News Release: Finance and Economics

Sep. 17,  2009

Can Companies Maintain Quality as They Cut Costs?

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This week, U.S. Federal Reserve Chairman Ben Bernanke announced that the "recession is very likely over." While there are indicators to suggest the American economy is in recovery, executives at most companies are still grappling with ways to manage costs.

Indeed cutting jobs continues to be a leading method companies use to prop up their bottom line. In August, economic concerns prompted businesses to shed a net 216,000 jobs, driving the national unemployment rate up to 9.7% last month, according to the latest U.S. Department of Labor report.

But is cutting human capital always the best option? Faculty at Emory University and its Goizueta Business School say indiscriminate cuts can yield unintended consequences over the long term, and add that trimming away expenses instead of hacking at them may be a better strategy.

“The steps that companies should be taking during this recession are different from what they usually actually do,” warns Al Hartgraves, a professor of accounting at Goizueta. “Often, they reduce spending in training, maintenance, advertising and other discretionary cost areas just because it’s easier to cut in these areas. That may help profitability in the short term but it may hurt in the long term. Another common solution is an egalitarian approach where each department is required to cut its budget by a fixed percentage.”

But a better alternative is a “zero-based” approach, a sort of clean-slate strategy where each department has to justify and prioritize every component of its budget, he says.

“The advantage is that a zero-based approach adds transparency to the process and may help to highlight the essential costs and benefits of different functions,” Hartgraves explains. “Zero-based budgeting can help management to zero in on strategies that might have made sense during the boom times but are now dragging down earnings.”

Another important issue involves analyzing fixed costs to current revenues, he notes.

“During the boom years when companies expected to continue their growth curve, many firms increased their manufacturing, storage, distribution and other capacity,” Hartgraves says. “But in a downturn, the underutilized assets may have an outsized negative effect on the bottom line. [To counter this,] it may be a good time to dispose of machinery and equipment, buildings and other fixed assets that are older or less productive, thereby lowering their break-even point. When the economy rebounds, those assets can be replaced with newer, more productive assets.”

For decades, companies in trouble have first turned to downsizing, reducing human capital and operations in terms of the number of products and services offered, notes Shawn Davis, a visiting assistant professor of accounting at Goizueta. “However, in times of recession companies should proceed with caution,” she says. “To begin with, businesses should engage in activity-based costing and management: effectively evaluating their core operations and core projected operations to identify and eliminate non-value-added activities and costs.”

Non-value-added activities are operations that are either unnecessary or inefficient, Davis explains. “As such, they’re dispensable and their removal will not affect the quality, performance, and perceived value of the company’s main products and services.”

Externally, a firm also should conduct customer-profitability analysis to determine the activities, costs and profit associated with individual customers, according to Davis. “Companies are likely to make better decisions about customer service if they have a good understanding of which customers are generating the greatest profit,” Davis explains. “Cost-cutting strategies that result in the loss of a profitable customer would weaken, not improve, the company's position. As such, this profitability analysis would better help companies determine where to devote its limited resources in serving customers.”

Davis also says it’s not uncommon for companies to take an axe to research and development efforts in tough times. But they should proceed with caution, she adds.

“R&D tends to be a primary target when cutting costs is underway because these efforts generally do not provide immediate returns,” she says. “The key here is for companies to instead review their R&D efforts and weed out the ones that have the least long-term potential.”

Firms are better served if they forge ahead with efforts that offer a high pay-off expectation, she adds.

“Moreover, statistics indicate that companies that spend more on innovation during a downturn fair much better and get a higher return on capital in a recovery compared to ones that use a downturn as an excuse to scrimp on R&D.”

Quick-thinking firms may even find opportunities in a recession, according to Charles F. Goetz, an adjunct professor of organization and management and a distinguished lecturer in entrepreneurship at Goizueta.

“During a tough economy, many companies scale back their activity,” Goetz notes. “But a business that can invest in its operations may be able to expand its market share.”

Meanwhile, he says, all companies should be looking for ways to cut waste from their operations.

“You have to cut costs in a way that’s appropriate for your individual circumstances,” Goetz cautions. “Let’s say you’ve got a service-based business that rarely brings clients back to its home base. In that case, you may be able to jettison some office space—saving the outlay of lease costs—and perhaps have your people work from home.”     

Healthcare and travel costs also represent cash drains that may be addressed and reduced.

“Outsourcing your employees, through professional employer organizations (PEO), may save money,” Goetz says. “Besides taking care of administrative tasks, PEOs may be able to group together large numbers of small business workers under a single PEO umbrella and offer more leverage when it comes to negotiating healthcare coverage.”

Businesses also should reconsider their inventory order processes and such mundane matters as travel policies, he says.

”If your company maintains inventories of items, can you reduce your stock of goods?” Goetz asks. “Consider analyzing your inventory levels to see if you can maintain a leaner volume of goods, and see if you can negotiate with your suppliers for discounts, longer payment periods, or both. Additionally, try to convert fixed costs to variable costs that more closely track your sales by taking such steps as outsourcing more processes and leasing your equipment instead of buying it.”

If a business’s owners decide they need to cut salaries to survive, it is important to consider the psychological impact as well as the financial impact, Goetz notes.

“Make sure that top management is also taking a cut in salary, and it may be a good idea for the owners to take an even larger percentage cut,” he says. “Let the employees know that management is sharing the pain; otherwise you’ll have disgruntled employees who may hesitate to put much effort unto their jobs.”

One of the simplest and least painful ways to cut costs involves eliminating unnecessary product lines, or SKUs [stock keeping units], according to Jagdish Sheth, a chaired professor of marketing at Goizueta. The problem is that many companies focus on the wrong attributes when they pursue this strategy, he says.

“When companies reexamine their SKUs, they frequently focus on the cost of production, but ignore vital issues like logistics and storage costs,” he explains. “They also need to execute a thorough profitability analysis to determine if they’re carrying too many lines of products.”

As an example, Sheth cites consumer products companies that may produce multiple varieties of toothpaste and shampoos, manufacturers that make a wide range of appliances that serve similar functions with minimal differentiating characteristics, or flavor and fragrance firms that make a wide variety of flavors and fragrances that are essentially variations on a few central themes.

“Along with too many SKUs, companies with multiple product lines tend to lose sight of their individual products’ profit margins,” he cautions. “The aggregate business may be profitable, but a close examination may reveal that certain product lines are operating at a loss and are being subsidized by other, successful ones.”

“In a slow economy, it may not be advisable to keep carrying the laggards,” he counsels. “This may be the time to jettison the unprofitable lines unless there are compelling reasons to keep carrying them.”

The challenge has been compounded by the trend of “bundling,” or offering a variety of services (or occasionally goods) at a discounted price. One example is automobile companies that offer option packages, or suites of add-on configurations, like a larger engine, a specific transmission and perhaps an upgraded sound system. Another example is cable companies that offer bundled telephone, Internet and television packages that cost less than the total of the individual services purchased separately.

“For a long time, bundling was seen as a positive move since it enabled a company to get more of a customer’s business,” Sheth says. “The disadvantage is that it can mask cross-subsidies that may actually eat into a business’s profit.”

Firms should review their customers to determine if too many resources are being devoted to clients that are minimally profitable, Sheth adds.

“Some of the larger food production companies will service their bigger customers directly from company-controlled distribution centers,” he says. “But their smaller or less profitable accounts could be outsourced to third-party logistics companies that can still turn a profit with the smaller client companies.”

In some cases, it simply may not be worthwhile to keep a customer, Sheth adds.

“An effective analysis will utilize activity-based costing to allocate all of the related costs, including transportation and other overhead, by each customer,” he explains.

“Companies often overlook costs like vendor management and support activities including accounting, finance and procurement that are tied to specific customers but are not accounted for. Even worse, some of these overhead support systems may be unique to the customer, instead of being performed as part of a centralized department that can at least deliver economies of scale,” he says.

Analyzed like this, it is not unusual for some companies to find that 80 percent of their profits are generated by 20 percent of their customers, adds Sheth.

“If you discover this is the case, then some tough decisions may have to be made,” he says. “We’re already seeing this in some service firms, like accountants and lawyers who set up new offices or expand existing ones to make it easier to service a key account, only to shut down the new locations after discovering that the marginal growth did not yield the anticipated profits.”

At a time when the economy is spurring companies to reduce costs, executives must remember to balance expense reduction and quality, Sheth warns.

“Keep in mind that good service tends to increase revenue, so don’t compromise on quality,” he said. “On the other hand, bureaucracy and other inefficiencies hurt your bottom line. So be sure to keep your priorities in order as you seek to improve your operations.”

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