Cost-Cutting for the Elite

During the 1990s the average large corporation made substantial progress in streamlining operations and reducing costs. There was a dramatic decrease in the cost base, driven by new management philosophies and practices – such as lean manufacturing, Six Sigma and continuous improvement – combined with an aggressive categorical push to drive operational efficiency through outsourcing and process re-engineering.

Total expenses (cost of goods sold plus Selling, General and Administrative (SG&A) expenses) as a percentage of sales fell consistently throughout the 1990s. In fact, the average S&P 500 company removed $382m in total expenses between 1992 and 2000.

Despite these improvements, CFO Executive Board analysis shows that only 56 companies in the S&P 500 have continuously driven down their total costs in the past decade. These 'elite cost-cutters', as we have dubbed them, appear to have found the keys to sustainable cost savings that other organisations find so elusive.

In contrast to most other organisations, 'elite cost-cutters' have a single-minded focus on improving Cost of Goods Sold (COGS). Our research found that, between 1994 and 2004, the average COGS expenses of 'elite' companies accounted for only 49% of sales compared to their peers at 63% of sales.

More importantly, elite cost-cutters are rewarded for their COGS reduction efforts. From 2001 to 2004, they averaged a 17% return on equity compared to their peers at 15%.

ELITE SG&A MANAGEMENT

Perhaps surprisingly, the elite companies are much less focused on controlling their SG&A expenses. Their SG&A expenses average 26% of sales, compared to their peers at 21%.

Instead, their CFOs and other finance leaders have focused on ensuring that SG&A expenditure is specifically aligned to meet corporate performance expectations. Put another way, these CFOs ensure that their SG&A expenditure supports corporate strategy rather than pegging it to benchmarks based on industry peers or revenue size.

As one of our member CFOs from the financial services industry put it: "We are currently moving away from short-term cost reductions to a more extensive analysis on SG&A spend and its impact on company performance and growth."

OLD HABITS HARD TO BREAK

Our conversations with more than 100 CFOs indicate that, regardless of cost management philosophy, companies' relentless focus on preserving margins limits their ability to align SG&A costs with corporate strategy.

Traditional SG&A budgeting mechanisms, such as holding costs constant with benchmarks or current revenue growth, may prevent margin erosion in the short term.

However these tactics make it difficult to understand which SG&A costs contribute to increased company growth or, more importantly, how they should.

Reactive SG&A management is characterised as follows:

• Benchmarking is used to identify opportunities to reduce costs or as a 'sanity check'
• SG&A resources are capped as a percentage of revenue
• Resource allocation processes rely on revenue projections and historical benchmarks to determine the size and distribution of SG&A spending
• Incentive systems emphasise bottom-line performance and year-on-year margin improvements

This can be contrasted with strategic SG&A management, in which:

• Benchmarking is used to pinpoint where SG&A over- or under-funding is hindering growth
• Justified deviations from lowest-cost benchmarks exist for specific 'strategic' SG&A costs
• SG&A spending is designed to meet both short-term and long-term corporate performance goals
• Incentive systems are linked to multiple operational efficiency and value creation metrics

STRATEGIC SG&A ALIGNMENT

Progressive CFOs use strategy-centred SG&A metrics to identify justified deviations from lowest-cost benchmarks. By benchmarking SG&A spending levels to strategy peers rather than just to industry or revenue-band peers, companies can pinpoint SG&A over- or under-funding decisions that prevent them from meeting their SG&A reduction goals and overall corporate performance objectives.

Companies with 'New Business Creation' (NBC) strategies have marketing and finance budgets higher than industry averages. However, these companies significantly scale back spending and headcount in branding, business processing and planning, and concentrate most of their resources on market research and business unit decision support.

For example, the rise in energy prices was putting pressure on materials manufacturers to cut SG&A costs. Rather than following the industry trend, one company, let's call it Alpha, continued to invest in its finance team capabilities, especially the group involved in supporting the M&A process.

Alpha saw these costs as integral to its core strategy of expansion through acquisition. The expanded M&A finance team was able to identify, acquire and integrate multiple materials manufacturers. The result was that Alpha had total shareholder return two-and-a-half times that of its industry peer group.

ASSESSING YOUR SG&A MANAGEMENT

For many CFOs, efficient SG&A management means performing traditional overhead functions better, faster and cheaper than in the past. All too often, this approach proves wrong-headed.

Since some SG&A costs have benefits that are difficult to measure and impact corporate performance at different times, CFOs must employ management strategies that align different types of spend to their impact on corporate performance. Selecting the right metrics to measure this impact involves a three-step process.

Step 1 is to identify the purpose of the SG&A cost – how will this item impact corporate performance? Typical targets will include:

• Driving short-term performance
• Improving talent pool
• Enhancing brand recognition
• Strengthening strategic alignment to business objectives
• Improving process efficiency
• Reducing costs
• Driving long-term revenue generation

Step 2 is to identify the SG&A impact horizon – when does the item impact performance?

• Immediate operating impact (six months or less)
• Annual operating impact (six to 12 months)
• Strategic impact (12 months to three years)

Step 3 is to identify the appropriate metric – what is the right metric to measure this SG&A cost's impact on performance?

• Screen for metric's alignment – does it directly support the achievement of business objectives?
• Screen for metric's quality – does it reflect the quality of the function's performance in supporting business objectives?
• Screen for metric's feasibility – can we collect the necessary data to implement it?

Industry and revenue size benchmarking is likely to continue; however, we have found that a strategic SG&A management approach, where SG&A levels are driven by the link to longer term corporate performance, coupled with SG&A impact measurement, will result in much better business outcomes.