Mike Freedman Executive Vice President, Kepner-Tregoe Inc.

Introduction

The week of December 14th 1992 was not a good one for some of the world’s greatest companies. IBM, BP, Ford and Volkswagen all announced job losses in their tens of thousands. This followed on the heels of similar cuts announced earlier in the year by a myriad of companies including Philips and Siemens. Many of these organizations were announcing the second or third round of cuts in a space of less than 12 months. IBM and BP were two such companies announcing their second cuts within the year. News from Japan was hardly better. A number of leading Japanese companies facing declining revenues and losses for the first time, such as Sony, announced their departure from the ‘job for life’ work pattern that has characterized Japanese industry this century.

In virtually every case the reason for cutting jobs was related to an overall plan for cost cutting. Similarly, in nearly all cases, these announcements were very reactive. They came as a result of poor operating performance whether it was measured in terms of market share, declining revenues, falling profits or, remarkably, second and third years of losses.

In 1993 the trend continues with massive financial losses accompanying further job cuts with IBM being the most notable example.

Two questions have to be asked ‘Why are management so reactive to adverse trading conditions?’ and ‘Why can they not be more proactive and prevent such traumatic work- force reductions often accompanied by the run down of plant, capital equipment and cost reductions of a variety of sorts?’

Strategic cost management

Perhaps the most apposite answer heard during that fateful week came from a five second sound bite allowed by BBC Television News to a trade unionist who was asked to respond to the announcement of the latest round of job cuts in Ford. He said ‘What they need around here is not cost cutting but strategic management’.

It is Kepner-Tregoe’s experience, based on extensive research conducted in 1991 and 1992 with major corporations, on a world- wide basis, that the trade unionist had hit the nail right on the head.

Traditional cost cutting does not work. The evidence for this is legion. This paper seeks to demonstrate that and to propose some alternatives which allow for a much more strategic approach to the management of costs. This would allow companies to approach the cost equation in a more pro- active, strategically oriented and rational way to handling the types of situation described above.

Research findings

Part of the research Kepner-Tregoe undertook in 1991 and 1992 was to conduct a survey among chief executives and their senior colleagues of major corporations in the US, Canada, the UK, Germany and Japan. Four hundred and ninety-five responses were received of which 60% were in the US, 40% being from the remaining countries. Some cf the main findings showed:

0 90% of companies had undertaken an initiative to cut costs in the last five years

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The trend has risen dramatically; in 1987 17% of firms cut costs, in 1992 a projected 86% of firms will have cut costs

restructuring, improved profitability, reduced headcount Rarely was business development and growth cited as an objective

Those firms who have cut costs are more than twice as likely to cut costs again

Those firms who have cut costs are more than twice as likely to cut costs again within 12 months than those who have not undertaken such exercises Similarly, those who cut costs two or three times are even more likely to repeat the exercise again! Those who have cut costs more than once do not believe they will be any more successful a second or third time in achieving long-term gains Poor impact on employee morale was the most frequently mentioned fear executives had for cost cutting Other fears included compromised quality and effectiveness, loss of key people, loss of long-term competitiveness and loss of customers When the exercises were complete the most negative impacts were on, employee morale, revenue growth, employee involvement and quality Things that would be done differently to improve the effectiveness of the cost cutting exercise if executives had their time again would be, undertake the task earlier, better communication, faster implementation, better planning, more employee involvement The most important objectives cited by executives for such exercises were, cost reduction, improved productivity,

Rarely was business development and growth

cited as an objective

Cost cutting pitfalls

This survey confirmed some of the earlier research findings by Kepner-Tregoe. They un- covered a number of pitfalls demonstrating that traditional cost cutting does not work. These include the following.

The law of recurring costs

Cost cutting is a futile exercise. It may produce a short-term improvement to the bottom line but the chances are costs will return. Sometimes they even increase. Cutting staff was often accompanied by an increase in other expenses which offset the savings from staff reductions. The problem is that although workforce reductions take place and expenses are reduced the actual workload does not fall commensurately. Frequently, behaviours do not change and people go back to their old ways quickly.

Failing to change the way people behave

Unless a cost cutting exercise includes an element that ensures behaviour change it will not be successful. Often skills are given to employees to help them in their new environment but the performance system discourages the use of these skills! The performance system in an organization must take account of the nature of tasks to be done; expected results; positive and negative consequences for employee performance; feedback mechanisms and employee re- cognition and reward systems in the new environment.

The timehalue fixation

To improve the speed and efficiency of making a product that is unprofitable com- pounds the cost cutting felony. Traditonal time value analysis, however, does lead to

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these situations. It only addresses the ‘how to’ aspect of an organization and is, there- fore, only half the story. The ‘what’ of an organization has to be determined. In other words what is the future direction and mix of products and markets that is required? Coupled with this, the true cost of the product/market mix needs to be understood- not just standard cost. Standard cost systems tend to produce misleading information and compromise decision-making. They tend to be outdated, do not keep up with changes and improvements in production processes and they allocate overheads that do not reflect the real cost of an activity. Many

muscle. Then, however, the issue is one of productivity and efficiency.

Employees are often involved in a ‘counterfeit’ manner

Shared decision-making is a sought after goal yet in cost cutting employees other than top management frequently are not involved at all. This is counter-productive. N o wonder implementation is poorly handled and the objectives of the exercise are not achieved.

Cost reduction is usually reactive and short term

Many employees do not understand the cost of a

part or a process whether they are on the shopfloor

or the executive suite

employees do not understand the cost of a part or a process whether they are on the shopfloor or the executive suite.

Cost cutting is often done outside strategy

Even the best run organizations undertake cost cutting measures in respone to short- term needs and do so outside the context of their overall strategy. In other cases, organizations do not have a clear strategic vision and the cost cutting that they do inevitably is non-strategic. Typical ‘10% across the board reductions’ mean that organizations cut muscle as well as fat. For those without a clearly understood strategy cost cutting results in different functions and operations responding incoherently. Although a reduction is achieved, it seriously weakens the strategic strength of the organiza- tion. Cutting 10% from the R&D budget for a pharmaceutical company heavily dependent upon new product does not make a great deal of sense unless that function is particularly poorly managed and has more fat than

Heroes are often made overnight as a result of drastic short-term cost cutting but they rarely sustain their status. Ensuring that

Journal of Strategic Change, October 1993

Heroes are often made overnight as a result of drastic short-term cost cutting but they rarely

sustain their status

managing costs is a proactive, business philosophy embedded in the culture and operational style of an organization is a more effective long-term way of handling the cost equation.

Cost is often seen as counter to quality

Doing the right thing and doing things right is at the heart of many quality efforts. As Alistair Cumming, Director of Engineering at British Airways says ‘Doing it right first time’ is always the most cost effective way as well. ‘To achieve perfect quality means cutting out waste, reducing jobs that need to be done twice and controlling excessive and unnecessary costs’.

Seven principles of cost management Against this background Kepner-Tregoe developed and tested a number of principles

264 M. Freedman

around the concept of ‘cost management’ as a more effective way of handling the cost equation inside organizations than traditionally looking at means of cutting costs. Work at BHP, Australia’s largest com- pany, Harley-Davidson in the USA, British Airways in the UK and other world class companies have subsequently confirmed the validity of a more proactive approach to costs and of the power of the Seven Principles of Cost Management.

True cost

Successful businesses develop accurate cost profiles including all costs, not just those allocated by standard cost systems, which are uniformly inaccurate. With a true cost profile unprofitable products can be eliminated as can unprofitable customers. They can either be dropped or the cost of servicing them improved. Harley Davidson has a goal to ensure that the true cost of every component is known by every employee throughout their main factory which will allow them to manage costs as part of their jobs at whatever level they are in the organization. Knowing the true cost of an operation allows better strategic as well as operational decision- making and such questions as what products and services should be offered, to what customers, with what inventory held, and whether to make or buy product, can be determined more effectively.

Continuously improving costs

Effective cost management never stops. It does not have to be painful. Involving employees and developing continuous im- provement as a day to day business process, as have British Airways, is a considerable improvement over the stop-start nature of traditional cost cutting rounds. In the Aircraft Maintenance Division their slogan is ‘Cost reduction is not dieting it is eating healthy’. Says Cumming, ‘Cost cutting can be quite dramatic, negative and frightening. Cost management on the other hand, presents us with an opportunity as a service organization.

Any cost savings free us to offer mote services on the market. Therefore, any capacity we can squeeze out in cost savings, we can sell on the world market, turning savings directly into revenue’.

Training people

Cost management is a learned business discipline. Investment in educating the work- force about cost makes a critical difference. At Blue Circle Cement such investment at the time of a major cost reduction programme reduced annual expenditures on plant maintenance and contract labour by 15%. As well as eliminating management layers, decentralizing the decision-making structure, flattening the organization and many other ‘standard’ aspects of cost reduction, Blue Circle provided critical skills to all levels of employee to ensure success. A common language throughout the organization was found to be extremely helpful. Employees were able to ask, and answer, important questions such as: ‘Is there value added to my activities?’, ‘Are there unnecessary complexities’, ‘What are the true cost implications of this decision’.

Involvement in decision-making

Employees who know most about an organ- ization are those who are closest to it. It follows that involving them in decision- making on the question of costs is necessary if costs are to be effectively managed. At Blue Circle Cement team training was vital. At USF&G, a major US insurance company, middle management taskforces were formed not just to find the answers but also to make the tough decisions. Their commitment was vital. CEO Norman P. Blake, Jnr., said ‘Their charge was to look at how we could be most cost effective-not “what are your recommendations for reducing costs?”, I asked them to justify the value of every cost in the organization’s superstructure’. Success was achieved by giving decision-making power on costs to those who would be implementing the plan.

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Reducing complexity

Organizational complexity makes the chal- lenge of effective cost management even more difficult. One definition of organization complexity is the sum total of the activities, systems and assets required to support the lower half of all products, customers, suppliers inventories and services. By Kepner-Tregoe’s rule of ‘ 5 0 / 5 ’ , which says that 50% of the activities produced less than 5% of the organization’s value added, that sum total represents a major cost management oppor- tunity. With proper analytical methods, such life-threatening complexity is uncovered, and, with effective decision-making, often eliminated.

Organization behaviour change

Costs will not be reduced effectively and continuously unless employees want them

Costs will not be reduced effectively and continuously

unless employees want them reduced

reduced. Leaving a performance system in place that encourages the same activities as before will lead right back to excess costs. Changing the performance system- everything from the definition of tasks and results to thinking through performance consequences, both positive and negative, feedback and rewards -requires the energy, focus and input of an organization’s key executives. Successful companies analyse their performance system and surface the issues, difficulties and frustrations that impede

the efforts of its employees. They then make the necessary changes to encourage the required behaviour .

Strategy and cost management

Organizations with a clear and effective strategy, well communicated and understood, will be much more successful in managing costs than those who are strategically con- fused. Dow Chemical allocates resources carefully to business areas that contribute to shareholder value and avoids the need for radical surgery by not over-resourcing businesses to the point where they cannot contribute. ‘Consistent, long-term cost management is the key to their success,’ says Chet Marks, Director of Economic Planning and Research. Understanding product/ service and market/customer emphasis is a fundamental prerequisite to effective cost management. Keeping a strategic focus can make painful cuts more palatable, as well as make the reasons for decisions more apparent.

Conclusion

Turning a company from a cost cutter to a cost manager requires a process for integrating initiatives, aligning them with existing systems and tapping into the energy of employees at every level. Cost manage- ment must not be just another programme but a way of life. It is this that ultimately distinguishes companies who are successful in managing costs from those who are not. Kepner-Tregoe’s experience with some of the world’s leading companies is testimony to the dangers of the pitfalls in cost cutting and the value of following the Seven Principles of Cost Management.

Journal of Strategic Change, October 1993 0 1993 Kepner-Tregoe Inc.