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Five ways CFOs can make cost cuts stick

Optimism is on the rise that a solid economic recovery is taking hold around the world, but the cost cutting so prevalent during the recent recession looks to remain a strategic priority for some time.

Indeed, the number of executives reporting steps to reduce operating costs in the next 12 months increased significantly between February and April, even as confidence in the economy grew.1 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 months2 —and prior research found that only 10 percent of cost reduction programs show sustained results three years later.3

On either schedule, any programs initiated in the early months of the downturn are already beginning to fail—just as savings would be most useful to finance growth. Sales, general, and administrative (SG&A) costs prove to be particularly intransigent. While manufacturing efficiencies have enabled an average S&P 500 company to reduce the cost of goods sold (COGS) by about 250 basis points over the past decade, SG&A costs have remained at about the same level (Exhibit 1).

Why is it 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 can—and 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.

While there’s no single silver bullet to ensure that cost-management programs will stick, large, multibusiness unit organizations can better their chances by improving accountability, focusing on how they cut costs, drawing an explicit connection to strategy, and treating cost reductions as an ongoing exercise.

Assign accountability at the right level

Few would dispute that the support of top executives is necessary for cost-management efforts to succeed. Involved CEOs and CFOs, in particular, can help mediate the inherently political nature of such exercises and provide critical energy and motivation. Yet in our experience, the involvement of top managers is not by itself sufficient—especially in a period of growth, when they naturally turn their attention to other initiatives.

Instead, most cost innovation happens at a very small and practical level. Breaking costs out in this way helps managers to find the specific groups or individuals responsible for them and to identify and swiftly deal with pockets of expense mismanagement. Take, for example, the cost-cutting program at one multinational high-tech company. Initially, the CFO had little actionable information on who was responsible for which costs. Profit-and-loss (P&L) statements were reported only for product-based business units, even though geographic sales units had higher costs. This lack of detail made it very difficult to assign responsibility for overall cost reductions. For instance, if freight costs for a business unit increased from year to year, it was difficult to determine whether this happened because of shipping behavior by factories or costs incurred by the sales organization in delivering third-party parts to customers.

To resolve these issues, the company redefined the way it collected and reported information, to ensure that costs were broken out for each of 100 organizational units. That helped managers quickly identify two headquarters units and a sales organization that were responsible for large cost increases. Together, the managers came up with a plan to control future costs. Among other things, the plan assigned cost accountability to the company’s more than 60 separate organizational units. This approach ensured that the people managing costs were those closest to the decisions, who could ensure that cost management was not hurting the business.

Importantly, the process planners who run such programs as Six Sigma improvement efforts are generally the wrong choice to manage cost-cutting programs. Typically, they lack both the content expertise and the authority to make difficult trade-offs in areas that often require more detailed knowledge of where costs occur and the ability to make keen subjective judgments about which costs to cut. Only someone at the level of, say, a sales manager has the detailed knowledge and authority to decide whether it’s really necessary to travel to one client meeting in person, while conducting another by videoconference. Such informed cuts are more likely to endure because the people responsible for them can be held accountable through appropriate incentives, such as performance evaluations, that consider both costs and business performance.


Source: McKinsey Quarterly

Wednesday, July 21st 2010
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