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Takeovers - the search for cost synergies

Jim Riley

7th February 2012

Students researching the topic of takeovers and mergers will come across several unfamiliar terms. One of the most important for them to understand is “synergy” and we’ll write in more detail in subsequent blog entries about what these are. However, here is a useful piece of research which indicates the potential and significance of the most common kind of synergy - “cost synergies”.

First, a little background explanation.

Typically, takeovers and mergers transactions create value for shareholders in two ways.

First, the takeover/merger can help a business to sell more goods or services than the competition in new or existing markets. This effect is known as “revenue synergy”.

Second, the takeover/merger can allow the combined businesses to operate more efficiently together. This effect is known as “cost synergy”.

In both cases, the assumption is that the performance of the combined businesses will exceed the expected performance of each each business on their own. You might see this written as 2 + 2 = 5. How does this equation work? Because of synergy. Something happens to the two businesses combined which cannot happen if they simply operate independently.

So, back to the research by Deloitte looking specifically at cost synergies.

Deloitte highlighted the potential for cost savings that arise following a takeover or merger by looking at the details of 150 takeovers completed between 2004-2007 to analyse the reasons why some businesses were able to make more significant cost savings (cost “synergies”) than others.

Some of their key findings include:

The average overhead cost synergy has been found to be around 17% of the combined overhead cost base of the buying and the target company, where the entities are of comparable size; So, for every £1million of overheads in the two businesses operating independently, a takeover/merger can result in overhead savings of £170,000 per year. That’s a big saving, though it doesn’t necessarily happen straight away.

The greatest overhead savings can be achieved by removing costs in the IT (average cost synergies of 30%) and finance (25%) functions, primarily through the elimination of duplicate roles, making both businesses use the same IT systems and elimination of duplicated development projects. Deloitte found that the Sales & Marketing and Research & Development functions tend to offer the least potential for overhead cost reduction;

Capital-intensive sectors, such as manufacturing or telecoms can also exhibit potentially high overhead synergies of over 15% although these savings mainly depend on the elimination of excess capacity in the combined businesses.

At the other end of the scale, labour-intensive sectors, such as media and software, exhibit much lower overhead cost savings of around 10% due to their reliance on their creative talent and people. Management in these sectors clearly perceive a greater risk that the takeover or merger will disrupt the workforce;

However, it is important for students to appreciate that the achievement of cost synergies does not come for free. Up-front minimum investment is required, normally of £1-£1.50 of one-off implementation cost for every £1 of annual cost saving. Furthermore, the full achievement of annual cost savings typically takes three years to deliver.

So, for example, a firm might have to spend £1million to support overhead reductions (e.g. cost of redundancies, closure of duplicated locations) in order to unlock annual cost synergies of £1.5 million thereafter).

Deloitte make a useful summary observation about what a firm needs to do to fully realise the potential cost savings from a takeover. The essence is detailed integration planning, taking a long-term view on which activities and costs are important to the combined businesses. Deloitte caution against poorly thought-through and short-term cost-cutting which runs the risk of “causing operational disruption and organisational confusion”.

Jim Riley

Jim co-founded tutor2u alongside his twin brother Geoff! Jim is a well-known Business writer and presenter as well as being one of the UK's leading educational technology entrepreneurs.

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