Tough times: When should you cut costs?

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?