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Tough times: When should you cut costs?

Not all cost reductions pay off in the end, so a short-term fix must be balanced with long-term value.

 

At a glance

  • In challenging times, cost-cutting is a common, knee-jerk reaction to deal with difficulty and keep a business afloat.
  • There is no catch-all approach to smart cost reduction, but experts advise that the cuts that present the lowest long-term risk are to discretionary spending.
  • In terms of more significant cost cuts, it is important that all decisions be backed by a comprehensive analysis of the organisation’s financial performance and strategy.

There is nothing like a financial crisis to bring cost management into focus. When the COVID-19 pandemic triggered the deepest economic recession in almost a century, most businesses responded with cost cuts, some trimming around the edges, others cutting right down to the bone.

However, not all cost reductions have the desired outcome. In the absence of sound financial analysis and a link to business strategy, short-term cuts can actually lead to lower long-term profits.

While cost cuts are not always the best response to a downturn, they are among the most common.

Data from a recent CPA Australia Asia-Pacific Small Business Survey, for instance, shows the top three ways that business have responded to COVID-19 have been to start or increase their focus on online sales (25 per cent), reduce capital expenditure (24 per cent) and seek government support and subsidies (23 per cent). Almost 20 per cent reduced staff numbers and salaries, while 16 per cent negotiated a rent reduction or waiver with their landlord.

Bruce Sweeney, advisory partner and financial services sector leader for small and medium business at KPMG, says there is no one-size-fits-all approach to cost cutting.

“Squeezing your cost base by an arbitrary 10 per cent has been the rule of thumb, but this doesn’t always take into account the uniqueness of your organisation and what your cost drivers are,” he says. “As a result, it can be quite damaging. There is a time and a place for putting in some relatively quick cost wins.”

Quick wins vs lasting value

Cuts to discretionary spending rarely present long-term risks. This is what Sweeney describes as “trimming the low-hanging fruit”.

“We certainly recommend those quick wins at the start, like cutting unnecessary spending on subscriptions or supplies, or maybe some IT costs that are just a ‘nice to have’.”

Pausing non-critical projects also presents an opportunity for a low-risk cut, says Sweeney.

“Other immediate solutions could be putting a freeze on certain recruitment that’s not core to the business, streamlining the way you order, renegotiating terms with suppliers or taking some overdue actions like rationalising some of your underperforming assets, if that’s a relatively easy thing to do.”

Brett Hay, principal consultant at Expense Reduction Analysts, says most categories of expenditure can produce savings, but this kind of cutting requires diligence.

“For instance, a business could easily get 20 per cent to 25 per cent savings by switching to an online ordering system,” he says. “It avoids errors and reduces paper, because fewer people are handling it. Ultimately, those savings go straight to the bottom line.”

Weighing up the risks

However, some cost cuts present potential long-term risks. Reducing staff numbers is one of them.

A third of respondents in CPA Australia’s Asia-Pacific Small Business Survey cited staff salaries as the most significant cost to their business in 2020. However, Hay advises business owners to seek alternatives to staff cuts.

“Compare two organisations of similar sizes – one that cut staff and paid redundancies and one that retained them,” he says. “The first one didn’t streamline their work processes after cutting staff, and suddenly 80 staff were picking up the work of 100 people. When things started to improve, the organisation had recruitment costs and training costs, but much of the corporate knowledge had been lost.”

In Hay’s hypothetical scenario, the second organisation, which kept its staff, fared better.

“Not only did they save recruitment and training costs in the long run, but they were also very transparent about the company’s performance, and so staff were willingly prepared to take a short-term hit to their salary of, say, 15 per cent.

"There's a much larger picture than just cutting costs and a range of alternatives that can be taken. Flexible budgeting is underrated, and I think there's a general lack of detailed budgeting among businesses." Jeffrey Luckins FCPA, William Buck

“When the business bounced back, it was able to restore historical salaries. It avoided a lot of disruption and was able to continue servicing its customers.”

Decisions to cut spending from advertising, marketing and sponsorship commitments may also present short-term savings at the expense of long-term business risks.

Virginia Pracht, head of strategy at advertising agency Ogilvy in Melbourne, says cost management should be linked to the overarching purpose of a marketing strategy.

“For instance, is your marketing effort aimed at driving the brand long term or short term?” she says. “Research shows that, if you stop spending on marketing during a recession, you’ll actually take longer to recover.”

Trimming marketing spend may seem prudent in a downturn, but Pracht says maintaining your marketing efforts may actually give you an edge over your competitors.

“What usually happens in a recession is, most brands cut back [marketing spend],” she says. “If you can afford to continue with your level of communications, your share of brand voice is going to increase, because you’ll be heard much more than the other competitors. That gives you a massive advantage.”

 

Cut, borrow or delay?

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At a time when the cost of debt funding is at an all-time low, cutting business expenses may not be the best way to address cash shortages.

Jeffrey Luckins FCPA, director of audit and assurance with William Buck, says negotiating with banks and other financiers can help maintain vital cash flow.

“If you’ve got a five-year borrowing, for example, could you increase it to 10 years and reduce the amount of cash outflow?” he asks. “You’ll be in debt for longer, but that will give you the cash that you need now to survive.

“There were a number of smart strategies that we saw among our clients that enabled them to prop up their operations and maintain their going concern.”

One of these strategies is delaying costs rather than cutting them. Luckins cites an example of a professional services firm that signed a nine-year lease at the start of 2020. The deal included lease incentives for a renovation, with the landlord and the firm contributing A$1 million each to cover the costs.

“In this case, signing the lease included one-year lease-free payments in the first year, when cash was most needed,” says Luckins.

“The renovation has been delayed until probably 2022, when there is more certainty over financial performance and position, and the A$1 million estimated costs could possibly be financed, further preserving cash.”

Back to basics

Whatever the approach to cost management, Luckins stresses it must be backed by a comprehensive analysis of financial performance.

“There’s a much larger picture than just cutting costs and a range of alternatives that can be taken,” says Luckins. “Flexible budgeting is underrated, and I think there’s a general lack of detailed budgeting among businesses.”

Sweeney adds that cost management should not be driven by a single event.

“It shouldn’t be something that you’re reacting to,” he says. “Having good financial control should be daily behaviour for your organisation. What that practically means is having a good ability to plan and forecast, and get visibility of your spending against some sort of agreed target or plan.”

Navigating through a financial challenge requires a thorough understating of your current business position and the risks you face, no matter how unexpected.

“Sensitivity analysis is key, because who expected something like COVID-19 to happen?” says Luckins.

“You need to ask yourself, in a worst-case scenario, where half of our revenue is gone, how would we cope? What would we do? How would we reduce our expenditure? How would we maintain the ‘pilot light’, so that when things improve, we can get this business going again?

“There’s lots of new thinking that’s going on, but, in many ways, the old tried systems are the best. The problem is, they have not been properly implemented and actioned by businesses. I think many have become lazy.

“After the current downturn, hopefully we’ll see a greater focus on risk management that goes all the way through to financial budgeting and knowing all the resources that are available to help you cope in a crisis.”

 

How accountants can provide cost management advice

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An accountant is often the first port of call for SMEs during an economic downturn. Jeffrey Luckins FCPA suggests four simple steps accountants can take to help clients manage their costs. 

Step 1: Analyse expenditure and capital commitments as well as contingent liabilities.

Step 2: Consider financing capabilities, which may include:

  • Capacity for equity injections from owners
  • Capital raising alternatives for listed companies
  • Debt raising from owners, related parties and stakeholders
  • Bank finance available or renegotiated over a longer period to reduce current cash outlays
  • Delaying or renegotiating trade creditors and/or commitments

Step 3: Use flexible budgeting to help the business understand its financial position, especially where sensitivity analysis is conducted on revenues and the variable expenses associated with sales.

Step 4: Consider the mix of inputs required to produce goods and/or services. Could the same result be achieved by changing the mix of raw materials, labour and overheads that are invested in the total cost of your products or services? Will labour outsourcing lower your cash commitments and allow the variable costs associated with your revenues to rise and fall depending on demand, thereby preserving cash?

 

This article was originally published in IN THE BLACK