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COST CUTTING CAN BACKFIRE "Downturn" can be a frightening word. Whether expected or unexpected, unfavorable economic or industry conditions can be a catalyst for panic among managers and business owners and can cause them to respond impulsively with sweeping cost cutting. Indiscriminate cost reductions, however, can prove harmful to long-term growth and revenue generation. It is important, therefore, to remember that certain expenses help to keep a business functioning properly. The strategies that a business implements to conserve cash should be appropriate to sustain profitability and to support its long-term objectives and direction. We recommend that companies plan and execute continuous and intelligent cost reduction strategies rather than immediately resorting to arbitrary overhead cost-cutting at the prospect of a downturn. The following is a hit list of strategies that businesses often employ to reduce costs. These strategies may not translate into actual savings or may have serious financial consequences for their associated risks. Suggestions for alternative areas to cut costs are provided at the end of the article for further consideration. Staffing. Many companies opt to terminate employees as a means of reducing costs because the calculated savings are guaranteed. Issuing pink slips, however, may only yield short-term savings and cause lasting damage to company morale. In addition, eliminating human capital during slowdowns can produce increased costs when there is a countering upturn. Before downsizing, consider the need to rehire for the positions being cut. Assess the cost of both recruiting and training new employees who will replace the experienced people the business has let go. Another detrimental mistake some companies make is cutting back on their accounting personnel at a time when experienced accountants who are familiar with the company are critically needed. If a decision is reached to cut personnel, a downturn is actually a great time to consider clearing out unproductive and sub-productive employees. Try classifying the employees into 3 groups: "must-have;" "would-like-to-keep;" and "why-does-this-person-even-work-here?" Some consultants, in fact, believe that a good rule of thumb is to replace the bottom 10% of your work force annually. Software Support. Some well-intentioned, but misguided business owners discontinue software support services in order to keep expenses low. By doing so, they leave a critical component to their business operations vulnerable, risking the possibility of a crash in their project management, job cost or overall accounting system. With no software support, the company has little recourse for recovering its system, or might later expend more money than the cost of simply maintaining software support services. Service Contracts on Equipment. When equipment is in proper working order, it may seem that its service contract is just another waste of money. It is this thinking that fuels decisions to cancel service contracts. However, as in the case of completing the last payment on a car loan, equipment seems to break down and needs repair once you self-insure and end the service contract. Without the coverage and insurance that service contracts offer, inoperable equipment will slow productivity and increase expenses associated with repair. Advertising and Promotional Expenses. Unfortunately, marketing is another easy cost to slash, as companies focus more on managing costs than on gaining market share. This strategy can ultimately cost a lot more in future lost revenues, depending upon how important marketing is to the business. Consider evaluating the effectiveness of the company’s existing advertising program to ensure that it is receiving optimal value for its investment. Some economies can be achieved without stopping advertising altogether, as many media outlets lower rates on advertisement space or airtime when demand is low during a slowdown. Purchasing Cheaper Products. Cheaper is not necessarily better and buying inferior merchandise, such as printer toner cartridges or paper, can cause mechanical breakdowns that later require equipment replacement. Buying in Bulk. Purchasing a year’s worth of copier paper might sound tempting, but think about the hidden cost of storing the paper, quality degradation while in storage, and risk of damage. Insurance. Insurance shields business from a wide variety of disasters, both small and large. For this reason, insurance is an area where cutting premiums does not necessarily translate into cutting costs. By canceling insurance policies, no protection exists except for that which is in your own pockets. And if a potential risk becomes reality, it can be devastating to the business. Example. Toby and Keith own a heavy equipment company as equal shareholders. They have a finely tuned business succession plan that protects them and their families in the event one of them should encounter death, disability, divorce, bankruptcy, or retirement. The company funded a life insurance policy of $2.5 million on each of the shareholders. Toby and Keith each agreed that they are more likely to retire before dying, so they intentionally fail to renew their buy/sell insurance. Shortly thereafter, Keith is involved in a car accident with a drunk driver. Certainly, this is an awful thing for Keith’s family to deal with. As a result of allowing their insurance to lapse, Toby and the company will now be unable to meet their obligations under the buy/sell agreement. Litigation must now ensue with Keith’s estate. The expected costs are as follows:
Any business owner can see that it is essential to be both careful and discriminating in implementing cost reduction strategies. Look to the future to make a wise decision and don’t get caught up in the present. Perhaps the company can economize on the type of policy being used for business succession purposes. Perhaps exchange the current policy for something more suitable. In any event, resist the temptation to just relinquish the policy altogether. In the above example, even if Keith had continued to live, what would have happened if he and Toby decided to acquire new insurance a few years later? And what if Toby, in the interim, develops cancer, rendering him uninsurable? These types of risks need to be managed as they can become detrimental to a business and are well worth their costs. So, as we can see, poorly considered cost-cutting can be injurious to a business and can put it in a position where it can no longer survive. However, there may be other measures the business can consider. These strategies include: Human Resources. Consider subcontracting certain functions out, such as payroll. Consider utilizing part-time personnel who would not be eligible for employee benefits. Review the overtime policy. Determine whether you can implement a "comp time" policy in lieu of overtime. Re-evaluate health insurance costs and benefits. Review employee expense reimbursement policies. Defer Major Purchases. Evaluate whether large purchases are immediately necessary. If not, wait for a more opportune time to buy. Postpone an Upgrade. It is tempting to keep up with the Jones’ but sometimes it is not necessary to spend money on a computer or software upgrade if the current system is presenting no problems. In fact, waiting until all the kinks are worked out of an upgrade can make great sense. Alternative Methods of Acquiring Equipment. Decide whether the company or employees need a brand new vehicle(s), or whether the vehicle(s) can be leased or purchased off the auction block instead. Avoiding Unprofitable Work. There is a hidden cost in taking on work that is not profitable or only marginally profitable. Some contractors believe high volume tends to spread overhead, so they bid far too low to make sure they are awarded contracts. The result is that the unprofitable jobs require more time, more attention and ultimately, create additional overhead expense. Reduce Taxes. Numerous strategies are available for reducing income taxes while also continuing to save toward retirement goals. When performed in a lawful manner, tax reduction does not equal the cost cutting that causes a business to make unwanted sacrifices. Asking your CPA. As someone who is familiar with your profitability levels and overhead expenses, your CPA can be a terrific tool in helping to decide which specific costs can be targeted without risk of serious side effects. Remember, improper cost cutting can backfire, but appropriate cost reduction strategies can help you ride out a significant business downturn, and flourish afterward!Large & Gilbert, P.C. |
