure. A better approach is to use the initial cost reduction program as an opportunity to build a competency in cost management rather than in cost reduction.

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