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In the middle of a severe downturn, every company will do some form of cost cutting in the hopes of creating a leaner organization that can survive the economic turmoil and emerge to thrive once the economy turns around.  Columbia Business School professor Rita McGrath offers some tips on how leaders should approach their cost-cutting measures.

Yesterday, I participated in a workshop whose theme was "Cost Cutting: Beware the Traps." One of the cautionary tales of a company whose aggressive and ultimately mis-placed cost cutting is Home Depot, which I have blogged about before. Since then, other firms that followed a similar slash-and-burn approach have collapsed, among them Circuit City and Mervyns department stores.

Among the insights that emerged from the workshop were:

Beware the hidden dependencies among different parts of your operations when you are evaluating areas to cut. In the Home Depot case, a huge part of their value proposition was the experienced and helpful nature of their long-employed staff. These were people who had been professional carpenters, plumbers and electricians, in many cases, and they could help a neophyte tackle do-it-yourself projects with confidence. Firing them and replacing them with part-timers and inexperienced people looked good on the bottom line for a while, but ultimately undermined the Home Depot's fundamental value proposition to its customers. Other cuts resulted in long checkout lines, out-of-stock items and a general undermining of customer loyalty. What do to? Ric Merrifield, of Microsoft, recommends analyzing the "what's" in your business processes (see his HBR article "The Next Revolution in Productivity" and his forthcoming book, Re Think). "What's" are the specific things a business needs to accomplish, as opposed to the process they typically use to accomplish it. Some are high value; some are not. Understanding the difference can give you great insights into where you can safely pare away and where you should leave well enough alone. As a corollary to this concept, Merrifield and his colleagues found that truly high-value work constitutes only a small percentage of the total work being done in an organization.

Speed is good; spend analytics can deliver speed. The more quickly you can identify cost-out opportunities, the more likely you are to gain credibility and the more good news drops to the bottom line. One approach to doing this is to search for and eliminate redundant activities and over-payments, which sounds obvious but which can quickly get lost in the complexities of a large organization. Merrifield from Microsoft uses the example of a company that was inadvertently paying a vendor 19 times over for the purchase and use of exactly the same data to use in a verification process! Once the duplication was discovered, literally millions of dollars in licensing fees simply went away. Lexington Analytics has saved many of its clients millions by deploying sophisticated spend analytics. In one of their case studies, a services company discovered that they were buying the same item from multiple vendors, but were paying different prices. By getting at that information, the client was able to successfully negotiate prices an average of 15-20% lower than had been the case across the board, an immediate boost to net income without any need for reduction in services or quality.

Out, out, complexity. One 'win win' approach that received accolades at the workshop was when an organization can cut unnecessary complexity in how it does business. Not only can it save cost, but it often results in far greater customer satisfaction by eliminating unnecessary activity on both parts. I'd suggest starting with your payments and invoicing processes here — in many cases, there are huge amounts of duplicate, complex and ultimately unnecessary work that has crept into those processes over the years.

Not all customers are good customers. Sometimes, the best way to cut costs is to "fire" the most high-maintenance and expensive customers that cause you to have to take on complexity or service activities that are expensive beyond the value of what the customer can deliver to you. A textbook case of this approach can be found in Larry Selden's book Angel Customers and Demon Customers. In that book, he illustrates how companies like Best Buy realized that many of their costs were being generated by relatively few, badly-behaved customers. For instance, people who chronically buy and return items generate massive costs in terms of back office and inventory activity. So Best Buy can now track and discourage this sort of behavior. Clothing retailers have adopted this approach as well. Internet bank ING Direct regularly 'fires' needy customers who make too much use of their telephone service or back office capabilities. And American Express, as of this writing, is actually offering a select group of customers a $300 gift card to pay off their balances and shred their cards.

Strategy first, cost-cutting after. Although this is a time-honored homily, cutting costs across the board seldom leads to effective results. In those situations, people simply don't see a path that will ultimately lead to a winning outcome. So your best people decamp for the competition, a slow degradation of basic systems occurs, and the people you've retained become demoralized and anxious, wondering whether they will be laid off. Instead, what's needed is a clear sense of purpose around which to rally people's imagination, so that the core strategic activities are done very well while those things that are less central are eliminated altogether. DuPont, for instance, famously exited its textile business (which was a slow-growth business) and put the resources it released from the sale of that operation into higher growth areas such as emerging markets, biotechnology and new digital technologies such as OLED cells.

Costs may be saved where the budget isn't. One of the major dilemmas of structuring any complex organization is that expenditures and savings don't necessarily line up in the same budgets. Consider your information technology budget, for instance. Say the IT department does something that really improves productivity in accounts payable. The cost savings show up as a "good" number in the accounts payable department, and a "cost" number in the IT budget. Unless you have a way of systematically figuring out where investments — particularly in things like IT, HR and infrastructure/operations — are really paying off, you can go terribly wrong cutting in those areas. My dad used to tell the tale of a guy in the chemistry lab whose major responsibility was to make sure that all the glassware was clean and ready for use. In a cost-cutting spree, that job was eliminated. And guess what happened? Yup. High-priced Ph.D. chemists spent their time hunting for clean glassware, doing the job themselves or not doing certain activities because they couldn't find the right supplies. I would suspect that sort of mindless cost-cutting is going on all over the place right now. Will you notice in the short term? Maybe not. Will your company notice in the long term? You betcha.

By: Rita McGrath

Source: Harvard Business Publishing