Cutting costs

A conversation with a CEO

By Marwan Emile Faddoul (Managing Partner, NFG Consulting LLC)

As Joe* stepped into the offices of our management consulting firm for the first time, he stood still for a minute, looking around. No doubt he was getting a sense of the work atmosphere, drawing on his long experience as CEO of a Tianjin-based company. No doubt he was also judging us, deciding whether he wanted our services as management consultants. Later, he told me, "you can sense the quality of a company right away by how enthusiastic the staff are about their work, and you can sense how well they treat their clients by how well they treat each other."

Stepping into my office, after some small talk, he dropped the bombshell "I want to cut costs. How can I do that?"

For this week's article, I'd like to give you some of the tips we provide to clients on this topic. More importantly, you will also hear how to analyse such issues to reach a solution tailored to your own needs. My response to Joe's bombshell was to try to better understand the situation:

Marwan: "Joe, tell me more. The right approach to cost-cutting depends on your context." However Joe refused to be drawn out.

Joe: "Marwan, before I give you specifics about my company, I'd like to test you. How would you answer the question if you don't have any further information?"

Marwan: "Well Joe, the most important point is that it all depends on your objectives. Why are you seeking to cut costs? To illustrate this, I'll give you two example scenarios.

Scenario 1: The Company in Distress. This is the case of the company which wants to cut costs because it desperately needs money. The objective is to free up cash in order to become solvent again. Otherwise the company will die. This scenario happens to good companies that meet bad times, but also to start-ups just before funding rounds, and to companies being re-structured by private equity firms.

Scenario 2: The Rationalization. In this scenario, the company is simply seeking to rationalize its costs given its current strategy. There is no desperate need for cash, nor any other particular need to cut costs. The company simply seeks to improve itself, step-by-step. This scenario is often the case for companies that seek continuous improvement. It is also often the case in Merger & Acquisition scenarios, since cost-cutting is a more reliable way of producing value than synergies.

Joe: "Alright, my company is in the Rationalization Scenario. But how would you have addressed the Company in Distress scenario?"

Marwan: "For the Company in Distress Scenario, the two objectives are to find cash, and to find it very quickly. Given the urgency, the first step is to take immediate control over all expenditures. Often, this is done by making all expenditures above a certain amount – chosen to be as low as possible – require the CEO's personal signature. That gives the CEO immediate control. The second step is to analyse all expense items, sorting them into those that are essential to keep the doors open, and those that aren't. Those that aren't are ruthlessly axed."

Joe: "Even if they are necessary for the long-term growth of the company?"

Marwan: "If the company considers that surviving is more important than long-term growth, then yes!"

Joe: "I suppose all companies consider that!"

Marwan: "Generally, but not always. For example, for a high-tech start-up seeking funding, prospects for massive long-term growth are what attract the investors. Hence long-term growth is the most important consideration, as important as survival."

Joe: "Understood. I notice how each step of your advice is a direct consequence of the company's objective."

Marwan: "Yes, exactly! The need for speed is the reason for step 1, and the desperation is the reason for step 2."

Joe: "How about my case, the Rationalization Scenario?"

Marwan: "Here, the objective is to gradually improve. As a first step, we'd create a simplified model of the company. Then, for each part of the model, we'd compare the actual costs of the company with the ideal costs. For example, we compare the staff expenses of the IT department to the ideal staff expenses for this type of company. This allows us to identify opportunities for improvement."

Joe: "Why not list all the expense items of the company and go through them one-by-one?"

Marwan: "Bad idea. You wouldn't want to cut an expense which you don't understand, unless you are desperate for cash."

Joe: "Agreed. But you could investigate each expense item."

Marwan: "We would do that eventually, but we wouldn't start with it. Faster results are achieved by analysing at the high-level, and then going into increasing detail. It allows us to achieve cost cuts faster."

Joe: "What if you don't find any cost-cutting opportunities because the company's expenses are fairly close to ideal?"

Marwan: "This is often the case for companies that are cost-conscious. In that case, we model the company differently. For example, if in our professional judgment the cost-cutting opportunity lies in developing the staff and improving equipment, then we would analyse the company as composed of management resources, line staff resources, equipment resources and cash/current asset resources. We would then analyse how to work on each in order to reduce costs. For example, we might train line staff and incentivize them to reduce waste, and recommend spending more on maintenance of equipment in order to reduce their cost of operation."

Joe: "And I suppose that you might recommend a more proactive management of current assets in order to reduce financing expenses. But how might you act on management staff?"

Marwan: "There are many different approaches. One would be to train them in the scientific method."

Joe: "What! Why would you do that?"

Marwan: "If you want continuous improvement, then you need to constantly be trying to find new ways of doing things, trying to find issues with how you are currently doing them and trying to improve even those new ways."

Joe: "Yes. So what?"

Marwan: "These are key steps of the scientific method: generating hypotheses and falsifying your hypotheses."

Joe: "Go on."

Marwan: "Also, you need to be able to measure results. To be able to do this, you need to have established a baseline. In other words, you need to clearly understand how you are now doing things and how much it is costing. Otherwise you will not be able to fine-tune nor to measure the impact of the fine-tuning. Put it all together, and you have the steps of the scientific method: establish a baseline (how you are doing things and what the costs are), formulate a hypothesis (what you can change to reduce costs), and design an experiment to try to poke holes in your hypothesis. Then, based on the results, you repeat the entire process!"

Joe: "Ok, now that you've told me everything, why should I hire you? Just joking!"

I merely smiled. If Joe wants brainpower on demand, then he knows where to find it.

* Note: the people and situations mentioned in this article are fictitious and used for illustrative purposes. The confidentiality of our clients prevents us from directly using a real client case.

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