Driving Down Costs: Techniques And Tactics

Before we take a look at how cost leadership can be applied to particular areas and functions, here are some overall techniques and tactics for getting the best results. I've used all of them over the years, both on consulting projects and as a chief financial officer.

First, you need to understand cost drivers and dynamics. What creates cost? How do costs move? In particular:

• Which costs move mainly with revenue, and how?
• Which costs move mainly with headcount, and how?
• What are the main drivers of all other remaining big lumps of cost?
• What are the key cost trends, up and down?

Take a headcount hiring decision. Direct salary and bonus cost might be $50,000. Add in payroll taxes and benefits like healthcare or a car. Then include other fully variable costs, which would not exist if that person wasn't on the payroll. That might include a mobile phone, travel and entertainment for a salesperson and personal computer gear. $50,000 has become $80,000. Now you know how costs really change with changes in headcount.

A key metric to track is people-related cost (PRC) by department and level. In the example you can see that total PRC a head is increasing at a 10% annual rate, which is pretty high. Your team is going to get very expensive unless you can change the trend. The fastest increases are in taxes and benefits, so you could focus there.

This type of calculation doesn't capture all the costs of headcount, however. If you hire lots of extra people, you might have to rent extra office space and hire additional managers and support staff in accounting and HR.

These are step-change costs. For day-to-day management you keep these separate from the fully variable costs. You have to know what they are, but they don't change frequently, and they usually involve a different set of decisions.

Cost creators laid bare

Headcount costs are one of three cost creators that drive these dynamics; the other two are:

• revenue producing costs – those created by a production unit, service activity, customer or transaction
• other costs – derived from having a facility or a location, or by an enterprise process.

Take an airline's cost structure – its key production unit is a flight. Many costs occur when a plane flies from A to B: fuel, pilots and cabin crew; aircraft depreciation and maintenance; take-off and landing charges; and air traffic control.

Further costs come from having passengers: in-flight meals, sales (bookings, changes, refunds), airport handling (check-in, baggage, airport passenger charges). Others are driven by choice of home base and hub airports. For British Airways, flying out of Heathrow costs a lot more than flying out of Gatwick. BA's low-cost competitors use cheaper London airports, Stansted and Luton. If an airline flies between Poland and the UK, its labour cost will be a lot lower if it can use Poland-based pilots and cabin crew and overnight them in the UK as necessary, rather than vice versa.

Finally, there are costs associated with central enterprise processes like brand building (advertising, Airmiles, PR, loyalty programmes); safety and regulatory compliance; inventory and yield management; or financial control and compliance.

Once you have accurately broken down the costs in this way and understood the drivers and dynamics, you can work on driving down unit cost in each area. You can accurately model and manage costs and financial outcomes,including what will happen if volume changes. And you can price accurately, so you don't unintentionally lose money on sales and can stimulate "win–win" behaviour from customers.

Knowledge is power

Not understanding cost drivers and dynamics is very dangerous. I once worked in the US with a software business at an early stage of development. The founder (and CEO) had come from Microsoft, and he was using their model of software economics for Windows and Office: high up-front development and mass marketing cost, then very low variable production, delivery and service cost on each new customer and sale – meaning each additional sale carried a 90% profit margin. The key unit of cost for Windows and Office was developing the product suite; after that the cost per customer was very low.

This new business was selling CRM (customer relationship management) software licenses to medium-size companies. Sales were starting to take off but the expected profitability didn't match the sales volume.

The CEO was expecting the 90% marginal profitability on new sales that he was familiar with at Microsoft, but selling enterprise software to medium-size companies just wasn't like that. Extra costs were incurred on every additional sale: very expensive in-person sales meetings, sales commissions, original equipment manufacturer software purchases, product customisation and demos, professional services for installation and training.

It turned out that the key unit of cost for this business was the cost to sell and service an individual customer. That cost was running at over 60% of sales value. The marginal profitability of an additional sale was maybe 30%, not Microsoft's 90%.

We had to get more aggressive on pricing and focus on how to drive down our sales and service cost per customer, including charging for professional services that we had been giving away free or at below cost. We also had to rethink our financial plans and how much cash we needed before we got to break even.

As another example, I was working with one of the top internet-only travel agencies. They had built a good sales base and were pushing toward profitability. Each additional transaction needed to be profit positive, covering its variable cost at least.

But, like traditional travel agencies, they thought that only their "fulfillment" costs were variable: the call centre, tickets and credit card charges. But for internet retailers this was no longer true. Marketing had become a mainly variable cost. Extra transactions generally involved paying for keywords, search engine ads, and price comparison and affiliate commissions.

These variable online marketing costs were bigger per transaction than the fulfillment cost. For low-margin products like hotels and short-haul flights, extra transactions made a loss – so the more the revenue, the greater the losses. Once this was understood, the business made certain it was spending online marketing money only where it generated a positive marginal contribution.

FDE reader offer

FDE readers can learn more from Andrew Wileman's recently updated book, Driving Down Cost: How To Manage And Cut Costs – Intelligently. To order your copy for the special price of £12.99 with free UK p&p, call 020 7239 0360 and quote "FDE". Offer ends 31 July 2010.