Strategy in a recession - cost optimisation not cost minimisation

The quick fix is easy. The economy worsens and customer confidence plummets. Monthly sales begin to decline; fewer customers respond to the direct mail shot or visit the shops. The word goes out after the latest board meeting. All functional budgets are to be cut by 10% as a strategic response to the economic crisis. But does it work? Or should a business take a much more strategic approach to cost management?

When revenue falls, profit will fall too unless costs are reduced by at least the amount of the contribution lost. The breakeven and profit calculation is simple. Every business student should be able to handle that. But business decisions are rarely so simple.

The intuitive short-term response to a fall in revenue (assuming a firm has an objective of profit maximisation) is to cut costs. But for most businesses, the best strategic response is to aim to optimise costs rather than minimise them.

Take a really important business activity for many manufacturers and service businesses – research & development. While R&D costs might seem like an easy target for cutting, the innovation that they might provide for the business could give it a long-term competitive advantage. The best strategic response is to take care before blindly cutting an R&D programme.

Apple is a great example. The cure for Apple during the recent recession has not been cost-cutting. The cure has been for Apple to innovate its way out of the economic downturn. The iPad is just the latest in a series of innovative product launches – this time right in the depths of one of the worst recessions in memory.

Apple is not alone. Look at the evidence in the annual survey of 1,000 global businesses by consultants Booz & Company. The study of the world’s biggest corporate R&D spenders finds that most companies have stuck with their innovation programs despite the recession—and many are boosting spending to compete more effectively in the upturn.

Marketing is another hugely significant business function. But should marketing be viewed as a cost or an investment?

Marketing has been a prime target for cost savings during the recession, as the sharp fall in TV, newspaper and magazine advertising demonstrates.
However, no matter how squeezed a firm’s finances might be, it is vital for businesses to maintain a strong brand presence and to keep communication with customers. Research shows that marketing spending reaps benefits in the long-term.

Viewing marketing as an investment puts it in the same category as R&D spending, or investing to improve or increase production capacity. In other words marketing needs to earn a satisfactory return on investment. The problem facing the marketing department during a recession is that it is easier to measure the return on marketing spending on, say, direct mail campaigns or online advertising, than it is on brand-building and PR activities.

So in the recent recession in the UK, we’ve seen a reduction in traditional marketing activities (such as newspaper adverts) but increased activity on promotional campaigns which are perceived as being more cost-effective. The use of social media and other digital communication channels (e.g. mobile channels, viral online campaigns) is a great example of this. Brands that have sustained their marketing budgets have also been able to take advantage of an advertising market which is much less cluttered with competitor messages.

Another good place to look for examples of cost optimisation rather than cost minimisation is the IT function in businesses. ICT is still one of the biggest investments for any business, so it might seem to be an obvious candidate for the zealous cost-cutter. However, even the recession can’t slow down the relentless forces of change in IT, so a decision to cut back on IT spending is fraught with dangers.
Many firms have found that the trick is to spend smarter rather than spend less. Two great examples come to mind.

The first is the rapid growth in the use of “cloud computing” – which involves using data storage and other facilities provided by third parties. This is effectively outsourcing much of the IT function. If a business needs more server capacity or data storage, it simply rents it rather than spending big to buy and manage extra equipment.

The second example is the widening use of open-source software. Software such as Mozilla and Linux have revolutionised the home and business computing markets – the beauty is they are free. Open-source reduces costs, even if it doesn’t always come with the same level of service provided by some proprietary systems.

So, the economic downturn has forced companies to rethink the relationship between short-term costs and long-term profits. The challenge has been to think not about how costs can be minimised, but about how to maximise the returns from costs. Savvy firms have begun to apply investment appraisal to seemingly sacred items like overheads.

I increasingly find myself in agreement with the notion that economic booms are bad news for firms that want to optimise their costs. In recent boom years inefficiencies have been tolerated. I know from running tutor2u that unnecessary complexities were built into the way we did business – it must be the same for nearly every business that prospered in the boom. Things that should have been done simply were actually done in a most costly, difficult way. But fast-growing revenues and profits hid the inefficiencies.

How times change! In the economic downturn the emphasis has switched. Cost optimisation is now about:

- Making the business operational as simple and efficient as possible
- Better business planning and smarter decision-making
- Focusing on activities that really add value and build or sustain competitive advantage

I came across a useful checklist from accountants KPMG recently which highlighted how these issues can be translated into questions a firm needs to ask about its costs. The checklist is very useful for students as it helps them to focus on the key cost issues facing a business. I have summarised these below:

Cost of supply
- Is the business making and buying the right things?
- Is the company eliminating waste?
- Are production / operations designed to support what the end consumer needs?
- Can savings be made by consolidating suppliers

Value creation

- Does management understand where value is being created or destroyed?
- Can product or service costs be accurately identified? What is the true profitability of key products or product groups?
- Why is the business wasting money on loss-making or low value-adding products?

Business structures

- How is the company organised to supply the customer in the lowest cost way?
- How much is spent on business support? Is this appropriate?
- How much overhead creates value (from the customer point of view) and how much is just pure overhead?
- Would it be cost effective to outsource a business function, or share it with other businesses?

Managing people costs

- Are my people in the right place at the right time to maximise profit and minimise waste?
- Can flexible working and other changes to people management result be more cost-effective?

Cost culture

- What cultural change (including business planning & decision-making) is required to take unnecessary cost out of the business - and keep it out