You work for an organization that has grown steadily by getting the fundamentals right — hiring and developing good people, instilling a strong work ethic, conducting solid analysis, and making smart choices.
Yet, despite these efforts, your company is struggling to make ends meet. The economy has faltered, your reserves are dwindling, and your biggest clients are scaling back.
It is time to make cuts, but where do you start?
Many organizations currently find themselves in this situation. Recently, major cost-cutting programs have been announced by Hitachi, BNP Paribas, Yahoo, Johnson Controls, Pfizer and Air France, not to mention many of the world’s national and regional governments.
Contraction is a critical part of the business cycle. Unfortunately, most organizations are not very good at it. As a rule, we are much more comfortable expanding rather than contracting, buying rather than selling, adopting rather than discontinuing, and hiring rather than firing.
Our research shows that spending reduction programs tend to be dominated by an inward-looking focus, revolve around emotionally charged arguments, and result in uncourageous decision-making.
In order for companies to succeed in scaling back, we uncover some of the most commonly encountered bad habits:
Remaining a slave to the budget cycle
Too many organizations fail to adjust their budgeting process to changing market conditions. Budgets remain on annual cycles, where performance is measured “to budget”, even after it becomes clear that budget levels are no longer reasonable or sustainable given competitive or market changes. At best, budgets are static representations of last year’s reality; and at worse, reflect conditions that were relevant many cycles ago.
In place of a planned and deliberate re-consideration of all options, many organizations simply try to “cut the budget” and thus do less of their original plan. Instead, they should reevaluate the entire budget in light of changing conditions, and proceed accordingly.
Going for the easy wins
When it comes time to make cuts, firms often look no further than the most obvious targets. Unfortunately, the best targets are not always those that are most visible. For example, since they tend to be large and distinct, capital expenditure projects are often the first to be cut. However, in most cases, the lion’s share of expenditure (and inefficiency) is hidden in operating costs.
Operating expenses should be examined with the same frequency and rigor as capital expenses, ideally on the assumption of zero base budgeting. Courageous decision making means going beyond the most visible targets, and attacking the real sources of inefficiency.
Not culling the herd
It is well known by vintners that in order to make great wine, vines must be pruned during the season so that the rich flavor is not spread too thinly among the grapes. Companies should follow the same practice, particularly during economic downturns. When times are good, companies tend to let a thousand flowers bloom; however, when performance falters, they fail to effectively go through rounds of pruning.
Most organizations try to manage far too many initiatives. Only proven or promising projects that show a clear “path to performance” based on well-defined metrics, and an unambiguous timetable can be spared. Initiatives that do not clearly demonstrate these factors should be considered for cutting.
Across the board cuts
A much too-common reaction to a downturn is to decrease spending across the board, perhaps by 10 percent or 15 percent. Governments are the main culprits in this regard, although many large corporations have also been known to follow this strategy. CEOs have argued a need to “spread the pain” so that “no one will be spared the knife”.
This approach to contraction is, in fact, the very absence of strategy! What it really says is that management lacks the courage to act; is disinterested in making the kind of tough choices that are necessary in a downturn; or is unaware of the real priorities and where value is created. Across the board cuts are destructive because they are based upon the unlikely premise that all areas of an enterprise are equally important. Indiscriminate horizontal cuts only serve to penalize managers who have actively and correctly managed their businesses.
Rather, vertical cuts or strategic divestiture, based on clear priorities and rigorous measurement, should drive decision making during these periods. They provide a welcome opportunity to get rid of nice-to-have projects that offer little in the way of profits or synergy.
So, how should executives approach strategic decision making during a recession? We believe that the first step is to define a clear strategic direction, and from this, to develop a set of high-level priorities.
Each funding request, both for new and existing expenditures, should then be rigorously assessed and ranked against these strategic priorities. While there will always be exceptions, like for reasons of safety or compliance, forced ranking enables a stage gate hurdle process that winnows out non-conforming requests and allows management to compare opportunities and clearly delineate preferences.
Although priorities can be discussed in groups, we believe it is important that the rankings are analyzed and assessed individually, in order to reduce group think and other biases. Only in the final stage should the results should be aggregated into an ordinal ranking.
If managed properly, the objective of budget allocation is not so much to reduce costs as it is to prepare the organization for a better future. This process turns on establishing priorities and ensuring that only activities that support these priorities are advanced.
Due to decades of buoyant economic conditions, few managers today have experience with prolonged periods of contraction. It could be argued, in fact, that a true test of management is the effectiveness of decision-making during a downturn. We are currently in a shakeout period, where some firms will succeed while others will struggle and fail.
In the future, we will associate this period with the rise of new global giants and the fall of others. To be successful in today’s economy, managers need to carefully and strategically learn to avoid cutting flowers and watering weeds.
Michael Wade is a professor of innovation and strategic information management at IMD (www.imd.ch). He teaches in IMD’s Breakthrough Program for Senior Executives.
Peter Tingling is an associate professor at Simon Fraser University in Canada.