In a sector downturn, companies need to adapt their cost structure to the new market reality. During this time, demand shifts, and supply adjusts. As revenue growth decelerates, the most critical business concerns become how to sustain profits and generate positive cash flow, and how to maintain an edge over the competition. As a result, management needs to plan and make important decisions about costs, investments, and cash management.
The company’s cost structure becomes the most critical source of competitiveness during a downturn. The reason is straightforward. The firm must protect its financial position, i.e., stabilize the business in line with slowing revenue growth, defend against downside risk, and ensure that it has adequate cash flow and access to capital.
To be effective in confronting the downturn, managers need to get beyond short-term fixes. Quick wins such as improving procurement, reducing personnel, and increasing operating efficiencies can be beneficial, but won’t be sufficient because they don’t get to the root of the problem. In reality, with this course of action, cost-cutting won’t stick, and costs will creep back up even stronger.
ADOPT APPROPRIATE COST REDUCTION MEASURES
When demand shifts, supply adjusts to reach equilibrium. As a result, managers need to think in broader terms than business as usual and isolate the critical determinants of cost: Are our product lines aligned to new patterns of demand? Which activities drive value and which weigh down the organization unnecessarily? How is industry supply reshaping the competitive landscape? Do we need to cut production capacity to match new levels of demand? Should we restructure to align with projected competitive trends? Alternatively, do we need to change the business model? Following is a sample of critical levers of cost to illustrate the concept.
- 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 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. Moreover, 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 substantial reductions in direct and indirect costs, working capital, and lead time in less than a year.
- 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 adequate supply chains, reduce the cost of goods sold, and bring significant bottom-line improvements to the organization.
- Rationalize capacity: In an oversupplied market, management needs to address the situation sooner than later because it only gets worse over time. The proper response requires strategic action. Executives need to push beyond conventional cost tactics and focus on achieving the appropriate level of production capacity for their company.
These levers get to the root of the problem and attack the determinants of cost. By taking this course of action, cost reduction will stick.
During a contraction, returns on most of the investments get downgraded, reflecting different thresholds for growth, profitability, and a reexamination of the businesses’ competitive position. This downgrading should drive a smaller selection of investments. In making your selection, break down the process in steps to avoid cognitive and organizational biases in your decision making:
- Re-calibrate: Update performance standards for investment thresholds in light of the slowdown.
- Differentiate: Differentiate investments and activities among sectors, value steps, and markets, identifying which are critical and which are not.
- Classify: Rank investments in three groups (critical, non-critical, discontinued) based on updated thresholds, and standardize investment guidelines for each group.
- Justify: Place the burden of proof on the business units to provide justification for why an asset should be retained.
- Hold: Slow down investments immediately in all non-critical sectors.
- Cut: Identify underperforming assets that need to be divested and discontinue.
MANAGE CASH TIGHTLY
You need to ensure that your company has critical cash flow and access to capital. Monitor and improve your cash position with a disciplined cash management system:
- Enhance your working capital performance:
– Shorten inventory conversion periods; i.e., Days inventory outstanding (DIO)
– Accelerate the collection of payment from customers; i.e., Days sales outstanding (DSO)
– Extend payments to suppliers as long as possible without impairing the credit rating/ standing of the firm; i.e., Days payables outstanding (DPO)
- Manage customer credit risk aggressively
– Avoid granting trade credit to higher-risk customers
– Balance the tradeoff between credit risk and the revenue potential of a marginal sale
- Develop a standard of minimum liquidity and stick to it
THE PRICE FOR 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.
Others 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; 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, higher operational efficiencies, reduced spending, tighter cost controls, gradual staff cuts, 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.
Finally, a company 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.
Do you think that the downturn won’t last? If not, revise your strategy and your investments in light of 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.
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 the cost structure?