If companies don’t find ways to operate more efficiently, their chances of long-term survival may be compromised. We discussed the importance of cost optimisation and efficient business operations with Uros Camilovic, Partner at BDO Business Advisory.
What are the biggest challenges regarding cost reduction companies face in today’s demanding business environments?
Challenges that companies face depend on several factors. They depend on the size of the business, industry or industries it operates in, and the actual market conditions. In general, markets today are very competitive, and with the development of technology the competition is becoming global. Therefore, if companies don’t find ways to operate more efficiently, it will lower their chances of long-term survival.
Cost optimisation is one of the most important ways of improving efficiency. In this respect, one of their biggest challenges is actually finding the balance between cost reduction and cost optimisation. Inappropriately reducing the costs can have a negative effect on development and harm the sustainability of the business.
Cost optimisation is a dynamic process that helps find a balance between long-term goals and the most efficient cost structure to achieve these goals. It has positive effects on achieving long-term sustainable business development, and maximising shareholder value. On the other hand, it is a much more complex process than simple cost reduction, and that is more challenging by itself.
Another related challenge that companies frequently face is understanding of the actual cost structure, and realising how it can be improved.
An efficient cost structure is often seen as a source of long-term competitive advantage. Why are cost strategies still failing?
In our experience, cost strategies usually fail because of the approach that is taken to improve the cost structure. Often the common reason is mistaking cost reduction for cost optimisation. Usually we recommend taking a hands-on project approach which has several predefined steps: benchmarking, due diligence and proposed measures, planning and implementation.
Another reason why cost strategies may be failing is that supervision and monitoring should be conducted throughout the process, and companies are often not doing it adequately, while waiting for long-term results. Businesses could be viewed as live organisms and results of the therapy should be monitored and if they are not appropriate or as expected, corrective measures should be taken to put everything back on the right track.
Can you compare the benefits and downsides of short-term cost reduction against strategic cost optimisation?
Benefits of conducting a cost reduction compared to cost optimisation are mainly short-term. Effects can be measured in a shorter period of time, but long-term effects on the business aren’t necessarily taken into account, when we talk about cost reduction.
On the other hand, cost optimisation takes into account long-term goals of the business and is therefore more efficient in the long run for all the stakeholders. I mean, this doesn’t concern only the shareholders, but also business partners and employees.
It is important to notice that certain activities may not be mutually exclusive and may be necessary in both scenarios – cost reduction and cost optimisation. For example, one of the areas where this comes to effect is headcount reduction and reduction of the employees cost. The difference comes from the level of analysis that is conducted in order to come to these conclusions. Simple cost reduction by reducing the number of employees or the salaries may only have a short-term effect if a proper analysis is not conducted. Company may lose its best people very quickly. It will reduce the cost, but lose valuable knowledge, and that is a rather negative effect.
As a downside, cost optimisation does take a longer period of time because it is more complex, but the long-term effects are way better. Also, as it is more complex, unless it is properly performed and followed through until the end, it could lead to opposite effects from what was initially planned.
Why companies need to sustain cost optimisation even when economy is recovering?
The keyword here is competitiveness. In order to remain competitive in the very dynamic environment companies are facing today, it’s important to sustain cost optimisation even when the times are good. In these times, with more optimal cost structure, companies can enjoy higher profit margins and reinvest their profits in further development that will help them remain competitive in the long run. Also, in case it comes to price wars, which is usually the last strategy companies tend to revert to, the companies with a more optimal cost structure can maintain or even gain market share without their existence being questioned.
Companies tend to focus on this issue when they are facing a downturn and don’t think about it when times are good. When the economy is recovering, companies usually allow things to go the way that is not the most efficient, even though they preach cost optimisation. In the few years following the global crisis that affected most of the industries, companies have generally been more and more focused to maintain optimal cost structure. This is more obvious in larger companies.
Is it more difficult for small-sized companies?
Small size can be a benefit, as there are less processes and costs to control. However, when business operations become more complex, yet companies are still considered small, cost optimisation can be more difficult to sustain and also to perform. You need tools and expertise, but small companies cannot afford to hire people or buy services of consultants for the job. Also, economies of scale are something that is very difficult to achieve in smaller businesses. Larger businesses certainly have an advantage in this respect. Size can be a benefit and a downside for maintaining cost optimisation.
I would advise smaller companies and their owners/management to get some training in this respect, rather than to immediately hire people. It’s not as complex as one might think, because a lot of it is common sense. When companies grow, management becomes side tracked, and focuses on gaining market share. They should refocus on where the cost is, on the inside. If they can afford to hire someone experienced to take care of it, even better. This person would actually introduce certain appropriate procedures and make sure that cost optimisation is taken care of.
Can you explain the main phases of the cost optimisation methodology?
We split it into three phases or even three and a half. The initial phase is called benchmarking and market analysis, where we compare the company to its peers to see how the company fares against the market. If you want to benchmark efficiency, you have to compare it with something, otherwise you cannot say if something is efficient or not. We compare it with efficiency in companies in the same industry, ideally in the same market. This helps us understand which are potential areas for cost improvement. In most cases their cost structure is not entirely efficient and there is still room for improvement in certain areas of operations.
After that we move on to phase two, which is a due diligence exercise. In this phase we analyse the processes, how things work within the company, who is responsible for what, and what is generating costs. As a result we propose measures for improvement, and that ends the second phase.
Phase three means the implementation of these measures. This one is the most difficult, because it may happen that company doesn’t have adequate people to implement them. That’s why I was mentioning three and a half phases, because between the second and the third phase we have to do some very careful planning where each improvement measure is viewed as a separate project and planned appropriately. It helps us to determine what needs to be done, the time frame, responsibilities and reporting. Supervising the process is important from the beginning to the end. It also involves management reporting system, without which we don’t have supervision nor proper diagnostics, and it prevents us from assessing the effects of implementations. Companies should have this in place anyway, but it is often not the case or the existing system isn’t adequate.
How do you choose companies against which you benchmark your client?
Ideally, selected sample companies would be of the same size, operating in the same industry and in the same markets. In real life and in our region, this ideal scenario is usually very difficult to put into practice, and then we select companies that are to the largest extent similar and comparable. In the best case five to ten companies would be in the sample. Most of the time there is no single company which is most efficient in all aspects of operations and we select different key performance indicators (KPI) from different companies for various segments of operations. For example, we may use KPI for employee costs from one company and KPI for other administrative expenses from another. These KPIs are then compared to the client’s KPIs, and we can see segments where these companies are doing something different. These are the areas to consider performing some improvements. Following this we try to gather information about the approaches that benchmark companies have undertaken in their operations, and we focus on the client’s processes and organization issues to determine where in their organisation things can be improved, so that the KPIs are even better.
What tactics and strategic measures are companies taking to control costs, and what are their most common mistakes?
It depends on the industry and on the overall cost structure. For example, manufacturing, which is labour intensive, has a different approach to manufacturing that is capital intensive. For some industries the greatest costs are costs of goods sold, while in others it’s labour. Those are the things that should be considered.
In our region, particularly in the Balkans, companies are usually inclined to primarily make cost savings with their employees, but this is something that could lead to a downward spiral. As mentioned before, by simply reducing the salaries you start to lose the best employees, which leads to losing market share or making smaller profits. Instead, one could consider introducing some performance backed bonus schemes, which will not necessarily lower the cost of employees by lowering their salaries, but, being performance based, it is most likely to have some short-term and long-term effects based on performance of employees. The idea is to stimulate employees to perform better, either by having positive effects on revenues or affecting cost reductions, and this would have an overall positive effect on operations, efficiency and welfare of employees.
The most usual mistake regarding the cost control is its short-term focus and focus on immediate effects, without considering the strategic long-term goals of the company. One of the main problems, again specific to our region, is that many companies don’t have any strategic or long-term business plans. Planning is very important in business operations, but if you want to do cost optimisation, you have to know what your goals are, and do it in the most efficient way. Basically: do the most with the least.
Sometimes, more often than not, if they want to control the costs, companies have to invest first. This defies the logic of entrepreneurs, thinking that in order to save they only need to cut the costs. As advisors, we often have to, by showing them the figures, convince companies to invest to achieve long-term savings.
So reducing the numbers of employees is usually not the right decision?
If we focus on larger private companies, we have to differentiate large internationally run corporations, which are usually more efficient, from organically grown companies operating in our region. Usually those have evolved with the market, with entrepreneurs only thinking about growth and profit, but not focusing on the organisation itself. When revenues start to decline, they first think they have too many employees.
Companies should focus on the market and on achieving the highest revenues, and doing it with the optimal cost structure. So the immediate reduction of head count or salaries without analysing why revenues and profits are falling could be a mistake. Only by analysing the processes, how they work and how they are organised within the company, we can come to a conclusion whether they have an excess number of employees or not. Managers in our region usually revert to cost savings when there is a crisis situation. Decisions must be taken quickly, but not without proper consideration. As mentioned before, sometimes reducing the cost of salary can have an immediate effect on cash flow, but in the long term, if it is not focused on best results, it can harm the company. Also, a lot of industries have employees with very specific knowledge, and they are not readily available in the market. There is also the cost of replacing somebody, measured in the time you will have to invest to teach someone new to do the work of the previous employee.
Having said all this, we can see that it is difficult to conclude whether reducing the number of employees is the right decision without properly assessing all the relevant factors.
How do you identify inefficient P2P, D2F and C2C processes and why they can be so costly?
Here we’re talking about the working capital management processes, dealing with payables, inventory and receivables. The effects of these processes all end up in the financial statements of the subject company, and this is where we can identify the inefficiencies. For example, if we see that the average days sales outstanding is greater in the subject company than its competitors, then it may be worthwhile looking into the customer- to-cash process. If we find that average days payables outstanding is shorter than that of its competitors/peers, we should look into the purchase-to-pay process.
Benchmarking will not show what the problem is, but it will indicate where the problem may be. It will show us the symptoms, but not the exact causes of the problem. To identify the causes, a thorough diagnostics review of the processes (due diligence) is necessary to identify what exactly are the problems that lead to these symptoms. This way we find out how things are done and how they can be improved. Technology can help a lot, as it leads to fewer mistakes, reducing human error. Processes run more smoothly and efficiently when they are digitised, while technology also impacts the cost structure by reducing the number of employees that are needed to do the job.
Improving the working capital processes can have side effects. Ideally these improvements will lead to more cash flow, but they may not necessarily and automatically lead to more profit. For example, it may be the case that C2C process is inefficient because there are not enough employees working on collection of receivables. Employing adequate people to work on collection will lead to a better cash position, but it will also increase the costs. On the other hand, inefficiencies in these processes, like in every other process, are costly because they may have negative effects on results, in this case higher interest costs and higher leverage which have negative effect on the business value. Also, if these processes are not efficient, top management (CFO, or even CEO) spends more time on them. This is also inefficient and could have negative effects on long-term business development. If we can get the attention of the CEO and CFO in different areas to develop the business, it can lead to better results in the long run.
What is your opinion on the position of the modern CFO?
From my perspective a CFO should be the second most important person in the company. In our region we often find that CFOs don’t have a role that is now generally expected of CFOs. They are frequently acting as chief accountants, but this should generally not be their main concern. The CFO should be focused on cost structure, financing, financial risks, management reporting and, generally, facilitating achieving long-term goals of the company from the financial perspective. With the impact of technology CFO can have readily available insight into financial data from their accountants. They should focus on efficiency improvements, where they can fully benefit from new technology. It is important for modern CFO to recognize and understand the benefits of using new technologies, and how they can make their life and work easier and more efficient.