UK companies are still shedding jobs as an easy way to cut costs in the face of the continuing downturn. In recent months, job cuts have included 3,166 announced by the bank HSBC and 800 by car company Honda.
But are too many CFOs aiming at the wrong target? When times get tough, it seems natural to take the axe to headcount. But some companies could probably make more cuts more quickly if they focused on non-labour costs.
This, at any rate, is the conclusion of a paradigm-shifting piece of research among Britain’s largest quoted companies. Researchers looked at published accounts for FTSE 350 companies over a three-year period. They discovered that although labour costs accounted for an average 14.2% of revenue among the companies, non-labour costs took up an average 67.2%. The remainder is largely accounted for by profit.
Most organisations have a big, complicated supply base. But they’re not investing in managing and driving their suppliers in the way that they would like
The figures varied dramatically across different industries. For example, labour costs are only 3.1% of revenue and non-labour 85.4% in the energy industry. But labour costs account for 35.5% and non-labour 44.3% of revenue among media companies.
Even so, the implications of these statistics should make CFOs think seriously about the impact on the bottom line of relative cuts in labour and non-labour costs, argues Guy Strafford, chief client officer at Proxima, a company specialising in procurement outsourcing, which sponsored the research.
Strafford points out that for average FTSE 350 companies a 1% cut in costs increases EBITDA by just 0.8%. But a 1% cut in non-labour costs increases EBITDA by 3.6%.
CFOs should be checking their own figures, because the higher the ratio of non-labour to labour costs, the more opportunity there is to leverage EBITDA improvement by cutting non-labour costs.
And Strafford argues that this focus on non-labour costs is likely to continue. Between 2009 and 2011 (the last year for which complete figures are available), FTSE 350 companies’ non-labour costs as a percentage of revenue rose from 65.6% to 68.3%, while labour costs declined from 15.7% to 12.9%. The shift has been largely accounted for by outsourcing more activities. As a result, supply chains have often become longer and more complex. But, Strafford argues, the amount of time and money invested in managing non-labour costs has not increased to reflect the growing significance of their role in the typical company’s cost base.
“Most organisations have a big, complicated supply base,” Strafford says. “But they’re not investing in managing and driving their suppliers in the way that they would like. There’s a deep asymmetry between how they handle their people and how they handle their suppliers.”
So it is not surprising that a survey earlier this year by cost transformation consultancy 4C found that 49% of CFOs believe cost reduction and improving operational efficiency are “driving elements” of their 2013 strategies. When a company looks seriously at its suppliers, it often finds substantial cost savings.
Nick Whale, a consultant at the transformation consultancy Moorhouse, worked on a country-by-country review project at ICI. He recalls that the project found wide discrepancies in contracts with the same supplier in different countries.
“When you aggregated the contracts across the world and came to a global deal with each supplier, the economies of scale were incredible,” he recalls. “That was even the case simply by driving the global price down to the most competitive rate in the most competitive country.” His advice to CFOs: order an audit on each supplier to uncover multiple contracts and pricing regimes across the world.
The onward march of M&A activity makes these kinds of reviews even more important. Merged companies will often be using the same suppliers but at different rates. After fitness centre operator Virgin Active acquired Esporta in 2011, it almost doubled in size from 69 to 122 clubs. “That meant a larger spend and more suppliers,” recalls Alun Morris, a senior e-sourcing consultant at Wax Digital, an e-procurement specialist.
Virgin Active rationalised its supplier base and consolidated product and service contracts. In all, the number of suppliers was reduced by 46% and there were 13% of savings in 12 months.
Fewer is more
There are lots of these stories of companies being able to find quick wins by simply reviewing their suppliers and contracts in a systematic way. Laura Hinton, who heads the HR consulting practice at PwC, recalls a company which discovered it had 52 versions of a leadership training course. “By having one version centrally managed and controlled, it was possible to gain economies of scale with venues and third-party training providers,” she says.
On another occasion, she discovered an organisation had 600 suppliers on its recruitment preferred supplier list. “All had different rates and terms and conditions,” she says. “Having a consolidated list of around 20 recruiters meant it was possible to negotiate a competitive rate.”
And it’s not just cutting the number of suppliers that saves money. Toughening up on contract compliance also has the potential to deliver significant savings. The problem, says Jonathan Betts, a director at Science Warehouse, which provides procurement software, is that most companies have less than £4 in every £10 they spend managed by the procurement function.
“That can lead to maverick or uncontrolled spending with a good deal of value leakage going on,” Betts says. Typical areas where CFOs need to watch for “value leakage” are office supplies, marketing, professional services, maintenance and travel.
In order to do this, companies need the kind of visibility of deals across the company that e-procurement systems can deliver, Betts argues. CFOs who want to get a firmer grip on these kinds of cost-cutting activities may need to cosy up more to some of their management colleagues, particularly in procurement and HR. And where other functions haven’t yet taken on board the cost-cutting message, CFOs have a duty to ram home the consequences of the alternative.
Happily, there are more managers in other disciplines who understand the need for cost cutting. Harry Dunlevy, a seasoned HR director and partner at Independent, an HR consultancy, has been in the thick of cost-cutting exercises at a number of big-name companies. When Guy Hands’ Terra Firma private equity firm acquired ailing EMI in 2007, Dunlevy looked at overhead costs and discovered a “can of worms”.
Among the savings he made was £700,000 from the company’s annual taxi bill. His tips for cutting costs: “Take the most important 10 cost areas first, then move on to the next 10. And don’t do things at the lower end of the organisation unless you set an example at the top.”
But although a passion for cost cutting in the short-term can ensure survival, it may do damage in the long-term. “One-off cost-cutting programmes can often have the reverse of the intended effect,” says Rashpal Hullait, managing director of the Hackett Group, a consultancy that helps companies improve their overhead costs. “One-off cuts risk undermining the strategic intent of the change initiatives and the cuts are rarely sustainable unless combined with fundamental changes to operating models and procedures. World-class companies approach cost cutting in a sustainable and systematic way rather than as a one-off event. They run projects on an enterprise-wide basis and ensure genuine business transformation is a key component of the change agenda.”
Even so, it is clear that world-class companies – which Hackett defines as being in the top quartile for both effectiveness and efficiency – have been on the cost-cutting trail recently. They have, for example, slashed travel and entertainment costs per human resources full-time equivalent by 21% between 2008 and 2012.
Try to learn lessons from the past - not just to slash and burn without thinking about what skills are needed in the future
So what should CFOs be doing in order to gain a better grip on non-labour costs? The first step is to improve the level of “visibility and granularity” of the costs throughout the company, argues Strafford. “You need a better understanding of what you buy from suppliers. It’s not just about what you’re spending but what you’re actually getting for that spend from your suppliers,” he says.
The second step is to encourage more people in the finance function to focus more on profitability, not to think only about cutting costs. Strafford admits this is a subtle change of thinking, but an important one. “It moves the thinking away from clubbing your suppliers over the head to reduce prices to getting the best from your supplier to meet your needs in the most value-effective way,” he says.
“By framing the question in a subtly different way, you get different outcomes. The finance function needs to encourage those spending the money to have a more systematic way of thinking through what their real needs are.”
But many companies have been cutting costs since the credit crunch and it’s getting harder all the time. “I think we’re in uncharted territory because companies have to look harder to find ways to improve profitability,” says PwC’s Hinton.
“Try to learn lessons from the past – not just to slash and burn without thinking about what skills are needed in the future. It’s about ensuring you can grow when the better times come. It’s about cutting costs without cutting heads.”
David Manning, group finance director at Universal Music UK, has a clear strategy for bearing down on non-labour costs. The company, part of Universal Music Group, has outsourced its procurement for nearly 10 years.
Manning believes the approach generates savings of around £1m a year. He explains: “The ethos in our industry is to invest in the artists and their marketing, so we’re never going to invest heavily in back-office functions.”
Outsourcing procurement to Proxima meant that Universal moved from having just one person in-house working on it to three implanted specialists. Besides, as Manning explains, Universal also has access to experts in specialist areas when it needs them. This proves especially useful when purchasing services such as advertising or telecoms.
The three-person procurement team reports directly to Manning. He has a monthly governance meeting with the team’s manager to review projects. “The team looks after the bread-and-butter work and we feed in challenges that we’d like the team to tackle,” says Manning.
The approach works well, but Manning says any other company trying to reap similar benefits needs to be prepared for some change management. There can be resistance from some parts of the business that see outsiders’ involvement as a challenge to their independence. But Universal’s procurement team has earned its stripes by delivering consistent savings. “People in different departments will invite procurement specialists to see them. They’ll get the team to look at deals and benchmark them to ensure they’re on the right tariffs,” Manning says.
Manning reviews the savings in a monthly performance management report. This shows savings during the previous month as well as year-to-date figures. The statistics break down savings between cost reduction (a lowering of the price) and cost avoidance (negotiating away a planned supplier increase).
“My guys will sometimes go in and audit those savings and make sure they’re real,” says Manning. “And not just real – but that they are being reflected in the invoices we’re receiving.”
The key to gaining acceptance for this approach throughout a company, he argues, is to deliver some quick wins. “We trumpeted our quick wins throughout the business so people started to trust the team. Because we’re in a business where margins are tight, people started to see them as a valuable resource.”
But this cost-cutting approach only works when an organisation has a culture in which people expect to be challenged, says Manning. “People are then happy to talk about their day-to-day activities and how they could be done differently.”