Too much cost-cutting can lead to less corporate muscle. Here are 10 tips for leaner, meaner growth.
When British Airways chief executive Bob Ayling announced a crash cost-cutting programme designed to take £1 billion out of the business by the year 2000, many observers wondered why he was making such a fuss.
Here was the most profitable airline in the world talking about the urgent need to slash its costs. It didn't seem to add up. But if BA's costs continued on their current course, Chris Willford, BA's manager for financial strategy and investor relations, told a gathering of BA executives in September 1996, major European airlines would catch up and pass BA in terms of cost efficiency, while its US competitors would be able to undercut it on price without sacrificing profits. Warned Willford: 'If we do nothing British Airways won't be the leading airline as we fly into the year 2000.' The path it has chosen is one therefore most leading companies feel obliged to follow after the painful lessons of the past. For too many companies, however, ill-thought-out cost-cutting leads only to reduced growth potential.
The red hot item on the board agenda is how to really grow the business - grow it, that is, without putting the fat back on.
Seasoned managers are only too aware of the pitfalls that await them.
CEOs and finance directors know that it's as easy as falling off a log to grow by getting fat.
Only the most exceptional leaders of the most exceptional companies avoid getting sucked into a period of heady growth followed by desperate cutbacks.
These companies have learned the hard way that cost-cutting alone doesn't guarantee customer preference. And now they're beginning to realise that too much dieting can actually make their companies fat.
Among people, it's now recognised that diets, when unaccompanied by an exercise programme, can lead to the loss of muscle rather than fat. Now, as companies are discovering similar problems, the whole subject of cost-cutting is being thrown into the air. An obsession with corporate dieting leads to 'an insidious spiral of decline', warns Paul Taffinder, head of management consultancy at Coopers & Lybrand. The process starts off logically enough: a recognition, in the face of crisis, of the need to 'slice off great chunks of organisational flesh'. But then things start going wrong. 'Over time, you get a cost-cutting culture, and once you have, the types of people who are good at building things - creating new values, new products, new services - are driven out of the business because it is unpleasant for them to work there. Then, once boom time arrives again, the organisation piles on capacity but doesn't solve the problem of creating innovative potential. It has to hire talented people again.
But of course the people left in the organisation don't have the ability to spot new talent and they don't have the systems and processes in place that are needed for building.'
The result is, Taffinder suggests, that after one of the longest booms in history many organisations are currently presenting an 'appearance of corporate health'. But this is a veneer built on 'what are, in fact, damaged sinews and muscles - damaged innovative capability'. Avoiding this syndrome is now a key challenge for companies. The race is on to find that crucial middle way between aggressive growth targets and counter-productive crash-dieting. But how? Management Today asked leading corporate transformation experts. Here are their 10 top tips for a lean, mean growth machine.
1. Embrace cost-cutting as a marketing issue
Too many companies see cost-cutting as a technical, financial or operational issue. But at root it is a marketing issue. As the marketing guru Ted Levitt pointed out, the critical link between cost, margin and price drives the modern industrial corporation.
Take BA again. It makes most of its money from the high-cost, high-margin business customers - but it still has to meet customers' quality and service expectations at the lowest possible cost. 'It is about making sure we cost no more than the cheapest available alternative which can offer a similar service,' says John Patterson, director of strategy at BA. The critical issue, therefore, is not lowest costs per se, argues Joao Baptista of Mercer Management Consulting and co-author of the book Grow to be Great. 'It is to have the highest margin per customer.'
This means cost-cutting cannot simply be left to accountants - and this is where the value of good marketing comes in. As Dan Jones of Cardiff Business School's Lean Enterprise Centre explains: 'If you are going to talk about waste, you need to define what value is, because the opposite of waste is value. And you can only define value from the end-customer's perspective. If you can really do this - if you really know what it is that doesn't add value to the customer - then you can start asking "how can we get rid of that?" Otherwise, we are just saying "let's cut costs".'
One of the techniques used to do this is target costing: work out what the market wants at what price, and then work backwards to cost. It's hardly a new idea. Henry Ford was practising it as long as 75 years ago.
Companies which take their costs and then determine the price have got it all wrong, he wrote in 1923. Instead, he declared, 'our policy is to reduce the price, extend the operations, and improve the product. You will notice that the reduction of the price comes first. We have never considered any costs as fixed. Therefore we first reduce the price to the point where we believe more sales will result. Then we go ahead and try to make those prices.'
2. Embrace cost-cutting as a strategic issue
While Levitt was right to stress the first point, it is clear that companies targeting these different markets need very different cost structures based on different types of operation. Every piece of the jigsaw has to fit together. For example, Southwest Airlines and its European competitors do a number of things that set them apart from traditional airlines, including flying out of less expensive second-tier airports, not offering meals, not assigning seat numbers, bypassing travel agents, and not organising baggage transfers. But crucially, they make sure that each of these characteristics mesh with one another. For example, policies on meals and baggage transfers help speed up turnaround times, which means that the airlines squeeze in more flights per plane, per day.
As strategy guru Michael Porter comments: 'Any individual thing that a company does (including cost-cutting) can usually be imitated. Competitive advantage grows out of the entire system of activities.
Successful companies fit together the things they do in a way which is hard to replicate. This fit among activities substantially reduces cost or increases differentiation. You have to match everything, or you have basically matched nothing.'
3. Build market-sensitive decision-support systems
Most companies rely on what Deigan Morris, professor of accounting and control at INSEAD, calls 'legacy accounting information'. This is very good at telling managers what existing costs are, but gives them no pointers as to what they should be. The subtle but insidious effect of legacy accounting information is that it encourages managers to take the continued existence of other legacy systems - such as factories and warehouses, branch networks, outdated computer systems, existing staff terms and conditions for granted.
Yet the reality of a rapidly changing marketplace may mean these legacy systems are no longer necessary and have become a dead weight.
What is needed, therefore, is a parallel information system which compares actual profitability with each product's 'intrinsic profitability' (calculated on the basis of competitors' average costs).
It's not good enough to have a system that tells you a product is unprofitable, says Morris. 'You should work back from customers and competitors all the time, maintaining visibility in your cost structures so that you get signals as soon as possible that you are drifting out of line.'
4. Distinguish between quick fixes and long-term solutions
'Slash and burn' cost-cutting measures tend to be quick fixes. They may make you thinner, but they probably won't make you any fitter, argues Morris. 'It's good training and a sensible regime that wins medals.' Yet according to his colleague, INSEAD's professor of marketing Jean-Claude Larreche, it is 'scary' how many chief executives admit (privately) that 'the performance they have delivered is really beyond their organisations' capabilities'.
Larreche is five years into a long-term research project which aims to identify what the key elements of competitive fitness for global organisations are. But one thing he has found is that many 'have been squeezing the lemon and squeezing the lemon. We are seeing some big P/E ratios that anticipate future growth in profits. But there is only so much you can squeeze. They cannot sustain it and they are a little scared about the future.' Another big drawback of many cost-cutting exercises, notes Jones, is that they create win-lose situations, where those involved have no incentive to co-operate. If it's at all possible, he says, craft some sort of win-win solution. 'If you are going to involve people in the process, it has got to be in their interests to do it. It will not be sustained otherwise.'
5. Distinguish between fat and reserves
No organisation can maintain a sprint for a marathon and those who try will fail to take their organisation with them. 'You can ask people to make a major effort but there comes a point where they don't believe it any more,' notes Morris. Also it's vital for managers to realise the value of resources that give them flexibility and enable them to deal with contingencies.
3M, for example, builds 'redundancy' into its systems, by giving staff a certain percentage of free time to 'dream dreams'. It sees this as key to maintaining its edge as an innovator. But where 3M sees huge potential, a narrow-minded cost-cutter might see 'fat'. For example, according to a LSE research project, re-engineering left some companies so 'anorexic' that they were unable to seize new opportunities. Likewise, companies competing in fast-changing markets have to be able to draw on resources as new challenges are thrown at them, argues Bill Murray of CSC Computer Sciences. 'There is a cost of contingency that we must bear. To me, that is not fat.'
6. Dont't fall into the trap of measurement myopia
All too often, cost-cutting initiatives go wrong because managers work according to the numbers in their accounts and fail to consider effects which are not measured by their accounting systems. Yet, often these intangibles make or break the initiative. One example of measurement myopia is attempts to improve the efficiency of isolated parts of the business without considering their connection with other parts. For example, in the rush to get ready for a single European market many manufacturing companies rationalised their production processes, moving towards pan-European sourcing.
Yet, argues Jones, this is almost 'certainly a dead end to ruin'. Ever bigger machines focus on just one element of efficiency - the efficiency of the plant itself - and ignore other cost factors such as higher levels of inventory on either side of the new megaplant, higher distribution costs, slower customer response times, etc. 'Bigger machines mean bigger bottlenecks,' he declares.
7. See cost-cutting as the acid test of innovation
It is a common assumption that innovation is a polar opposite of cost-cutting. Precisely the opposite is true. One of the most powerful ways to innovate is to cut costs by investing in new ways of doing business. Direct Line, for example, did that in UK insurance, by cutting out the middleman and dealing direct with its customers over the phone. And in the tyre industry, Goodyear is now implementing a system called Impact (Integrated Manufacturing Precision Assembled Cellular Technology) which, it claims, will improve quality (for example, through tyres that can ride safely at 50 miles per hour even if they are completely flat) while cutting raw material costs by 15%, labour costs by 35% and production by up to 70%. Put together, the new system will allow Goodyear to improve productivity, not by a marginal 10%-20% but an awesome 135%, claims chief executive Sam Gibara. 'To me, that is genuinely transformational,' comments Coopers & Lybrand's Taffinder.
'It would not only transform Goodyear, but the whole industry.'
8. Take a system view of what adds to (and what helps cut) costs
Too many companies adopt cost-cutting strategies which throw costs out of the front door only to let them come creeping back through the rear window. Employees are made redundant and then re-employed, at twice the cost, as consultants. More 'efficient' working practices are adopted, but their main effect is to pass on extra costs to a supplier, who is then forced to put up his prices. Such initiatives make the part look better but fail to make the whole more efficient.
But once companies start trying to make their supply chain more efficient, the cost benefits can be 'staggering', claim enthusiasts such as Jones.
Some of the biggest costs are not created in companies per se but between them, and they are often invisible to their managers, he contends. For example, high stock levels can be seen as a form of institutionalised uncertainty - uncertainty created by a failure of two companies to communicate properly.
One of the most effective ways for firms to cut costs, Jones argues, is to sit down with their trading partners to 'document the costs each side impose on the other by passing inaccurate schedules backward, by not synchronising production and having to wait for stock. Once you put those things on the table, there is a powerful incentive for both organisations to change their behaviour.'
9. Seize the opportunities presented by technology
Many of the best ideas in management have not borne fruit simply because businesses didn't have the tools to make the changes necessary, argues Taffinder. But nowadays, through IT-reliant techniques such as activity-based costing, companies are increasingly able to understand - and work on each constituent element of cost bottom up rather than top down, rather than through abstract averages such as overheads. 'Averages obscure a lot, and aggregate financial statements are pretty meaningless,' notes Michael Dell, founder of Dell Computers. 'Until you look inside and understand what's going on - by business, by customer and by geography - you don't know anything.'
10. Doing nothing may be the biggest mistake of all
To be successful, firms must keep cost structures aligned to changing markets, technologies and customer requirements. 'When you say "fat", I say "out of alignment",' comments Morris. There is a natural tendency for companies to lag behind the requirements of the marketing place, he argues. 'Unless they are nimble on their feet, they will drift out of a competitively aligned cost structure.' The hardest thing for managers, shareholders or analysts to spot, adds Larreche, are errors of omission - failure to take the actions necessary to stay aligned.
Yet even with tips like these, how many companies will avoid being sucked into the endless cycle of dieting and getting fat again? Certainly there is a well-known logic about business cycles. Individual business leaders naturally respond to the signals they are getting from the market, so when times are good they draw up optimistic projections, plans and budgets. But the sum of many individually rational decisions often leads to collective irrationality. Soon, say, 10 companies are each budgeting on the basis of projected market share of 15%. That adds up to 150% - an impossibility. Then, when they fail to reach projections, they scale back and a shakeout begins. Later, during the depths of the downturn there are only seven companies left, each forecasting a market share of 10%.
That adds up to 70%, which means that suddenly it's as easy as anything to grow again. And the whole cycle starts up again. 'What you need,' says Taffinder, 'is some sort of orbiting satellite view of those cycles.
But very few chief executives have the talent, self-confidence and values not to be drawn into them.'
Perhaps the most dangerous mistake is for managers to use the current fashion of 'growth' as an excuse for getting fat again. The obvious conclusion, says Morris, is that 'therefore, you don't have to worry about costs. But you don't get a winning Olympic team that gorges on pasta and spends its time at Club Med. You have got to train for this stuff.'.