Cost Reduction as an Element of Business Strategy By Allen Pierce
In this article we discuss the reasons why many companies view cost reduction as a strategic imperative, the frameworks companies use to guide their cost reduction efforts, the goals they adopt, and the range of results that companies can expect to achieve through the use of the techniques we describe. The article concludes with recommendations for a business leader wanting to pursue strategic cost reduction.
When is Cost Reduction Strategic?
Many well–‐run companies view cost reduction as an integral part of their business strategy and not as something they do only when times are tough. Many companies adopt cost reduction as an ongoing, never–‐ending part of their strategy for several reasons:
They may not be up to the profitability level expected by their stockholders, owners, or lenders. In the case of a publicly owned company, stockholders usually expect improved profitability each and every year. For both public and privately held companies lenders look for acceptable profitability levels in order to deem the company a good lending risk.
They may rely on reducing costs in order to fund growth or infrastructure initiatives such as developing new products or replacing older, inefficient business information systems. Most companies have no shortage of good ideas to grow or otherwise improve the business. These good ideas almost invariably cost money, and that money has to come from somewhere. Most businesses, including those that are publically or privately held, don’t have the luxury to simply fund these ideas by reducing profits; by reducing costs in other areas of the business, a company may be able to fund growth or infrastructure initiatives without reducing their overall level of profitability.
Many companies use cost reduction each year to fund annual employee merit (pay) increases. In times of positive inflation, employees expect to receive pay increases each and every year. Ten years ago it was common for annual pay increases in the range of 2% to 4%; more recently, annual pay increases have been lower, often in the range of 1% to 2%. For many companies, salaries are one of the largest elements of their cost structure.
If your company is lucky enough to be able to increase prices to customers each year, you may be able to recover the cost of higher wages from your customers and not suffer reduced profitability. In many industries, though, companies have limited ability to pass along cost increases to customers. In those instances, many companies reduce costs in other areas of the business in order to avoid having annual pay increases result in smaller profit margins.
In some industries customers expect price reductions each year. This is most common in newer industries that are highly competitive and where aggregate sales volumes are increasing rapidly. It can also occur when there are new entrants to an industry, and those new entrants position themselves as low price providers. In those instances companies may need to reduce costs each year in order to offset price reductions and avoid lowering profit margins.
Finally, those companies that have made an ongoing cost savings program a part of their business strategy generally find it easier to take extraordinary cost cutting measures during economic downturns or other periods of time when their business is significantly depressed.
Companies with more sophisticated cost reduction programs often adopt one goal and set of activities aimed at reducing internal costs and a second goal and set of activities aimed at reducing the cost of purchased materials and services.