One of the challenges facing today’s finance executives is improving operating margins for the business. Top-line growth is very slow, inflationary pressures are causing higher input costs, and customers are pushing for innovative new products and services, albeit at discounted prices. All these factors, among others, are significantly squeezing company margins left, right and centre.
Uncertainty is the norm today, rendering tried and tested ways of creating value unfit for purpose. Thus, finance executives and their teams have to come up with new innovative and agile ways of capturing value and striving in this environment, while at the same time keeping costs down. Look no further than the number of profit warnings, earnings miss and business closure announcements by companies of all types and sizes. This just shows how the pressures on margins are considerably increasing, and also not expected to abate anytime soon.
When it comes to improving operating margins, many finance executives normally make one of these common mistakes. Implement across the board cost-cutting initiatives (mostly focused on reducing employment costs), raise products/services prices, or offer steep pricing discounts with the hope that the discounting will boost revenues and translate into higher operating margins. The problem with these approaches is that they fail to take into consideration the value-add to the customer.
So what must finance do?
Think and Act Differently
Most of the time the finance executive’s focus is on improving specific elements of the Income Statement, instead of the entire business. This in turn results in the finance organization embarking on one-off cost reduction initiatives, that fail to differentiate and understand the difference between good and bad cost.
Instead of focusing on cost reduction, heavy discounting and price increases, the CFO and the team must apply innovative, non-traditional thinking to margin management. They need to have a deeper understanding of the forces (both internal and external) driving the business margins. Many finance executives are aware of the factors influencing their margins. But, do they really know the significant drivers at granular levels for each product, channel, geography, segment, market, or business unit?
Thinking differently and making use of ABC/M, Customer Life-cycle Value and Customer/Product Profitability Analysis techniques can help CFOs understand their organization’s costs and their drivers. It also helps them to think beyond historical top-line focus and current constraints, and focus on doing the right things. For example, the CFO will be able to ask and answer the following questions:
- What does our customers value most?
- Is our current value proposition delivering customer value?
- Do we need to change our current business operating model?
- Should we sell all the under-performing assets or not?
- Should we exit all the under-performing businesses, brands, markets or channels?
In order to improve operating margins, it is critical that executives consistently apply margin management to the entire business. You need to manage margin the end to end processes of the entire value chain, and find a more integrated way of driving overall results as opposed to one element of the income statement or business. This helps eliminate waste and also leads to more transparent and informed decision making.
Make Insight-Driven Decisions
Although information systems have improved significantly, many organizations are still struggling to benefit from their use. For instance, there is an organization class that is still reliant on primitive systems that are no longer fit for purpose in today’s data driven-economy. Then there is another class of organizations who have implemented modern technologies to enhance decision making but are struggling to integrate these with existing systems or have experienced dismal implementations with far-reaching consequences.
The modern finance organization must leverage data and analytics to inform margin decision-making. For instance, CFOs can make use of advanced predictive modelling and simulation tools to identify drivers of margin, calculate margins under different scenarios and evaluate ways of improving the margins.
Care must be taken that you do not embark on a data-hoarding spree without first understanding why you need that specific data. You need to make sure that you are collecting the right data to analyse and extract meaning from, otherwise you will end up wasting your time, energy and resources analyzing wrong data and generating ineffective insights. Information is only as valuable as the decisions it drives.
Wrong data collection often results in ineffective analysis and generation of misleading insights which ultimately leads to slow and ineffective decision making. This also causes the business to react slowly to new opportunities and threats. Instead of being proactive, overall decision-making is mostly reactive.
When margin decisions are made based on insights, more emphasis is placed on adding value to the customer and not on quick fixes such as slashing more costs. You can cut costs only up to a certain extent, long-term this is not sustainable. Hence the need to find alternative ways of boosting margins. Evidenced-based decision making also enables executives to develop a more detailed understanding of the full set of profitability drivers for the company.
Cultivate a Margin-Focused Culture
Delivering improved margins also requires the organization to develop a common understanding of the meaning of margin management and why this is crucial. This is necessary to promote accountability, drive the right behaviours across the organization and ensure that margin optimization remains a key priority.
Successful fostering of this culture depends on senior management buy-in and involvement. If the drive is coming from the very top, it becomes easier to embed the culture into the business and make margin improvement an everyday part of the decision making processes. Senior executives have to therefore show a commitment to margin improvement otherwise the middle and lower level employees will also not be committed.
CFOs are better placed to drive this culture because of their constant engagement with the business – Sales, Marketing, Operations, R&D etc. By collaboratively working with other business units, finance executives can provide them with the information and the tools they need to make decisions that support profitability goals. They can also help put in place metrics that are not focused on volume alone but also drive the right behaviours and stimulate growth.
Furthermore, CFOs have to ensure that they are consistently reporting and reviewing margin performance across all brands, product categories, channels, segments and markets on a monthly basis. This will enable margin management to get embedded in the fabric of the business, and also be fully integrated with the broader strategy of the business.
Improving operating margins is not the responsibility of the finance organization only. It should be everyone’s concern. However, finance must lead the conversation. The CFO must ensure that the right operating model and capabilities have been developed to identify areas of margin leakage and define improvement actions.
I welcome your thoughts and comments.
Businesses in various industrial sectors are undergoing a fundamental transformation as a result of the effects of globalization, advancement in new technologies and increasing digitalization. Apart from presenting a wealth of opportunities to help the organization soar to greater heights, these changes are also presenting a variety of challenges on the business model.
They are altering customer behaviours, placing increased pressure on existing markets and impacting financial performance. In these trying times, the finance function is being called upon to help steer the organization in the right direction and improve profitability.
Popularly known as bean counters, accountants are now required to support business growth initiatives and help grow the beans within their organizations. The modern finance function has evolved from being a “just numbers” back-office function to a “strategic partnering” front-office role providing deeper insights and a clear direction for translating the numbers into effective actions for those operating on the front lines of the business.
Whereas in the past the finance professional spent his day behind the scenes, glued to his computer, producing and reporting the numbers, today’s finance professional is involved in the business interacting with the other organizational functions and helping drive business performance. There is a joke about an accountant without a spreadsheet being described as “lost”. In the past, this could have been true, but not today. The bean grower of today is a strategist, a motivator, a leader, a team player, a change agent, completely understands the drivers of business performance and drives improvements in respect of new revenue and value-producing opportunities.
It is no secret that the finance function is the custodian of the business profit and loss. In times of economic downturn when cost control is critical, the finance professional is called upon to help identify areas where the organization can scale back in order to improve overall profitability. In good times, finance helps senior management identify new opportunities (new markets, new products, potential acquisition targets, new services etc.) that need exploiting. Disrupt or be disrupted is the mantra in today’s ever-changing business environment. The business has to evolve with times.
The challenge on the finance function is to deliver more with less. This has led to many organizations to embark on ad-hoc cost-cutting programs hoping to improve the bottom-line. Unfortunately, cost control alone is not sufficient or effective enough to enable the organization realize the targeted gains. You can only cut costs up to a certain level. This is because each cost initiative reaches a point of diminishing return, after which, the company has to explore new ways of improving profitability. In order to grow its influence on company profitability, the finance function must:
- Understand the Drivers of Business Performance. To be effective bean growers, accountants need to move beyond numbers and get an understanding of the company’s product s and services and how they affect the profitability of the business. This means finance teams lifting their heads up from their financial reports and obtaining a better view of the business itself. Instead of focusing only on where the business has previously failed, finance should provide strategic insights, competitive intelligence and analysis that enable effective decision-making by the senior management team. For example, finance should be able to provide data, metrics and analysis that helps transfer the function’s own understanding of the drivers of profitability to others throughout the organization, in order to ensure that profitability develops into a basis for action.
- Help Identify New Pathways Toward Profitability. When it comes to profitability improvement initiatives, many at times the focus is on the bottom-line. As mentioned earlier on, eliminating fat from the bottom line works up to a certain extent. Cost reduction is a short-term fix but not sustainable in the long-term, especially if the company is looking to grow. Management become misguided and believe that by laying-off people to contain salary costs or postponing capital investments they are placing the organization in a better competitive position. The opposite is true. In fact, cost cutting by itself is counterproductive as it can lead to inefficiencies, missed opportunities and higher operational costs. There is nothing wrong in getting the business lean, but getting lean has to be linked to the business strategy, done the right way, at the right time and for the right reasons. Attention should also be focused on the revenue side of the business, for example, diversifying the business, internally growing existing business units, making additional productivity improvement, improving existing product or service offerings and making major business purchases.
- Invest in Modern Technologies. As the amount of data generated continues to grow, an enormous demand is being placed on finance to make meaning of this data, identify trends and develop the most effective responses that will help protect and improve company margins. Finance must know what information will have the greatest impact on profitability since having the right information is at the core of improving company profitability. Equally important is placing this information in the right hands. Relying on spreadsheets alone will not cut it. Finance must invest and make use of modern Business Intelligence and Analytics technologies in order to be able to identify accurate, reliable and relevant information and place it in the hands of the right people at the right times. These modern technologies help transform finance into a more flexible, responsive and forward-looking function. The modern finance function must have the ability to use technology to gain a more detailed understanding of the metrics underlying the company’s profitability.
- Develop Effective Pricing Capabilities. The sales organization is normally rewarded on revenue made and this sometimes results in the sales team being interested only in closing the deal at the expense of profitability. Not all customers are equally profitable to the organization; therefore sales should be tailored to optimize profitability. Getting the pricing wrong has negative consequences on the overall profitability of the company. Finance need to have an advanced understanding of the company’s different customer and product portfolios. By performing customer profitability analysis and product profitability analysis, finance will be able to understand the customer costs-to-serve and use these costs to segment customers, fine-tune pricing and manage profitability by helping direct efforts towards growing profitable product and customer combinations. Sales personnel can then use this cost-to-serve in negotiations as well as forward-looking analyses to drive effective decision-making.
- Collaborate With the Rest of the Organization. Although finance plays a central role, maintaining and improving company profitability is a team effort – it should be everyone’s concern. It is imperative that finance professionals work directly with their colleagues outside of finance (Sales, Marketing, Operations and R&D.) and develop a list of actionable items which impact profitability. For example, working more closely with the sales organization will ensure that sales personnel have all the information and tools they require to make decisions that support profitability goals, otherwise they will be ill-equipped to make the best decisions. Getting the buy-in and commitment of the C-Suite is also critical since the C-Suite is involved in setting the direction of the company. The C-Suite’s involvement will in turn lead to the establishment of a common goal and set of metrics shared with the front lines of the business through synergies with their finance teams. Remember Individuals don’t win, teams do.
If the organization is to succeed in maintaining and improving its margins, finance’s involvement is important. Finance helps make meaningful and measurable profitability improvements. Look at the bigger picture and beyond quick fixes such as rapid cost reductions. Develop a more detailed understanding of the full set of your business’s profitability drivers and take full advantage of new technologies capabilities to uncover the organization’s key profitability levers and challenges.
Have you ever wondered why your customers keep on buying your products or requesting your services? Why they are willing to pay more for some of the products and services and less for the others? Could it because you are the only supplier in the area? If so, suppose a new company in the same line of business as you opens up a shop in the area, would your existing customers still continue to buy from you or they would defect?
There are various reasons why your customers keep on coming back to do business with you but one of the most significant one is driven by the value that you are offering them. Value is the core driving force underlying every business decision.
Although managers talk of value when determining pricing strategies, unfortunately, very few understand the true meaning of value, what it is, why it is so important, how it should be communicated and its critical role in pricing products and services. To many of us, value means different things. As a test, ask your colleagues what it is that they refer to when they talk of value? Chances are high that you will hear different definitions. For example:
- Some people equate value to expectations. To them, value is getting more than what they paid for, be it for an item or service delivery. In today’s information and social media age, perception alone is driving purchases. Prior acquiring certain products or services, customers are communicating with each other on various platforms about the organization’s product and service offerings. By the time the customer makes a purchase, he or she in his or her mind has already built up expectations on what the offering will be able to actually deliver. Only at a later stage after completing the transaction is the customer able to reflect and conclude that his or her expectations have been met.
- Other people view value as a fair transaction. They look at the limited resources at their disposal and how best they can use them to meet their expectations. When purchasing an item, a lot of sacrifice has to happen. One has to set aside time to search for the right item and choose from among options, evaluate the cost of money to purchase, the price itself and any associated psychological risk factors. This sacrifice goes beyond looking at the monetary costs and also reflects on the time and efforts invested in seeking out the good in question. In this instance, value is therefore viewed as the worth of the item purchased at least being equal to and certainly not less than the sum of the sacrifices made in acquiring it.
- While others view value as expectations and fair transactions, others see value as an improvement of the current situation. Customers are looking for investments that are capable of improving their lives significantly. Likewise, business managers are not keen on throwing money and resources at investments that will deliver a poor return and put the business in dire situations. Instead, they are looking for investments that enhance the business’s competitive advantage. If any investment derives a return that surpasses expectations and genuinely improves the current situation, then value is said to have been delivered.
The challenge on business managers is to look beyond pricing and make sure that their products and services are delivering value to the customer or to the end-user consumer. Making pricing decisions based on cost and competitors’ prices alone will not cut it through in today’s business environment. Customers possess the buying power and can easily defect to new suppliers if they are not happy with the current offering. Businesses therefore need to keep on reinventing themselves, re-examine the reality of the value they are offering to their customers and find ways to enhance the value they deliver.
Focusing on value helps business managers to understand the actual needs of its customers and find unique and differentiated ways of meeting those needs effectively and efficiently. When we talk about differentiation, it is not just about doing something different. It is about doing something different in a way that really matters to your customer and not just offering price cuts. So many at times, when confronted with a customer challenge on price, the sales response is often to discount which often leads to early product commoditization. Of course, your product may be heading toward commoditization. If this is the case, a thorough assessment and evaluation of the product and its relevance in the market is necessary. This will help you craft a strategy to reposition the product in the mind of your customers and prolong its lifespan.
Focusing too much on price prevents useful discussion of the real value of the offer. As a result, the buyer fails to distinguish the merit of what he or she has acquired and fails to gain, through lack of awareness, the full benefits from the products and services purchased. You need to challenge any claim that your product or service is just like everyone else’s. How are your products or services positively changing the customer’s overall product or service experience? Communicating your differentiated solution in a clear, compelling and persuasive manner is vital to persuading the customer do business with you.
Differentiating the organization’s total customer offer from competition means that this difference delivers real value that the customer can identify, understand, acknowledge and be willing to invest in. Unfortunately, this is not the case for many businesses. What these organizations are referring to differentiation are merely differences in specification and nothing more. There are no critical differences between their offering and those of the competitors. For instance, many are making changes that are resulting in easier production of the product or easier delivery of the service just because they have the technology or know-how to do so but not a differentiation from the customer’s perspective. What impact is the change you are making on your product or service having on the customer’s business, in terms of both economic and emotional considerations?
In today’s copy-cat environment, it is easier for competitors to emulate your products and services and surprise you. Despite this, many organizations are still of the assumption that their differentiation will make the competition irrelevant. Never underestimate your competitors’ abilities to shock you. You need to find unique ways of influencing the relative value the customer perceives, make the customer choose your product and service and remain with you. How good are you when it comes to listening and fully understanding the customer’s context, value-adding processes and pain and pleasure points? Are you able to consolidate this information and create a product or service that offers real differential advantage from that customer’s perspectives?
Gone are the days of pushing products and services to the market. To do well, the business has to be a good listener of its customers. You need to possess intelligent consumer and product insights that are capable of leading you to new ways of differentiation. You can differentiate your service by ensuring that your customers receive consistently great service. Consistency is key to having dependable and reliable customers.
Convenience and customization are also key to successful differentiation. By improving the convenience to your customers of using your product or service through using methods that are difficult for your competitors to imitate, you may be able to lock them in. With regards to customization, you need to deeply understand your customer’s value adding processes or production operations. Having this deep understanding will enable you to identify where your company’s unique skills can be applied for the benefit of both the client and the service provider. By fully understanding the real needs and motivations of your customers and timely responding to them, you can differentiate your total customer offer and reap great benefits.
Although there are various ways the organization can choose to differentiate itself from competition, regardless of how it decides to do so, learning and understanding as much possible about the customer, her company and market is vital. Where are the sources of pain and problems he or she is experiencing that no one else seems to be addressing? As a business, how can we leverage our unique capabilities, contacts, technologies or other resources to address the customer’s problems in a way that is difficult for our competitors to copy but at the same time make it easy for the customer to buy and remain with us?
You need to deeply know and understand your customer in order to build a powerful, persuasive and compelling value proposition. In this day and age of plenty information, you can never know too much about your customer. Every single piece of information you collect goes a long way in helping you understand your customer’s business, context, strategy or desires. Value is different for every customer and even for the same customer under different circumstances. This value comes from knowing all the critical details about your customer. Learn everything about their value drivers. In addition to understanding your customer, know your differentiation – how and why you are different from your competitors. This will help you identify your competitive advantages and disadvantages, develop effective business and pricing strategies and enhance customer value.
If you are unable to justify totally the value-adding elements of your product or service proposition, your total customer offer is highly likely to be rejected by your target market.
Not all customers are the same. Some customers are profitable and others less profitable depending on the behaviour they exhibit. Some people believe that the customer is always right and should therefore be satisfied at all cost. I tend to differ on this notion. Although customer satisfaction is crucial, the organization’s long-term goal is to increase customer and corporate profitability.
Achieving this goal requires management to strike a balance between managing the level of customer service to earn customer satisfaction and the impact this will have on shareholder wealth. The best solution is to increase customer satisfaction profitably.
Some customers, suppliers and trading partners are extremely high-maintenance. Unlike customers who place standard orders with no fuss, high-maintenance customers demand nonstandard everything. They are always asking for that special treatment. For example, they make unwarranted delivery changes and require more after-sale services. If that is not enough, you always hear from them and in most cases to inquire about and speed up their order, or return or exchange their goods. If you add up all these costs-to-serve plus the costs of the products and base service lines you will be surprised to discover the magnitude of the erosion happening to your bottom line.
Knowing who your troublesome suppliers and customers are and also how much they are eroding the organization’s profit margins is critical for effective resource allocation and decision making. What kinds of customers are loyal and profitable? Of your existing customer profile, which customers are only marginally profitable or, worse yet, losing you money? Does the customer’s sales volume justify the discounts provided to that customer? Using Activity Based Costing/Management (ABC/M) techniques helps managers and employees find solutions to these questions and take corrective actions. Through ABC/M analysis, managers and employees will be able to trace, group and reassign costs based on the cause-and-effect demands generated by customers and their orders.
With better cost data at its disposal, the organization will be able to decide whether to push for volume or for margin with a specific customer, to alter its product and service offering to improve profitability or to assess whether benefits can be realized from changing current strategies by influencing its customers to alter their behaviour and buy differently and more profitably. This in turn enables the organization to become more competitive because it knows its sources of profit as well as understand its cost structure.
The whole idea of carrying out the organization’s customer and channel profitability analysis is to identify the less-profitable customers and suppliers. Having identified these troublesome suppliers and customers, then what? Should you immediately terminate your relationship with these customers? Should you continue business as usual? What about the already profitable customers? Must you streamline your delivery processes to reduce the costs-to-serve? With the facts, unprofitable customers can be migrated to higher profitability through managing service costs, introducing new products and service lines, offering discounts to gain more volume with low cost-to-serve customer, reducing their services, renegotiating prices or shifting their purchase mix to richer and higher-margin products.
Remember customers with high sales volume are not necessarily highly profitable. Customers tend to cluster. Medium-volume customers can be much more profitable than large-volume customers. Each customer’s profitability level depends on whether the net revenues are sufficient to recover the customer-specific costs-to-serve. It is therefore important to know the types of customers that cluster in the various profit or loss zones as this can be valuable in determining what actions to take.
Furnished with better cost data, the organization can protect its most profitable customers from competitors. Because so few customers account for a larger portion of the organization’s profit, management must focus on retaining these profitable customers and derive value from their loyalty. For those customers who drain resources and time, yet provide negative financial return and are concluded impractical to achieve profitability with them, they should be terminated.
These days customers are more equipped with more information about the company’s products and services before they have even talked to the salespeople. Unfortunately, in most organizations, the sales function normally lacks high-quality data to drive sales effectiveness. For example, sales managers lack data to help align sales incentives, overcome price pressures and become a strong competitor in the market.
In these organizations, finance can play a critical role in delivering the information required to maximize sales productivity. In today’s economy of big data, the difference between success and failure more than ever lies in the quality of the data that finance shares with the organization’s salespeople.
Taking advantage of its analytical skills, the finance function can assist salespeople obtain the most relevant information about the company’s customers which ultimately helps transform the selling process and cultivate new relationships with the right customers. For any organization, sales costs are a major component of the expenses hence the importance of managing sales processes and improving sales performance. It is therefore imperative that you improve the way your company gathers and uses sales activity data in your planning, budgeting and forecasting processes. How do you rank the quality, timeliness, accuracy, transparency and completeness of the sales information used to forecast top-line revenue?
The quality of sales data at your disposal determines the usefulness of that particular data and your company’s ability to plan. In a world where technology is constantly evolving and aiding successful decision-making, to maximize sales force effectiveness, company’s should invest in analytical and modeling techniques in order to find out what changes would bring the best improvements in outcomes. This also includes improving management’s ability to use sales reporting tools such as dashboards. Getting hold of high-quality data for revenue forecasts requires you to match sales resources to changing opportunities and business objectives. This will help you retain customers from the jaws of aggressive competitors.
By gathering and integrating timely information about the company and its industry, salespeople will be able to gain insights about changes in customer behaviour which in turn leads to smarter pitches, shortened sales cycles and opening up of new opportunities. Data that reliably reveals valuable selling processes and practices as well as patterns in customers’ buying habits is effective for improving sales force effectiveness.
As market competition continues to intensify, managers must improve the effectiveness of their salespeople as quickly as possible to avoid losing market share to rivals. Improving sales performance involves improving existing sales methods and processes, better training, better hiring, better sales management and making use of refined selling behaviours such as cross selling, bundled selling, targeted discounting and focusing on sales profitability.
In many organizations, salespeople are regarded as catalysts for growth and profitability. For salespeople to successfully fulfill their role, they need high-quality data and analysis. Thus sales must partner with finance in order to gain better insights necessary for effective decision-making. Instead of just reporting on the periodic sales figures, finance can educate salespeople on data gathering and analysis and provide them the relevant information so that they become better informed prior engaging current and prospective customers. Improving collaboration among finance, operations, sales and marketing and human resources enables the company to reach its stated objectives.
As the guardians of the company’s finance data, the finance function is in a better position to supply salespeople with the information they need to take a more strategic and data-driven approach to winning over customers. Finance is able to provide more analysis, more insights and more recommendations so that people are aligned with what drives the business forward. Thus with quicker and better information, as well as accurate forecasts and targets, salespeople are empowered to make more informed decisions about which customers to target and interact with.
To successfully deliver on their business partnering role, finance people should move beyond their isolated number crunching and routine transaction processing roles and partner more with other functions of the organization. Finance must become more proactive with data. More than projecting into the future, finance could use the information in the present to improve market and competitor insights and build better selling tools. Making data-driven decisions helps managers deliver more customer value with less, outperform rivals, target the right profitable customers, design the right value proposition and create value for the company. The key for finance is therefore to provide better information that is actionable to improve sales.
If salespeople are lacking in high-quality data about their company’s costs and price competition, they can and do end up working in complete opposition to management’s goals. Selling is not about selling products that are considered legacy products but no longer support the company’s strategy. Instead, selling is about selling products that are targeted to grow top line revenues. Salespeople should therefore not be encouraged to close deals that weaken the bottom line. Pricing controls should be implemented to ensure minimum levels of profitability while remaining sensitive to market competition. Find more profitable customers and avoid negative margin deals.
Furthermore, finance can also help educate sales managers redesign sales incentive compensation plans by better linking rewards with the salesperson’s achievements and the company’s strategic objectives. However, there has to be a mutual understanding between sales and finance of what success looks like so that incentives line up with the organization’s performance measurement systems. By utilizing ABC/M techniques, finance can provide salespeople with quality information that helps them understand the various cost components of their activities, their drivers, whether they can be influenced or not and their ultimate impact on bottom line.
With the right data, salespeople will have answers to their various questions. For example, “Whether to sell to existing customers through cross selling”, “Whether to use leads to tap new markets”, “What price is no longer worth making the sale”, and “What the financial impact of sale is.” Finance therefore plays a critical role in helping the sales function achieve its effectiveness.
As sensibly as the sales function may plan and implement its strategy, it will not produce better leads, attract more customers and generate higher profits if the data is not used dynamically by finance. Finance ensures the timeliness of sales and sales-activity reporting. Finance is also capable of responding quickly to changing business situations with relevant reports and analytics.
How else can finance drive sales effectiveness?
I welcome your thoughts and comments.
Business leaders always spend a lot of time thinking about costs and how they can reduce them, free resources for investment and improve the bottom line. The pressure to reduce costs is normally driven by cash flow position, shareholders, uncertainty, investments and the need to improve business performance. In light of the aftermath of 2008 global economic crisis, there has been increased pressure on business leaders, especially financial executives, to achieve more with less. The finance function has had to transform itself in order to improve productivity and efficiency.
If not managed properly, cost-cutting exercises may prove to be an unnecessary enemy that the company does not want to deal with. In some organizations, cost-cutting exercises have taken precedence resulting in the business becoming weak and more limited. On the contrary, if managed properly, cost reduction using activity-based costing and management techniques leads to better performance.
Cost-cutting measures should not be considered in isolation. Instead, cost-cutting should form part of the organization’s overall strategy because every investment, whether good or bad, is important. If the organization is not able to contain unnecessary costs, the impact will reflect in lower profits and cash flow problems. It is therefore important for managers to understand that no strategic planning process is complete without a close analysis of costs. At the same time, no cost or strategy project is complete without a closer look at its impact on the company’s capabilities system.
As Paul Leinwand and Cesare Mainardi clearly state in their book, The Essential Advantage: How To Win A Capabilities-Driven Strategy, the management’s approach to cost control is a key indicator of how coherent the company is or is not. Cost-cutting is meant to free up resources for strategic investments that are aligned with the organization’s capabilities system and way to play. If managers have no clear way to play and are cutting costs randomly, this fuels incoherence.
Unfortunately, some business leaders are still using the conventional approach of cutting costs with the hope of achieving positive results. So many at times, these leaders receive satisfaction only in the short-run. Adhoc across the board cuts, where a percentage of cost reduction is shared equally between functions, normally fail to free up the much needed investment. This is so because adhoc across the board cuts negatively impact some parts of the company that are strategically aligned by stripping them off of the resources they desperately need to perform better. Also, most of these exercises are a benchmark of the competitors’ cost levels which by far are not linked to the company’s strategic priorities.
Using ABC/M techniques can help managers avoid the mistake of focusing on the short term. ABC/M helps identify cost drivers of different processes, activities, products, channels, customers etc. and this in turn help reduce waste by eliminating non-value adding activities. In 2008-2009, many companies across national borders implemented across the board cuts which were misaligned with their capabilities system and way to play. They instituted adhoc layoffs and cost reductions without considering the long-term implications on business performance and competitiveness.
As the global economy started to rebound, these companies found themselves in not so favourable positions of lacking the capabilities and skills essential to drive growth. In turn, they were forced to embark on massive recruitment sprees at huge costs to replace those skills lost during the downturn. On the contrary, those companies that implemented talent management strategies aligned to their overall strategies have managed to come out of the economic slump much better and stronger. This just shows that if the root cause of unnecessary costs is not identified and dealt with properly, they will come back again as if nothing was learned.
To cut costs and grow stronger, the conversation about costs needs to change to a more productive one. The starting point requires you to categorize your costs into costs you need to incur to keep the business running; costs you must incur to maintain your industry position even though your business might run without them; costs that support your capabilities system and way to play and lastly all other costs which are those that do not specifically fit into the first three categories. This distinction of costs helps evaluate the downside that the business would face if it makes cuts or changes in either one of these categories.
Today, many managers are facing the challenges of huge overcapacity and steep loses. The best way to react to these challenges is start looking at their businesses with fresh eyes. For example, to reduce operations costs, they need to start looking at operations as a single network and reconfigure production flows as needed to more flexibly serve customers.
Having eliminated unnecessary costs, the challenge for leaders is to deal with expense creep. It is important to ensure that cut costs do not come back because if these costs manifest again, this is a sign of strategic incoherence. The best way to avoid expense creep is to continuously evaluate costs relative to the organization’s capabilities system and way to play. Only by assessing costs regularly and consistently can the organization become aware of the relationship between its capabilities system and other expenses. In the long run, this will ensure a viable good cost position.
Since the dawn of the new millennium, the world has experienced tremendous change, both positive and negative. There has been rapid advanced technological developments; introduction of new regulations; natural disasters; increased social and political unrest; growth of social media usage; global economic meltdown; increased cyber threats; increased globalization; increased competition; collapse of once dominant companies, and supply chain complexities.
These forces are dramatically changing the shape and course of doing business. What may have been regarded as the norm a few years back is no longer regarded so in today’s dynamic economic environment. In today’s ever competitive environment, businesses need to be agile and resilient if they are to achieve sustainable performance. With many players in the market vying for the same customers, only those organizations that clearly recognize and understand customer dynamics will reap positive returns from their marketing investments.
Many companies spend vast amounts of money on marketing campaigns in an attempt to create product or service awareness and solicit customer buy-in but, unfortunately, only a handful of these efforts actually achieve the desired outcomes. The problem lies mostly in their lack of understanding of the customer’s needs, wants and buying habits. Because of their reluctant to move on with time and adapt to change, these companies are still rooted in the pats. They are still holding on to their past success strategies under the mistaken belief that the champagne will keep on pouring. As Marshall Goldsmith said, “What Got You Here, Won’t Get You There”.
To reap positive ROI of marketing spend, organizations need to become customer intelligent. You have to be able to determine how much are you spending in marketing to retain customers and which type of customers should you focus and marshal more of your resources. Waking the sleeping giant and maximizing the ROI of your marketing spend begins with you segmenting your customers into logical groupings.
The best approach involves establishing a profound criteria for defining each customer segment, identifying all the characteristics of a segment that are foretelling, differentiating profitable segments from loss-making ones, analyzing the movement of each customer from one segment to the other over time and devising ways of proactively managing these movements, and deciding the appropriate communication channels and types of marketing messages for each segment. Gaining these customer insights will tremendously help you identify which customers to retain long term and those not to waste resources on.
The revolutionary transition from mass marketing to customer database marketing systems has even increased the need for organizations to garner vast insightful and informative customer intelligence. The internet and now social media have created a social platform for current and potential customers to access and exchange critical information about a company’s products or services. Comparisons are now easier and faster than before. The power has shifted from the seller to the buyer and the customer is in control more than ever. This new model requires companies to invest in customer intelligence systems capable of helping them refine marketing and sales effort, target individual customers with pinpoint accuracy and manage their conversation and interactions.
Customer intelligence systems help analyze customer segments and then formulate strategies that help satisfy and retain each customer segment. Because of their analytical nature (data mining and extraction tools), companies are able to gain insights about who their real customers are, their location, what they want from them, how often as well as anticipate their future needs. Instead of managing customers, companies will be able to enhance their customer relationships by fostering long-lasting good experiences and interactions that lead to repeat purchases and future referrals.
Rather than offer and deliver the right product or service via the right channel to the right customer at the right time from the business’s point of view, the company will be able offer and deliver from the customer’s point of view in much more pleasurable way. The company will no longer focus on outbound calls and marketing campaigns intended to sell its products or services. Instead, the company will maximize the responses from its inbound interactions with customers. The moment customers calls in, based on what the company already knows about them, it can maximize profit by up-selling or cross-selling its products and services.
Understanding this relationship between increasing customer satisfaction and generating higher revenues will help companies improve their profitability. This, however, requires more and better customer contact, closer customer relationships and the ability to proactively anticipate customer needs. It is the manager’s responsibility to place current and potential customers’ experience at the centre of the organization’s priorities and ensure that incentive systems, processes and information resources support these relationships by improving the experiences.
Most businesses are under extreme pressure to reduce costs while improving product/service quality and customer service. Developments in the global economy such as globalisation and advances in new technology have changed the traditional balance between customer and supplier. Customers are now spoilt of choices meaning businesses need to be more customer-focused. They need to re-evaluate their value propositions they present to customers and also find ways to capture value from providing new products and services.
Organisational support functions such as finance, procurement, information technology, sales, marketing and human resources need to collaborate to achieve organisational goals and objectives. However, these support functions are often the focus of cost cutting. They usually have little contact with external customers and as such their contribution towards bottom line is viewed as indirect.
I am of the belief that a business support function, whether it’s customer facing or not, is critical to the future success of the organisation. For example, without an effective and efficient IT function, how would front-line workers be able to interact with customers, retailers and suppliers? Also, how would companies improve their market share and competitive advantage with a marketing function constantly facing budget cuts?
Companies need to be aware that cost cutting programs are not exercises where you randomly streamline services or headcount. If these cost reduction programs are not carried out properly, organisations risk damaging relationships with customers, employees and other stakeholders. The results of such relationships include reduced employee morale, internal and external conflict.
So why is it that so many cost reduction exercises often fail?
• When companies implement cost reduction exercises the cost savings are usually short term with higher costs reverting in the long term. Companies need to have a long-term perspective of their strategies and identify sustainable cost savings.
• Poor understanding of how staff and business functions to be made redundant support the business strategy. Most companies make the mistake of focusing only on reducing headcount as opposed to quality and product/service delivery.
• Lack of involvement of both senior and middle level managers. One of the conditions necessary for the successful implementation of cost reduction initiatives is executive sponsorship otherwise managers and employees at lower levels will view the project as non-critical. If there is no buy-in from executives then there is need to have champions to lead the cause and promote buy-in.
• Lack of ownership of the project because cuts are randomly applied without consultation. This often results in lack of commitment to sustain cost savings. Consultation and engagement is necessary to instil employees and other managers to a noble cause to which they are committed.
• Lack of performance measures to track implementation or reward systems linked to their delivery. Designing KPIs related to cost reduction initiatives provides a yardstick to measure and monitor current changes. Tying incentives to specific KPIs often motivates personnel and challenges them to go one step further and produce great results.
The goal should be to achieve cost reduction and improve margins without damaging service or damaging employee morale. For cost reduction programs to be successful, companies need to understand how each overhead area (information technology, finance, marketing, human resources, purchasing, and sales) supports the business strategy and contributes to the achievement of goals and objectives. There should be an assessment and evaluation of the services provided by each support function and how they contribute towards the achievement of the entire business strategy.
Furthermore, companies must:
• Understand their business environment and strategies. This is key to identifying areas that require improvement and evaluating the impact of suggested changes on long-term performance.
• Conduct an activity analysis of their business support functions as this presents the cost-base for each department from an activity viewpoint. For example, instead of having standard management report for a marketing department classify its costs as salaries, telephone, insurance, advertising and promotions etc; Activity Analysis helps you identify the activities for each department, their cost, their cost drivers, their customers etc. In this case, typical examples of marketing activities include producing and printing magazines, organising social events, sending out brochures, newsletters and emails, liaising with media etc.
Departmental reviews/activity analysis also help identify areas of duplication across the company. For example, similar tasks being undertaken at both the local level and at head office. Eliminating this duplication will provide an impetus for service improvement.
• Conduct customer reviews to identify areas of cost savings. This involves performing internal and external customer audits to establish how product/service offering can be improved. By doing so, companies are able to identify non-essential services or non-value adding activities and their elimination helps cut costs. Customer reviews also provide a yardstick for comparing the cost of in-house services against equivalent third-party providers.
How else can an organisation strategically manage its costs and improve enterprise performance?
Look at any high street retail chain and you will be amazed by the sheer size of their product ranges or number of customers. But what’s more important, is that not all the products that we see everyday stacked up the shelves and not all the customers we see walk through those doors contribute meaningfully to the overall business profit.
According to the 80/20 principle, also known as the Pareto principle, only 20% of products/services that business provides are responsible for generating over 80% of the total revenues and profits. The same applies to customers as well. So does this mean that all the customers and products not within the 20% league should be neglected? The answer is found within customer and product profitability analysis.
Instead of just using guesswork to decide the range of products or services to offer or decide on which group or class of customers to serve, businesses can employ the use of Customer and Product Profitability (CPP) analysis to gain invaluable insights to aid decision making and improve performance.
1. CPP helps assign the cost and revenues to different products and customers helping identify the profitable and loss making ones.
2. CPP helps in retaining customers as programs are put in place to retain the most profitable ones hence resulting in customer satisfaction and loyalty.
3. CPP helps analyse the key revenue and cost drivers resulting in better decision making thus moving away from focus on only revenues and volume figures.
4. CPP helps identify areas where process improvements are required resulting in better cost management.
5. CPP helps formulate different pricing techniques for different products and customers.
6. CPP helps in reducing waste as the production team focus on the production of profitable products and sales team focus only on profitable customers.
7. Decisions can be made on whether to develop or neglect the loss making customers.
Costs are an important part of the business. Let them spiral out of control, they will affect both your profitability and cash flow. In meeting the needs and wants of customers, organisations have to employ the use of processes and activities. These processes and activities are critical for creating customer value.
However, to effectively and efficiently manage business costs, one has to have a thorough knowledge and understanding of all the activities and processes employed within the business to create value. In addition to that, knowledge of cost drivers is very critical. A cost driver being a factor influencing the level of cost.
One technique that can be used to analyse and manage your business costs is Activity Based Costing (ABC). This is a cost management technique which measures the cost and performance of activities, resources and the objects which consume them in order to generate more accurate and meaningful information for decision making.
As the modern business has become complex, it is no longer meaningful to assume that overheads are a function of volume only. Businesses now have multiple cost drivers, many of which are transaction-based rather than volume-based. Most organisations have moved and some are still in the process of moving from managing vertically to managing horizontally. What this means is that, there is a shift from a function orientation to a process orientation so as to effectively and efficiently meet changing customer needs and wants.
This focus by management on process or horizontal view of their organisations to remain competitive is supported by ABC since it provides cost and operating information that mirrors the horizontal view.
The benefits of implementing ABC include:
o It helps you identify all the overheads caused by the same activities.
o One can easily identify the cost drivers for each activity thereby allowing you to control costs at their source.
o It can help you identify, for example, profitable products, services, processes, activities, customer segments, distribution channels, contracts and projects. This should help you when making pricing, product/service mix and design decisions.
o ABC allows for continuous improvement. By thoroughly measuring and looking at the costs and cost drivers of different processes and activities, improvements can be made. For example, by knowing the cost drivers, cost reduction can be achieved, either through outsourcing particular activities or moving to different areas in the industry value chain.