The Ultimate Guide to Cost Reduction in Business Management
Cost reduction practices can enlarge company profit margins and allow room for financial growth. There are many aspects to analyze in this process, such as labor wages and inventory costs.
Maximizing profits and minimizing costs is perhaps the most widely recognized principle of doing business. In fact, according to Deloitte's 2019-2020 Global Cost Survey, cost reduction is a standard business practice around the world, with 71% of organizations planning to embark on some kind of cost reduction initiative over the next 24 months.
This, however, is easier said than done. The same survey also found that cost reduction failure rates are rising. Globally, 81% of businesses were unable to meet their cost-cutting goals - up by 18% from 2017.
In a nutshell, cost reduction is the process of cutting back on unnecessary business expenses to increase profits without negatively affecting product and service quality. The idea is to reduce overhead costs or the cost of goods sold. For example, a company can transition to more energy-efficient manufacturing equipment to reduce both its energy bills and waste.
Types of Cost Reduction Strategies
When business owners analyze ways to reduce costs, they may get overwhelmed by the sheer variety of ways to go about this process. Most cost-saving measures, however, tend to fall under the following strategies.
Automation is the use of technology and software to monitor and control certain aspects of business operations, such as the production and delivery of items. At its simplest, this involves repetitive tasks that are easy to execute. It is also one of the fastest ways to reduce business costs, resulting in savings of up to 40% to 75%.
Efficiency involves finding ways to make processes and equipment more efficient, whether it's by reducing the amount of time people spend on a task or lowering the energy consumption of machinery needed to make goods. One of the most popular ways to improve the efficiency of a business is to adopt sustainable processes. In fact, the World Economic Forum notes that sustainable supply chain practices can reduce costs by 9% to 16%.
Improving the productivity of workers is where tools and technology can come in. For example, using software that can perform routine and repetitive tasks (e.g., responding to customers' frequently asked questions) allows employees to work on more strategic, high-level work. Another way to improve worker productivity is by providing compelling benefits to keep employees motivated.
When done right, outsourcing can be an effective cost-saving solution for companies that want to focus on their core competencies. For example, a digital design firm can allocate the majority of its resources to hire skilled graphic designers. It can then outsource administrative tasks, such as accounting and human resources, to a firm that specializes in these services.
This cost reduction strategy involves removing waste from business operations and processes. One of the more common ways companies can reduce waste is by improving their supply chain. For instance, in 2018, a survey of over 2,000 US hospitals found that unnecessary spending on supply chain products and related operations reached $25.7 billion.
6. Quality Control
Clamping down on quality issues can eliminate the headaches associated with product returns. E-commerce retailers (who tend to already have thin margins), for example, know that returns are not only costly, but they also signal dissatisfied customers. According to CNBC, the average product return represents around 30% of its purchase price. Clothing returns are closer to 40%.
Last, but not least, is ensuring that the company's systems, processes, and equipment are reliable and in working order. Although this can mean any number of things for different businesses, the core principle is the same- maintain the integrity of your systems to avoid expensive workarounds.
Identifying Cost Reduction Opportunities with Spend Analysis
A spend analysis (also known as a cost reduction analysis) is the first step to reducing business costs - specifically, procurement costs. When done right, the analysis will help identify cost reduction opportunities and provide insights on how to ensure these opportunities translate to dollars saved for the company.
Spend analysis is the systematic evaluation of a company's historical spending to reduce purchasing costs, improve efficiency, and strengthen supplier relationships. It's one of the key tools procurement teams can use to do the following-
- Identify savings opportunities
- Manage risks
- Increase the visibility of corporate spend
- Ensure contract compliance
- Improve the efficiency of procurement activities
According to an AQPC report comparing procurement spending between organizations with $5 billion in revenue, companies with spend analysis programs saved $11 million in procurement costs compared to companies that don't engage in spend analysis.
This is hardly surprising. As procurement becomes a more strategic function of any company, analyzing procurement spend has become a crucial strategy for realizing both short-term and long-term supply chain savings. The supply management book Straight to the Bottom Line by Rudzki, Smock, Katzorke, and Stewart goes into the details of the potential supply savings companies can generate from spend analysis. For example, companies can save up to 30% on IT costs, up to 20% each on packaging costs, indirect materials and services, and marketing and promotional items.
Spend analysis also allows business owners, managers, and procurement teams to answer questions such as-
- What are the company's most expensive commodities and which items represent the best cost reduction opportunities?
- Which suppliers are most valuable to the company?
- How much is the business spending on preferred suppliers vs under-performing suppliers?
- What percentage of procurement spending is associated with long-term contracts?
4 Steps for Implementing a Cost Reduction Program
Implementing a cost reduction program is a serious undertaking and there are many ways to approach the subject. Below are some recommended comprehensive methodologies.
1. Assess the Potential for Reducing Costs
This stage covers a number of smaller steps, including-
- Cost Analysis - This step involves analyzing the structure of costs in your organization. This includes identifying the different types of costs and different activities that drive spending.
- Benchmarking - This involves conducting an analysis of business processes in your organization and identifying benchmarks. Internal benchmarks compare attributes within the organization, such as energy use between facilities. External benchmarks compare the company's performance with other, similar organizations.
- Assessing Cost Reduction Opportunities - This step is similar to spend analysis and typically involves organizing cost reduction opportunities by importance or practicality.
2. Develop the Cost Reduction Program
At this stage, business owners, managers, and procurement departments/teams can begin developing the company's cost reduction program by following these steps-
- Developing Initiatives - This entails conducting a detailed analysis of problem areas, usually through analytics for quantitative data or interviews and surveys for qualitative data.
- Estimation of Effects - This is where the company predicts the effects of its cost reduction initiatives.
- Testing - Discussions are held with the company's leadership to assess the effectiveness of the initiatives.
- Prioritization - Initiatives are classified by priority/importance.
3. Prepare for the Implementation
Once the company's cost reduction initiatives have been identified, the next step is to create a detailed plan for each initiative. This involves-
- Identifying Contractors - The company must identify any new contractors needed for its cost reduction plan.
- Identifying Key Individuals - These people are responsible for each stage of implementation.
- Planning the Implementation of the Cost Reduction Program - This involves the development of an integrated plan for implementing the program.
4. Implement the Program
Finally, the cost reduction program is deployed through the following sequence of events-
- Developing a Program Management System - This involves creating a project management office, a communication plan, and control deadlines for implementing the cost reduction program.
- Program Implementation - The project management office ensures that the objectives and schedule of the program are met.
- Continuous Improvement - Finally, the cost reduction program transitions to continuous improvements.
4 Tried and Proven Cost Reduction Strategies
Implementing a cost reduction program can be daunting. Fortunately, there are a number of relatively simple actions businesses can take to cut down their expenses.
1. Encourage Telecommuting
From a management perspective, promoting telecommuting (also known as remote working) as a cost reduction measure makes sense. For starters, it eliminates the need to lease a large office and purchase new office equipment. These things, in turn, reduce the cost of utilities.
But the benefits of telecommuting go beyond saving dollars. According to one study, remote workers are more productive than in-office workers, taking fewer breaks and working an average of 16.8 more days in a year. Remote workers are also happier, with one study noting that they are 22% more likely to report being happy than workers that work from an office.
2. Build Strong Relationships with Suppliers
If there's one place that small businesses can look at to save money, it's their contracts with suppliers. Businesses often overspend on raw materials because of weak relationships within the supply chain. Other times, they'll take the first quote they receive without making any attempt at negotiating prices.
Any small business must work on building long-term relationships with its vendors. This not only makes it easier to negotiate the best possible rates, but it also gets the supplier involved in determining how best to use their products and services in the company.
3. Control Business Travel Costs
Business travel is another expenditure that can cause operating costs to go up. According to a business travel report by Motus, there has been a steady increase in business travel costs over the past few years. In fact, the average business trip in 2019 cost $1,293, with lodging, meals, and ground transport accounting for 66% of each trip.
One way to control business travel costs is to clean up the company's travel policy and make guidelines clear to encourage compliance.
4. Invest in the Right Tech
As mentioned earlier, the right tech solutions can make business operations and processes more efficient. For small businesses, it's important to think carefully about what solutions yield the best return on investment. The high initial cost of tech products means that businesses must think long-term to recoup their investment.
The Impact of Inventory Management on Cost
One aspect of spend analysis that needs to be emphasized is inventory management and procurement. Managing inventory volumes can be challenging because it is both a supply operating lever and a balance sheet financial asset.
On one hand, reducing inventory means having fewer items sitting on shelves. This, in turn, means having better business cash flow through the reduction of handling and holding costs. However, having insufficient stock can also lead to unfulfilled orders, increasing the risk of losing customers to competitors.
The key is to strike a careful balance between having enough inventory and forecasting customer demand throughout the year. The better your inventory ordering practices are, the more money you'll save.
Tips for Increasing Procurement Savings
Procurement optimization offers a way for businesses to better manage their inventory. Below are a few general tips to generate savings in this area-
- Avoid Maverick Spend - Also known as rogue spending, maverick spending is a problem common in businesses that don't have a centralized procurement process. Go through your spend history to find evidence of uncontrolled spending, then redirect these purchases to preferred suppliers.
- Review Stock Replacements - It's easy to fall into the habit of replacing stock as part of your routine. However, this can lead to wasteful spending when the replacements turn out to be unnecessary. This avoids problems like ordering raw materials all year round for a product line that's only in demand during a specific season.
- Computerize Routine Processes - Conduct an audit of repetitive processes and find software to automate them.
- Conduct Risk Audits - Risks like supplier dependence should be nipped in the bud. Pay close attention to contracts and always be on the lookout for suppliers that not only offer better prices but also better product quality.
Inventory ordering software can digitally monitor supplier price fluctuations and inventory-related spending habits to help identify further avenues for procurement savings. These tools store local vendor catalogs so businesses can quickly identify the most affordable suppliers in their area while automating the process of producing purchase orders and tracking incoming stock shipments.
Utilizing this software will lead to long term cost savings due to the automation of tasks, such as placing repetitive stock orders, and give users easy access to detailed procurement spending data.