Need Big Cost Savings in Overheads? For the Sake of the Business, Do it the Right Way!

How to make overhead cost savings safely

What do you do, as a Finance Director or Senior Finance Manager, when the Board suddenly decides that one of their key strategies is an urgent round of cuts to make cost savings in overheads? And I don’t mean the 5% “budget task” or absorbing inflation. I mean what if there’s a downturn in the market and the level of overhead is no longer sustainable, and they feel the axe needs to fall to the extent of reductions of, say, 25%, 30% or even 40%?

The challenge of achieving those savings is going to be a collective responsibility, involving all directorates, but Finance is going to get the job of co-ordinating the review and making sure management take it seriously.

I guess if you work in Finance long enough you will see this kind of thing. It happened to me once.

Putting Yourself Out of a Job?

In fact, there’s a double-whammy for Finance. The costs of our function are part of the overhead costs of the business. So when I was involved in that big cost cutting project, Finance were expected to contribute our own share of cost savings along with HR, IT, Legal, Company Secretarial, Marketing, PR, Investor Relations, etc. But on top of that we were the ones asked to go probing into those other departments as well, looking for cost savings.

And being such savage cuts, the initial stages were Top Secret, and senior management in all the departments were asked not to discuss the analysis work with anyone. That created stress in itself, because none of the managers could discuss this high pressure, high impact, tight deadline, piece of work – that took up a lot of their time – with any of their staff.

So the first thing that was required of the Finance people involved was sensitivity.

And not only did it require sensitivity, but also a high degree of professionalism. What I mean by that is that I knew, as soon as I was brought in on The Secret – the intention to cut overhead costs by up to 40% – that I was in an exposed area. I knew that my own analysis would lead to me losing my job (I had no doubt of that for reasons I haven’t got time to go into). But, understanding the reasons for the strategy, I had to be professional and act in the best interests of the business.

But whilst the emotional and psychological side of the experience may be interesting, it’s not really my point here. Maybe another time!

My point here is, given the size of the challenge, what is the right way to go about doing it?

Drawing Around the Fat

The main risk – like when a plastic surgeon does his work – is that the cuts may go so deep that they injure the patient. You see it time and time again in government public spending cuts – they cut the money available, but don’t know where the cost savings are going to come from. And they end up with unpredictable and often negative consequences they weren’t expecting. Crime goes up, hospital waiting lists get longer, schools get oversubscribed, teachers and doctors start leaving their jobs through stress, etc.

But how does a plastic surgeon avoid injuring his patient? careful cost savingsHe identifies exactly where the fat is and marks it out before making the incisions.

In business, the fat is the expenditure that doesn’t give rise to sufficient value to justify it. Conversely, it’s detrimental to the business if you cut costs out that generate positive net value from it.

But these are overhead costs we’re talking about! How can you tell what’s value adding? I guess we’re all conditioned to assume that overheads are value destroying by definition. But that’s not true.

Good Old Activity Based Costing (ABC)

Without going back to our management accounting textbooks, it seems to me that overhead costs fall into two buckets:

  • Costs of owning/using stuff (e.g. software maintenance)
  • Costs of doing stuff (e.g. running a training course, producing a monthly report)

Most departments don’t have much of the first, but all departments have the second. All departments do things – activities.

So when I did the analysis to support the major cost cutting in the large group I was working in, I used the principles of Activity Based Costing (“ABC”).

I thought this was quite innovative at the time, because ABC is normally something used in a production environment. And certainly when I was taught ABC methodology, I was told that overheads are not part of the analysis! When you work out the cost of a product, or the cost of a customer, overheads are irrelevant, because overheads don’t change (much) with number of units produced, the number of customers, the number of products. So any allocation of overhead costs is misleading.

However, in this case I wasn’t allocating the overheads. I was analysing them, I guess, as if the various outputs from the ‘overhead’ departments were products.

Information Gathering

Information gathering had three main steps.

First, I developed an Excel template that simply asked the manager of each area (either a cost centre or group of cost centres) to:

  1. List the activities undertaken in the department
  2. And for each of the activities, capture:
    1. how many people (Full-Time Equivalents, temp/contract and perm) were needed to do them;
    2. what the related staff costs (direct and other, such as travel) were;
    3. what external professional fees or other significant costs related to them.
  3. Make sure the total staff numbers and costs agreed back to the agreed budget for the year (and the same for the most recent forecast).

Assessment and Categorisation

cost savings by reducing activity or reducing cost of activitySecond, once we’d received all those spreadsheets and amalgamated them (more than 400 rows of information), a working group was appointed consisting of three or four senior managers in the function I was working with. I took the working group through the data collected, and we categorised it in a couple of different ways.

Of course, the first thing we had to do was to work out what the categories should be. And that kind of emerged out of the review. First of all, we had to highlight where similar things were being done in different places. So we had to come up with categories of activities – general headings (and subheadings) for them out of the many ways the managers may have described them. E.g. leadership training, or management reporting.

The second kind of categorisation was the nature of the activities. Were they:

  • “Mandatory” (i.e. adding value by fulfilling a legal/compliance requirement)?
  • Serving customers, internally or perhaps even externally (i.e. adding value by helping managers to make better decisions, or helping employees to be more effective through training)?
  • Strategic investments (i.e. adding value by saving money in the future or increasing revenue in the future)?

Once the working group had worked through a good proportion, applying the categories that emerged, I passed the enhanced templates back to the managers to complete and confirm that information and more.

Review Impact of Cost Savings

When you come to making cost savings in overheads, there are really only a few things you can do:

  1. Stop doing some of the stuff (eliminate cost of activity)
  2. Do the stuff cheaper (reduce cost of activity)
  3. Stop owning/using some of the stuff (eliminate cost of ownership/use)
  4. Downgrade to stuff that’s cheaper to own/use (reduce cost of ownership/use)

Since we were doing an activity based review, of course we were focused on the first two of those. And what we wanted to capture in the next part of the analysis was the impact on the business of stopping or reducing each activity. So we asked each of the managers, when they were asked to do the second pass at the template, to give an indication of the business benefit (value) of each activity and the impact of losing/reducing it.

By doing it this way, what we were keen to avoid were two things:

  1. Reducing heads without reducing work, which just leads to pushing staff too hard, burn out, sickness, good people leaving the business, which in the end push costs up again. It also leads to some things naturally not being done, and management never gets the chance to choose what doesn’t get done, because employees just tend to run out of time to do some things. Whether they ran out of time to do the least valuable stuff is left to chance. Balls get dropped at random.
  2. Stopping things that the business was relying on to achieve its mission and vision, and thereby having a detrimental impact on performance overall.

Senior managers were then asked to have discussions with their internal customers (mainly the business unit Managing Directors), before coming back with a set of proposals, which were then discussed and agreed within the functional leadership team. Broadly the options available were:

  • Mandatory activities – do cheaper (lower quality, focus only on the essentials, etc)
  • Service to the business – review impact with internal customers, and cut or reduce
  • Strategic investments – review the business case, and stop, reduce scope or defer

The final proposals had to be presented as three options – cost savings of 20%, 30% or 40% – giving the impact of the proposals.

Agree Actions to Make Cost Savings

The Executive Committee representative of each function then had to present their proposals for cost savings to the CEO and CFO, who would then bring those together into a package in the Executive Committee for presentation to the Board. Out of that came the agreed actions, which then had to be worked into a detailed plan involving communication, legal consultations with employees and a redundancy program (that led to my own exit from the business).

Conclusion

Making cost savings of such severity shouldn’t be easy. If it’s easy that means you’ve been wasteful for years, and not managing costs very carefully. So when you do it, you need the analysis of activities, and the analysis of impact, to ensure that you make decisions that do not harm the business in the long term.

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