Times of uncertainty and financial recession implies reducing costs. Let’s discuss how to do it in a disciplined way to minimize a negative impact on organization.
We are living in a period of uncertainty – disruptive changes and unpredictable events lead organizations to tighten their belts and focus on cost reduction. The easiest way to do this is to define cost-saving targets and cascade them down to the lower levels…
Here we have a good question to start the discussion:
Should we cascade the overall cost-saving targets to the functional levels of organizations?
The functional units of the organization are unique:
- Their contribution to value creation is unique
- Their response to the uncertainty should be tailor-made
- They face different risks
The idea to proportionally cascade the overall reduction target to the functional units doesn’t make any sense…
A better approach is to start with specific cost drivers and:
- Move bottom up (Step 2) to align the contribution of sub-goals to the overall cost-saving target
- Move up down (Step 3) to add details necessary for successful execution
- Learn and implement findings along the way (Step 4)
That’s the cost reduction process by BSC Designer that we are going to discuss below. It includes four steps:
- Step 1. Analysis of uncertainty
- Step 2. Comprehensive analysis of the expenses: cost drivers, risks, general mechanics, value for stakeholders
- Step 3. Implementation: readiness, priorities, tracking progress
- Step 4. Adapting strategy to uncertainty beyond cost cutting
Step 1. Analysis of Uncertainty
We don’t start cost-saving with the analysis of expenses. Instead, we’ll invest some time in understanding the uncertainty we are facing now. This analysis will help to better understand the nature of expected impact and formulate the overall cost reduction target.
Step 1.1 Analyze Impact of Uncertainty
The key question of this step:
What is the expected impact of uncertainty/crisis/recession on the organization?
- Increase of operational costs
- Challenges in hiring/retaining talents
- Increase in the costs of raw materials
- Increase in logistics costs
- Increase of interest rates
- Drop in sales
If you did a scenario planning exercise, you already have some answers to this question, including early-sign indicators and draft of response plan. If not, use a PESTEL analysis to better understand the current external environment.
Step 1.2 Calculate Overall Cost Reduction Target
It’s not enough to name the affected functions of organization — try to quantify the expected impact according to some historical analogies or coming data.
For example, a rough estimation of the impact of Covid-19 pandemic was possible by analysis of other pandemics.
In the beginning of the pandemic, we could estimate that:
- The functions related to face-to-face interaction with clients could be affected by 60% reduction in the short term and 20% reduction long term, with an expected drop in sales 35% and 15%, respectively.
After the first lockdowns, we would need to adjust these estimations to higher percentages.
The outcome of this step is a goal with a specific cost reduction target.
For example, to address the 35% drop in sales, a company should reduce operational costs by 20% within a one-quarter period.
To setup this indicator, we have two options:
- Option 1: Track the costs saved. In this case, the baseline=0 and the target is the cost reduction needed to respond to the uncertainty; the indicator should be configured for maximization, or
- Option 2: Track the costs reduction. In this case, the baseline is the current total costs, and the target is the desired level of costs, the indicator should be configured for minimization.
In my example scorecard, I used option 2 and created the indicator Planned cost reduction in the Financial perspective.
Step 2. Analysis of the Expenses
Prepare the map of the costs. It can be a detailed budget document or a strategy/process map with financial flows aligned to the items (like we had for customer service example).
If you have your strategy scorecard in BSC Designer, switch to the “Budgets” view on the KPIs tab to display all the budgets by initiative, as well as total budget planned and used.
Step 2.1 Map Cost Drivers
Where to focus the efforts to reduce expenses? Some good candidates for cost reduction are:
- Bad complexities. Costs associated with complex products that are hard to maintain, administrative processes that slow down decision-making.
- Legacy business model with outdated or duplicated functions.
- Outdated IT systems vulnerable to cybersecurity risks and misaligned with new requirements.
- Low-value activities like digital transformation that were not properly aligned with the stakeholders’ value.
In the cost reduction scorecard, I’ve formulated these two sub-goals:
- “Simplify product to reduce costs and complexity” for “Product development” goal
- “Reduce online advertising costs” for “Product marketing” goal
Step 2.2 Map Relevant Risks
We discussed the cost reduction opportunities and their positive impact on financial health. What about possible negative impact – what are the expected risks of cost reduction? Think about:
- Direct impact of reducing costs on quality, cybersecurity, talents, supply chain, etc. For example, reducing procurement budgets could result in decreasing the quality of raw materials, quality of the final product, and ultimately will impact the customer satisfaction.
- Indirect impact – what changes in behavior will be induced? For example, reducing budgets for innovations will result in fewer ideas from the team (why suggest something when there is no budget anyway?), which can eventually result in losing market positions to competitors.
Among indirect impacts, pay attention to:
- Cost avoidance aligned with the costs. Subscription fee to a specialized software is a cost, but the alternative implies excessive labor costs.
- Competitors’ reaction. Use the Five forces framework for a formal analysis.
- Risk: By reducing the complexity of the product, we might remove functions that are used by some clients.
- Risk mitigation: Explain how to complete the required task using different functions; train support agents; prepare video tutorials.
Users of BSC Designer can visualize the active risk on the dashboard:
Step 2.3 Quantify Value for Stakeholders
A cost is a budget invested to satisfy the needs of certain stakeholders.
- Who are those stakeholders?
- What are their needs? What value is supposed to be created for them?
- What value is actually created?
- How to quantify this value? Here, you will find specific examples of value-based decomposition.
For example, the main stakeholder of online advertising is the sales team. We can quantify the value for them by the “Value metric: visitors to leads” indicator.
We quantify the value to have a good indicator of whether we are moving in the right direction with cost reduction.
- Reduced budget for search engine optimization (cost metric)
- Expected: small fluctuation in the number of website visits and leads
- Reality: losing search engine positions within 4 months; the number of leads (value metric) decreased significantly.
- Conclusions: review cost-saving initiative to protect value-creating activities
Step 2.4 Understand the Mechanics of the Cost
We are interested in understanding the degree of possible reduction for the cost, as well as understanding the general mechanics related to the cost.
Ask questions like:
- What are the success factors of the reduction?
- Does the economy of scale work? Is it a one-time or recurring cost?
- What ratios are involved?
Let’s take this cost-saving idea as an example: “Visiting new customers in person is a significant cost.”
- Analysis: Look at the visit to qualified lead ratio by type of customer and consider LTV.
- Conclusion: Cutting costs make sense for certain types of customers only.
We formulate a cost indicator as:
- Expenses related to worse converting clients
This indicator is optimized for minimization:
In other words, we increase its progress/performance by decreasing current value. When we hit the target, the progress will be 100%.
Most likely, the target for this indicator won’t be achieved right away, so we can introduce some benchmarks for different time periods.
These reduction targets consider:
- Analysis of the cost,
- Estimated impact on the value creation,
- Possible risks,
and define the cost-saving thresholds that can be achieved without affecting critical functions.
Step 3. Cost-Saving Implementation
Now we are ready to discuss cost-saving initiatives.
Step 3.1 Readiness for Implementation
To formulate a cost reduction initiative, ask these questions:
- What are the specific implementation steps?
- What business systems/infrastructure do we need to adjust?
- What changes in behavior/skills do we need to implement?
- If we are talking about reducing online marketing expenses, then a success factor of this initiative will be some tracking system that helps to identify the source of qualified leads.
Step 3.2 Prioritize Cost Reduction Initiatives
With the cost analysis, we can follow these principles:
- Minimize budgets/costs for low-value activities
- Protect high-value activities
The prioritization model will also involve the political power of stakeholders, expected risks, and implementation difficulties.
In BSC Designer, use the weight function to show the relevant importance of the certain goal or its cost reduction initiatives.
- It might sound contradictory: why do we need to define a weight/priority when a cost itself is a priority (higher cost = higher priority)?
The cost shows just a budget projection, while the priority/weight might include other projections, such as value created for the stakeholders, difficulty to implement, alignment with other goals.
In our example, I’ve assigned 80% weight to the product development and 20% of the weight to the product marketing:
The program will use these weights to calculate the performance of the internal perspective. In this case, a cost reduction of the product development will have a higher impact on the total progress than the same cost reduction of the product marketing.
Step 3.3 Track Cost Reduction: Planned Cost Reduction vs. Actual Reduction
In the beginning, we created an indicator called Planned cost reduction. Let’s create another one called Actual costs reduction.
We need to configure its value to be calculated as the sum of the values inside:
Now we can link the cost-saving indicators to that indicator by copy and pasting them and selecting the “Link” option:
The Value field of the Actual costs indicator will show the current level of costs reduction achieved for the selected period.
The progress column will be an indication of the cost-saving achieved on the scale from 0% to 100%, where:
- 0% is no cost reduction achieved yet, and
- 100% is all indicators achieved the assigned cost reduction targets
Visualize both indicators on the comparative diagram to represent the expected cost-saving versus actual cost-saving; we can also visualize cost-saving initiatives on a Gantt chart:
Step 4. Adapting Strategy to Uncertainty Beyond Cost Optimization
Cost-cutting is a quick patch to the challenges of uncertainty. Once in calm waters, your team needs to revise the existing strategy with more accurate data in mind to come up with some permanent solution.
The questions for the discussion are:
- What lessons did we learn after implementing cost reduction initiatives?
- What did we learn about the cost and the value creation for stakeholders?
- What new factors of the uncertainty were discovered?
- How can we adapt the strategy to the uncertainty?
- What is our readiness for future challenges (see scenario planning)?
BSC Designer is a Balanced Scorecard software that is helping companies to better formulate their strategies and make the process of strategy execution more tangible with KPIs.