Cost-Cutting Benefits Quickly Fade

CUNA’s E-Scan Newsletter
July 20, 2010 | COMMENTS

There's a measured optimism that an economic recovery is taking hold, but the cost cutting so prevalent during the recent recession likely will remain a strategic priority for some time. Faced with pressure on earnings and the costs of corporate stabilization, credit union executives know this as well as anyone.

But any successes companies have at cutting costs during the downturn threaten to erode with time, according to The McKinsey Quarterly. Many executives expect some portion of the costs cut during the recent recession to return within 12 to 18 months. Research shows that only 10% of cost reduction programs typically show sustained results three years later.

Why is it so difficult to make cost cuts stick? In most cases, it's because reduction programs don't address the true drivers of costs or are simply too difficult to maintain over time. Factors include:

• Managers lack deep enough insight into their own operations to set useful cost reduction targets. In the midst of a crisis, they look for easily available benchmarks, such as what similar companies have accomplished, rather than taking the time to conduct a bottom-up examination of which costs can—and should—be cut.
• Business unit heads try to meet targets with draconian measures that are unrealistic over the long term, such as across-the-board cuts that don't differentiate between those that add value or destroy it.
• Managers use inaccurate or incomplete data to track costs, thus missing important opportunities and confounding efforts to ensure accountability.

While there's no single silver bullet to ensure that cost-management programs will stick, organizations can better their chances by improving accountability, focusing on how they cut costs, drawing an explicit connection to strategy, and treating cost reductions as an ongoing exercise.

Assign the right accountability

Support from top executives is necessary for cost-management efforts to succeed. CEOs and CFOs, in particular, can help mediate the political nature of such exercises and provide critical energy and motivation. But the involvement of top managers isn't by itself sufficient—especially in a period of growth, when they naturally turn their attention to other initiatives.

Instead, most cost innovation happens at lower levels, in these practical ways:

• Line managers can help to break costs out by area to find specific groups responsible for costs and to identify any pockets of expense mismanagement.
• Mid-managers need detailed knowledge and authority to decide whether specific expenses are necessary.
• People responsible for informed cuts should be held accountable through appropriate incentives, such as performance evaluations, that consider costs as well as business performance.

Focus on how to cut

Cost reduction programs often lose effectiveness over time because top management kicks off the effort with broad cost reduction targets, asking “how much do we want to save?” Management may leave decisions on how to meet those targets to individual line managers, but in too many cases managing to a number has resulted in flawed decisions.

The results may include delaying critical investments, shifting costs from one accounting category to another, or cutting costs in a way that undermines revenue generation. A more enduring approach includes:

• Changing the way people think about costs. Setting new policies and procedures is only the first step.
• Setting the tone among senior managers. Starting at the top, executives who demonstrate cost-cutting behavior become the model for other employees.
• Avoiding mixed messages. Backpedaling on frugal behavior when the economy picks up again would send the reverse message. Managers should model only cost cuts they intend to stick with.

Link cost management and strategy

Strategy must lead cost-cutting efforts, with goals beyond merely meeting a bottom-line target.

But many companies do not explicitly link cost reduction initiatives to broader strategic plans. As a result, reduction targets are set so that each business unit does “its fair share”—which starves high-performing units of the resources needed for valuable growth investments while generating only meager improvements in poorly performing areas.

To create value through cost cutting, managers need to:

• Understand the best ways to allocate operating expenses. Mapping costs against business units and markets will reveal both opportunities for cost reductions and areas in which the business should increase its investments to take advantage of growth opportunities.
• Deliver a consistent message on how cost reductions would make a company stronger—a message reducing short-term resistance and even inspiring support for the effort.
• Realize that once these initiatives become standard operating practices, cost reductions will become a more enduring part of long-term strategy.

Manage ongoing costs

Most companies treat cost management as a one-off exercise driven by the need to manage short-term targets—and driven by constant pressure from the CEO or CFO. But hasty cost-cutting activity typically goes into reverse once the pressure is removed and rarely results in sustainable changes in cost structure.

The reason? One-off exercises don't require internal capability building.

A better approach is to:

• Use the initial cost reduction program as an opportunity to build a competency in cost management rather than in mere cost reduction. Cost-management programs are two- to three-year initiatives rather than immediate efforts with one-year horizons.
• Include plans for dealing with evolving business conditions such as activity-level changes or competitive drivers, or both.

To follow McKinsey's advice, credit unions that hope to reduce or contain costs in a sustainable manner must improve their processes and capabilities. Rethinking common practices in cost management can help to realize this goal. Creating a link between long-term strategy and areas where costs occur should be a centerpiece of successful cost-management.

This article originally appeared in CUNA's E-Scan Newsletter. Reprinted with permission.