The Challenge of Cost Reduction in a Downturn

In a sector downturn, companies need to adapt their cost structure to a new market reality. During this time, demand shifts and supply adjusts. As revenue growth slows down, the most critical business issues become how to sustain profits, generate positive cash flow, and maintain an edge over the competition.

In this climate, the company’s cost structure becomes the most critical source of competitiveness. Management must protect the company’s financial position, which means stabilizing the business in line with slowing revenue growth, defending against downside risk, and ensuring adequate cash flow and access to capital.

To get there, managers need to get beyond short-term fixes. Some take a tentative approach by making small, uncoordinated cost cuts across the board, hoping that total savings will add up to the desired level of performance. Unfortunately, these cuts never get to the drivers of cost. On the contrary, they delay improvement; cost reduction doesn’t stick, and eventually, costs creep back up over time.

Other managers opt for short-term solutions, including squeezing suppliers, driving higher operational efficiencies, reducing spend, using tighter cost controls, cutting staff gradually, and other immediate fixes. In the best cases, these cost-cutting programs provide band-aid solutions and delay real improvement. In the worst cases, they cut the wrong areas and set the company further back.

Achieving significant cost reductions requires managers to use strategic approaches that attack the drivers of cost and deliver lasting value.

COST REDUCTION

The fundamental challenge is the following: Where can you cut costs to achieve a 10% cost reduction that achieves lasting value? Where will the savings come from? Several levers are available.

• Rationalize product lines: Product lines tend to proliferate as companies offer more product variety to penetrate smaller market segments. Some companies may find themselves offering too many products, actually hurting profitability – in which case products must be rationalized. By eliminating The Challenge of Cost Reduction unprofitable product lines, the company can reduce direct cost and means of production, including labor, plants, equipment, working capital, materials and energy.
• Rationalize customers: According to the 20/80 rule, 20% of your customers contribute 80% of your profits. Review your profitability by customer and rationalize marginal accounts. These customers produce razor-thin margins and absorb large amounts of overhead cost. In addition, by eliminating marginal customers, the company can also reduce significant outlays of working capital.
• Improve core effectiveness: The primary objective is to align the business with realistic measures of customer demand, including cycle time, cost, and quality. The activities that cause the customer’s critical-to-quality issues and create the most extended time delays offer the most significant opportunity for improvement in cost, quality, and lead time – and shareholder value. This lever achieves significant reductions in direct and indirect costs, working capital, and lead time in less than a year.
• Rationalize production capacity: Falling demand may result in excess capacity. When this condition becomes permanent, it may require closing down some production capacity or marking structural changes to reorganize the firm’s operation to be more in line with demand in the interest of the effective use of assets.
• Simplify the organization: If left unchecked, organizational complexity can add substantial indirect cost to the company. Over time, growth initiatives place a burden on the organization and add significant complexity to the administration of the business. An economic slowdown presents a timely opportunity to streamline the company’s organizational structure and reduce unnecessary indirect labor.
• Source strategically: Review your suppliers and your procurement practices to acquire goods and services in line with market demand on a cost-effective basis. Assess and prioritize sourcing opportunities to leverage the firm’s purchasing power. The objective is to maintain effective supply chains, reduce cost of goods sold, and bring significant bottom line improvements to the organization.

The focus is to align the cost structure to market demand and supply. These levers get to the root of the problem and attack the drivers of cost; by so doing, cost reduction sticks.

COST RESTRUCTURING

When a company needs to reduce cost by 10% to 20%, traditional cost reduction measures don’t work. In this case, the right approach is cost restructuring. It is a strategy that leads to significant margin adjustments and efficient use of assets with long-term staying power. Several levers are available.

• Reconfigure the value chain: Companies with long value chains become weighed down by massive cost structures. Long value chains tie up large amounts of capital and infrastructure. They also expose the company to competitors to conceive new models of value delivery and ultimately disrupt the firm’s competitive position.
• Restructure the business portfolio: When companies find themselves operating in mature or declining markets, they may not be cost competitive. This situation exposes the company to mounting competitive intensity, erosion of advantage, decreasing market share, and ultimately declining profits. In this case, the business may need to restructure its portfolio of activities to reduce cost and rationalize unnecessary operating assets.
• Redesign the business model: Companies may become vulnerable to displacement or disruption. Business model design (BDM) is the fundamental driver of economic value creation and the foundation for company performance upon which all actions follow. Its primacy cannot be overstated. New BMD provides a significant opportunity to put the company in a winning position ahead of competitors and industry shifts.
• Lead active market consolidation: M&A is particularly useful in mature or declining industries. Some companies consolidate the market to gain scale and lower costs. They do so by acquiring related businesses and combining R&D, production, sales, and logistics activities; the underlying rationale for the deal premised on the value of synergies.

The focus here is for the company to redefine the playing field. Cost restructuring fundamentally changes the business model, the value chain, or the business activities to align the cost structure to the ongoing economic system of the industry.

THE PRICE OF DOING TOO LITTLE TOO LATE

In a downturn, timing and focus are critical. Some managers think that they can wait until it is over; when that doesn’t happen, they find themselves late to recover and scrambling to catch up, which leads to an expensive recovery and is not always possible.

Management that implements the right levers in two years versus one year makes a significant blunder. It will continue to falter and miss the timing. By the time other companies will be recovering out of the slowdown, the company will still be playing out its cost reduction program.

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Do you think that the downturn is over? If you don’t, update your strategy and CAPEX given slowing revenue growth. Take a comprehensive and aggressive approach. Shorten your action plans into a tighter time window; significantly advance some initiatives, and postpone others. This approach not only will help your company protect against the slowdown, but it will also strengthen your competitive position and ability to seize opportunities as they emerge. Think on these things:

How much does your company need to reduce cost?
What is your trigger point to take action?
When you get there, how will you reduce your cost structure?

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