Slimming Down the Budget: Understanding Cost Cutting

Today’s continued economic situation continues to apply pressure on many businesses. In establishing the next year's budget, it is important to take this opportunity to reflect upon the costs previously cut, decide whether or not they will be included in next year’s budget, or whether additional cuts may be required. Further evaluation of the short and long term effects of the costs cut are important based on the strategy determined in the previous year for going forward.

A company’s budget will reflect the anticipated operating activities for the next year, consistent with being the first step in the three to five year strategic plan. The specifics of how to build a budget can be found in the resource section of our website. After the budget has been drafted it needs to be reviewed for general operational achievement and results. In today’s economy, the budget may indeed show a net loss or negative cash flow. If such is the case, actions must be planned to address this situation. Cutting costs is one of the actions most often considered to address losses or negative cash flow. Before cutting, creating a plan is key.

Planning Before Cutting

Business owners facing deficits cannot turn a blind eye or rationalize the causes of these deficits. One of the main rationalizations for continuing expenses is that they have so much value. Too often the result is that the company continues to sink through deficits, not having sufficient funds to realize the benefits of the expenses. This is particularly true with investments; enterprises cannot carry investments when deficits exist. Good financial data aids in determining and monitoring the appropriate continuation for investment or expenditures. Where financial data is weak or late, it tends to be ignored and the obvious cost cuts are not made or are not timely made.

Additional factors to consider before making budget cuts are the following:

1. Nature of the deficit.  Determining whether the deficit is a cash, operating, or both cash and operating, sets the tone for the severity of the deficit and the business’ response. A non-cash deficit is serious, but more manageable, because there is still positive cash flow. The cause of such operating deficit should be understood. For example, acquisition of assets can lead to high depreciation.  While such depreciation may not create negative cash flow, failure to cover depreciation means that the business may have a problem replacing the assets when they wear out
2. Strength of cash balances.  Businesses with low cash balances face more of a threat. Negative cash flow situations require an assessment with an immediate response. There is less room for error.
3. Adaptation Time. Can the cut be made at once or does the cut need to be staggered over a period of time? Even with cuts, obligations must be met and a one-time cut may cause harm more than help. A word of caution here: too often the one-time cost for the cut, such as a contract settlement, becomes the excuse to not address the expenditure.  The result is often that the expenditure continuation creates even greater burdens. Aggressiveness is required in cost cutting.
4. Risk Tolerance. Failure to deliver a service drives away customers and significantly impacts overall revenue. If a cut causes difficulty delivering services, provisions must be made to notify customers of possible delays and/or a cut must be made elsewhere.
5. External groups. Any partners or companies that are affected by the cut should be considered.

Reasons for Cutting Costs

The number one reason why small businesses cut costs is due to a deficit in the cash flow. One cannot assume that revenue will increase to solve this problem. While the strategy should give some ideas of how to increase revenue, budgeting and cost management require a more conservative approach to revenue projections. As a result, small business owners will work with the budget to cut costs in order to continually maintain profits. Let’s examine some reasons for why the deficit exists.   

1. Company’s financials are not organized and/or utilized, including budget against actual and current year against last year. As a result, the company is effectively managed out of the checkbook. No financial warnings signals are clear. We are finding that bank access to checking accounts online has only serviced to facilitate this tendency to manage out of the checkbook, because there is a sense of control in knowing what is in the bank. The financial information gives warnings of things to come, not just what has happened in the past.
2. Lower demand for services. When revenues decrease for a product or service due to less market demand, costs need to be lowered in order for the overall business to remain profitable.
3. Emergence of new providers and/or additional price competition. These create the equivalent to lower demand noted above.
4. Unusual cost events. An unexpected event, whether man-made or market driven, can cause businesses to take a dramatic hit in revenue. For some businesses, the only way to survive such an event is to make cuts across the board.

Creative Tips to Cut Costs

Many articles published today promote a mindset of cutting costs simply for the sake of avoiding expenses. What is lost is the key discipline of cost management; owners must ask themselves “What is the value my enterprise is getting from this expense?” Those expenses with the least amount of value are eligible to be cut, thus providing the connection from cost management to running the business.  

Once a business has determined what expenses carry the least value and can be cut, it must determine both the size and method of the cuts. The Giersch Group recommends financial modeling to establish the extent of cuts, reviewing and understanding all aspects of the business that are currently operating at a loss.

Below are creative ways in which a business owner can cut operational expenses. In this process a business owner needs to avoid the “penny wise, but pound foolish” syndrome where they focus on small amounts that are easy while avoiding the larger tougher items. On the other hand, in saving pennies, the tone of the business can be changed, which has its own cost. The right answer is to be strategic and to accompany these decisions with good communication to the team. These decisions can be used as opportunities for the team to win on expenses as well as revenue and services.

1. Process changes or technology changes. Changing procedures or investing in new technology can certainly reduce the work required and increase production. While there may be upfront costs, increased sales due to increased production will certainly balance out the amount of cuts needed as well as provide increased revenue over time.
2. Be realistic on staffing needs. This is hard, but important. Staying ahead of staffing will help avoid the crisis cuts that many companies have experienced over the past two years.
3. Rethink advertising/marketing strategy. Advertising is often an early and easy cut. Yet, advertising is part of the revenue engine. Therefore, cuts here need to be very thoughtful and strategic. Trial advertising is probably one area where cutting is warranted.  Essential advertising should be understood and retained. Most experts will say that you cannot cut to success. This is true in advertising, but not true as a whole.
4. Energy efficiency. Measure and analyze your facility's efficiency at www.energystar.gov or have an Energy Star contactor visit. Both are great tools to identify savings opportunities and what impact this will have on your overall budget.
5. Eliminate the use of color ink when unnecessary. This is an overly written cost savings measure.  It rates right up there with penny wise, pound foolish.
6. Purchase supplies online. Purchasing supplies online allows not only direct delivery to the office, saving on time spent shopping for the supplies, but also provides opportunities to take advantage of unique discounts found online.
7. Sublet unneeded space. While the real estate market is tough, the scaling down of an operation can free up space. This space needs to be addressed aggressively.
8. Shop in bulk and store in warehouse. Here is another category where penny wise, pound foolish can be a problem. Too often bulk purchases may mean cash is absorbed in inventories and this will increase the cash crisis.
9. Solicit new bids from service providers. Often times mentioning to a service provider that the company is thinking of using a provider will lower the cost of the service.

Articles for Further Reading

1. McGrath, Rita. “A Better Way to Cut Costs.”  09 March 2009. http://blogs.harvardbusiness.org/hbr/mcgrath/2009/03/a-better-way-to-cut-costs.html
2. Applegate, Jane. “Practically Painless Business Cos Cutting Strategies.” Los Angeles Business Journal. 10 September 2001.  http://www.allbusiness.com/finance/808548-1.html
3. Wang, Jennifer. “Recession Cost-Cutting No-Nos: Resist the temptation to make these bad business decisions during the downturn.” 15 December 2008.  http://www.entrepreneur.com/savingscenter/article199184.html
4. McCarthy, Ryan. “8 Ways to Cut your Overhead Expenses from Minimal to Practically Non-existent.” 01 June 2009. http://goodplum.com/ways-to-cut-your-overhead-expenses/
5. Nutiile, Tom. “Guide to Cutting Business Costs.” http://www.business.com/guides/cutting-business-costs-399/

For more information, please visit the Giersch Group at http://www.gierschgroup.com/ or contact us at prosper@gierschgroup.com