Unnecessary costs are due to excess capacity and inefficient use of resources. There will always be necessary "cost of doing business" you would want to keep, unless you plan to close shop. These are mission critical costs that create value and assure quality, service, safety and compliance to regulatory standards. "Cost-cutting" is, therefore, a misguided if not dangerous concept that should be replaced by the more pragmatic "waste cutting." The challenge is how to quickly and accurately distinguish the necessary from the unnecessary costs. Cost reduction programs without this roadmap are doomed to cut necessary costs while maintaining the unnecessary ones.
It follows that companies with continuous improvement programs are more recession ready since they are adept at separating value-adding from non-value-adding processes. The typical cost cutter is the company is like the cynic described by the Irish writer Oscar Wilde (1854-1900) as one who "knows the price of everything and the value of nothing." Unless he knows what is a wasteful and what is valuable in the company, in spite of knowing all the costs, he will not be able to quickly and deeply cut costs. Chances are, he will be cutting the wrong costs. We are familiar with a cost reduction program that instructs an across-the-board slashing the costs (e.g., budget, head count) by a fixed amount, which has absolutely no basis. For example, "all divisions must cut their respective operating costs by 10% within six month or else... This mindless mandate serves no purpose but to terrorize all unit heads into scrambling for sacrificial lambs (among which some golden geese may inadvertently be included) to offer t beat the deadline. On the other extreme, this order from the top may allow units heads to perpetuate their wasteful ways, which may account for much more than 10% of their operating costs. An effective and informed cost reduction scheme is neither conservative nor aggressive. It is effectively appropriate, customized and opportunity-seeking in a nature. It is about cutting the right cost at the right amount at the right place. For instance, if a unit has 40% waste, a 10% cost reduction goal will e deficient. When time is of the essence, as in an economic crisis, you would want to immediately and decisively slash 40% of its costs not by trial and error or long-term installment.
The cost reduction targets must not be uniform company wide, but be based on the waste content or savings potential of each business unit. But this task is easier said than done. It requires a profound knowledge of the process and "deep dive" process and product cost analysis. It cannot be implemented and led y just accountants and the finance staff. It requires teaming up with those with hands-on process knowledge.
Typical cost cutters, mostly bean-counting finance types, are "unarmed and dangerous." They may act to fast or too slow. A cost accounting report, known as cost variance analysis, measures the difference between actual cost of products and their standard costs consisting mainly of standard labor costs and standard material costs.
Cost variance analysis has weak spots when it comes to crisis mode cost reduction.
First, reduction or elimination of unfavorable variances may not be sufficient to offset recession-induced losses or shortfalls.
Second, unit heads of budget-driven companies may think that the ultimate and maximum cost reduction goal is the achievement of standard costs or elimination of unfavorable variances. Variance analysis favors cost containment, rather thatn the cost reduction needed in a recession.
Third, the company may have embedded inefficiencies in standard costs and budgets, effectively hiding and standardizing wastes. Process owners will think that having favorable variances (or spending less than budgeted) is just an option or a "nice to have," rather than an urgent "must do" which would be the case had their wastes been more visible from accounting records. In a recession, it is urgent to cut both actual costs and standards costs.
Fourth, a cost variance component may be used to offset another, thus discouraging solutions to the inherent deficiency of inefficiency. For instance, material cost variance and usage variance. Any unfavorable material cost variance from excessive usage due to low yields and poor quality can actually be erased or hidden by a favorable price variance through the discovery of a cheaper supplier.
Usually, in reducing labor cost, it is better to look first for waste and excess capacity in indirect labor. Wastes are easily hidden in in-direct labor simply because it has no direct accountability to business volume. You may go beyond the production-oriented accounting definition of direct and indirect labor. In sales, the relevant ratio you want to increase is direct sales manpower/indirect sales manpower. This index recognizes sales people as value-adding and all other staff in sales and marketing as non-value-adding. In general, consider everyone in the company who is doing indirect work or those who are neither producing nor selling as non-value-adding. This includes management, the most expensive indirect labor. This is where you begin your labor cost reduction and search for waste.
With or without a recession, continuous cost (waste) reduction must be done as a strategy to make your business model robust. Even during normal times, cut costs early to cope with the inflationary increase in material and labor costs, anticipated supplier price increase, customer price discount request, competitive pressures on price and cost increase due to expected product proliferation demanded by your marketing department. Finally, what is the mother of all waste? It is cutting cost in a business that is not viable if the first place. It is better to shut it down than spend time making it more efficient in producing unsalable, uncompetitive products or services. Never wast your time cutting operational waste in a business that is strategically wasteful.
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