Cost & Capital Strategy
Leadership needs to continuously scrutinize and optimize the costs and capital of a business. A business is like a house. If you don’t periodically clean it up, things can get messy, especially the costs and complexity of the business. The core question regarding cost and capital efficiency is, “How can the company do more with less?”
The future growth of most companies necessitates substantial improvements in their cost and capital efficiency to stay competitive and produce the profits to invest in growth. Creating step-function improvements in cost and capital efficiency isn’t difficult; it just takes some strategy, analysis, and a ton of discipline and focus.
To drive step-function improvements in your cost and capital efficiency, simply answer the following questions to create a killer cost and capital strategy:
1. What are the trends and drivers of the financial model?
2. Does the company have a strong and focused overall strategy?
3. What opportunities are there to focus and optimize the customer value proposition & journey?
4. How can costs & capital be driven out of processes?
5. Are the costs and capital optimized across people, partners, infrastructure and inventory?
6. How can finance improve ROI analysis, business intelligence, controls / governance and the cash conversion cycle to continuously drive cost and capital efficiency?
7. What is the cost and capital efficiency initiatives roadmap?
So, let’s go over the core questions that need to be answered to create a killer cost and capital strategy.
1. WHAT ARE THE TRENDS AND DRIVERS OF THE FINANCIAL MODEL?
Before diving into building a cost and capital strategy, it is critical to understand the trends and drivers of the financial model of a business.
Create the top-line baseline
Ultimately, your cost and capital strategy will impact your profit and loss, balance, and cash flow statements. So, the first step of any cost and capital strategy is to conduct a trend analysis for the cost and capital drivers of the business. Gather historical financial statements and normalize them by percent of revenue. You’ll quickly create an interesting picture of the business’s cost and capital structure trends and answer questions such as?
Is employee cost growing or shrinking as a percentage of revenue?
How about COGs, accounts receivables, inventory, advertising, or other major cost and capital buckets?
Start digging into cost and capital buckets
Once you have the top-line baseline, you’ll want to start digging into the significant cost and capital buckets. Typically, the analysis begins by extracting substantial data from the company’s accounting software. Of course, the more detail, the better. You can cut the data by function, team, date, vendor, and more with well-organized and maintained ledgers.
Employee costs are one place to start. You’ll want to understand headcount, compensation, raises, bonuses, benefits costs, discretionary spending such as travel and entertainment, and other expenses tied to employees. Organizing and analyzing the data by function, team, and level of roles will give you an excellent snapshot of the trends.
Vendor expenses are another big data set for gathering, organizing, and analyzing. You’ll want to do trend analysis by function, general and detailed ledger categories, and other interesting cuts.
Also, conduct a Pareto analysis, which ranks order costs by whatever metadata you determine. You’ll often find that 20% of vendors drive nearly 80% of the expenses in a given category. The analysis will help prioritize which vendors to dig deeper into assessing trend drivers and potential reduction strategies. Pivot tables are another often used analytical tool, cutting spending data by the different detailed dimensions you have.
You’ll want to organize your insights by the size of spend, growth, the potential to impact (e.g., hard-to-impact such as rent, easy-to-impact such as contractor spending), and other interesting variables. Create a prioritization matrix, with one axis being Effort to Impact and Size of Impact.
Understand the trend drivers
The next step is building a perspective on what is driving the significant trends. This step generally involves many interviews or brainstorming meetings with the people managing the costs. They’ll have the best perspective on the drivers. Yet, the key is to get down to the root drivers. We worked with a manufacturer with a large and growing product returns cost. The fulfillment team knew the issue, but we had to utilize the “5 Whys” and talk to a few different groups to get down to the root cause of the returns, which was a poor design of one of the electronics modules.
Benchmark the costs and capital buckets
While trend analysis will help you understand areas of concern or strong performance, benchmarking will help you determine if the costs align with competitors, the industry, or functions. Thousands of companies utilize KentleyInsights.com to benchmark their cost and capital structure against the industry. Download your industry report to see if the industry trends and benchmarks can be helpful for your company. Some of the core benchmarks in the reports include:
• Revenue per employee
• Operating costs as a percent of revenue
• Detailed operating costs as a percent of operating costs
• Functional breakdown of organizations
• Compensation for major roles
• Inventory turns
Benchmarking will create a valuable understanding of under or over-spending gaps versus the industry.
What are you going to do to drive cost and capital efficiency?
While understanding the trends, drivers, and gaps versus benchmarks of your financial model is critical to sizing the opportunity, the rest of this section will review the major strategies companies utilize to drive the efficiency of their cost and capital structure.
2. DOES THE COMPANY HAVE A STRONG AND FOCUSED OVERALL STRATEGY?
Strategic focus and alignment are the main drivers of most successful companies’ cost and capital efficiency. Successful companies:
- Know who their target customers are.
- Focus on markets and geographies they can win in.
- Develop and deliver a killer value proposition that beats the competition.
- Amplify their value proposition through strategic marketing, pricing, distribution, and everything the organization does.
- Align all of the associated costs and capital to these strategic purposes.
In super strategic companies, there are few distractions, a calming absence of chaos, a sense of purpose and mission, a clarity of roles and who is accountable for what, and hence not much wasted effort, costs, and capital.
Companies with bloated cost and capital structures typically could have a better strategy. They are constantly distracted by new opportunities to chase, their business model is often fragmented across multiple markets, with no clear sense of who their target customers are, to subscale across product and service lines, and simply drowning in a toxic cocktail of complexity and lack of direction. Here is a simple and direct message to these companies:
Create a killer strategy to win and focus on executing it!
A killer company strategy focuses on the business and the cost and capital structure, eliminating massive inefficiencies while motivating team members to invest more of their mental capacity and energy into the business. Often, figuring out what a company will do to win makes it very clear what it shouldn’t and won’t be doing in the future. Things become crystal clear, and all those distractions are easy to identify and eliminate. Without the forcing function of a killer company strategy, it can be difficult to make the right decision to develop a practical cost and capital-cutting strategy. Cost and capital cutting without a killer company strategy can often seem pretty desperate to employees and often is the motivational tipping point for the good people to start leaving, which is a slippery slope to insignificance and the end.
Read more about creating a killer company strategy here…
3. WHAT OPPORTUNITIES ARE THERE TO FOCUS AND OPTIMIZE THE CUSTOMER VALUE PROPOSITION & JOURNEY?
PRODUCTS & SERVICES – COST AND CAPITAL EFFICIENCY
Every business sells products and services, which cost something to develop and deliver to customers. Those costs can be in materials, components, manufacturing, packaging, transportation, electricity, people, etc. Attack the core design of those products and services to cut substantial costs and capital from the business.
First, understand all of the costs associated with products and services. The typical analysis conducted is a simple Pareto analysis, rank ordering the expenses, by amount, associated with a product or service. In the case of a product, you conduct a Pareto analysis on the bill of materials (BOM) and related manufacturing, transportation, storage, and other product costs. You can do the Pareto analysis for a service, focusing on the direct labor and materials associated with a service. In some cases, where there are substantial indirect costs associated with multiple products and services within the same company, creating a view of activity-based costing or some variation can be extremely useful for understanding the actual costs of a product and service.
The bottom line is that once you determine the rank order of direct and indirect costs associated with products and services, start attacking the largest ones first. Now, given that you are attacking the actual design of a product or service, the payback is typically not immediate. Still, it is often substantial and can change the game with the competitiveness of your product and service. There is no standard approach to driving costs and capital out of services and products, but there are some core principles to think through, which we go over below.
Focus the features or functions of the product or service on the most important needs of your target customers. Feature and function creep is the death of too many products and services since those features and functions that aren’t important to most target customers can make the costs creep up and the associated price to a level, making it uncompetitive.
Customer value (benefits – price) is the name of the game in product and service strategy. Value engineering systematically prioritizes product or service features that drive high benefits versus cost ratios. The more you can focus on the features of a product or service that create substantial benefits at low costs, the more customer value you’ll be able to create and the more competitive your products and services will be in the market.
We live in a time when companies have access to unprecedented knowledge, skills, technology, and advanced materials they can leverage to innovate their products and services. Innovation is crucial in finding those step-function changes to the value equation of products and services, pumping up customer benefits while simultaneously driving down costs and capital.
There was a project to develop a truck where the team focused on massively simplifying the design of the truck, and one of their metrics was the number of screws and fasteners in the new design. They eliminated 50% of the screws and fasteners in the new design, which drove the cost down by 20% versus the old truck and improved the quality and durability. Simplification in the design of products and services is one of the most essential principles to driving out costs and capital and driving up quality, speed, usability, and other important dimensions to customers. In-N-Out, one of the most successful fast-food companies in the world, sells one type of burger, milkshakes, drinks, and fries. That’s it, nothing more and so simple.
Companies with multiple product and service lines create cost and capital efficiencies by standardizing as much as possible across the products and services, whether they are components, designs, software, modules, etc. Standardization and reuse naturally drive cost and capital efficiencies but can also improve quality and time to market.
DISTRIBUTION – COST & CAPITAL EFFICIENCIES
Your distribution strategy can dictate the majority of your cost and capital structure. Just think of physical retailers versus online retailers. Distribution is going through the most significant revolution of all the business model dimensions, mainly due to online models and digital apps. Many business models are simply innovating the distribution model to disrupt their industry.
MARKETING – COST & CAPITAL EFFICIENCIES
The equation for driving marketing and advertising cost efficiencies = target customer + great value proposition + killer campaigns + test & learn. Once again, get the big strategic questions right first. Having target customers whose needs you know intimately means you can better target your marketing and advertising to them on the media they like. A great value proposition that meets target customers’ needs better than competitors will activate and amplify the most significant and cost-effective marketing lever, word of mouth. Killer campaigns, which personify the critical differentiation of your value proposition versus competitors, accentuate the ROI of your marketing, diverting more target customers to your value proposition. A test-and-learn culture harnesses the power of experimentation to increase marketing ROI by continuously testing new messaging on various media to improve the relevancy and cost-effectiveness of marketing.
So much science is now available to marketers to understand the efficacy of messaging and media. If you have a substantial advertising budget, it behooves you to infuse some experimentation science into your marketing to understand the high ROI of messaging and media for your business. Take a look at our methodology for creating a killer marketing strategy.
4. HOW CAN COSTS & CAPITAL BE DRIVEN OUT OF PROCESSES?
Every action taken in an organization by a team member, partner, and infrastructure is a process, whether acknowledged as one or not. All of those actions or processes of the organization should be focused on efficiently and effectively developing and delivering the company’s customer value proposition and journey.
What percent of your company’s employees’ actions are creating value for the company?
Most estimates put the figure around 10-20%!
There is much excess capacity in every organization. If you can unleash that capacity, your organization can do much more with less. The core paradigm to unleash this latent capacity is Lean, a set of tools, concepts, and a cultural mindset focused on continuously improving the organization by engaging all employees to identify and eliminate waste (anything that doesn’t add value to the company).
There isn’t an organization out there that can’t benefit from lean. To learn more about Lean, check out our section on it.
Beyond a Lean initiative, there is also the opportunity to reduce costs through outsourcing functions or processes, especially those that don’t represent a core competency. The logic of outsourcing is elegant, given that you can take a process or function that a company doesn’t do well and maybe subscale at and tap into an outsourcing partner who has the scale, expertise, and core competency in that function or process.
Generally, the first step to improving anything is measuring it. And, when it comes to those processes that consume many resources, if you don’t measure them, you should. Whether they are product development, operational, sales and marketing, or financial, put a plan in place to establish and measure key performance indicators (KPIs), targets for those KPIs, and improvement plans.
Any process that necessitates many people should be a target to automate. With the amount of software and programs to automate manual work, every company should fully leverage technology to automate high-cost manual processes.
5. ARE THE COSTS AND CAPITAL OPTIMIZED ACROSS PEOPLE, PARTNERS, INFRASTRUCTURE AND INVENTORY?
The next step in developing a cost and capital strategy is to optimize spend on people, partners, infrastructure and inventory.
Developing a people spend strategy involves four major levers, including:
1. Do you have the right amount of people?
2. Do you have the right composition of people?
3. Are there opportunities to optimize compensation and benefits?
4. Are there opportunities to reduce discretionary spending on people?
1. Do you have the right amount of people?
This is always a difficult question to answer and solve. The easiest way to determine if the number of people is appropriate is to benchmark utilizing revenue per employee, which you can find on over 1200 industries at KentleyInsights.com. Otherwise, you can use data on public competitors utilizing data in their 10-Ks. Sometimes, you can find revenue data on competitors in articles or online, and then a number of employees in articles or utilizing LinkedIn.
2. Do you have the right composition of people?
This question can get trickier to answer. Kentley Insights’ reports have a high-level cut and a detailed job cut. Another way to get part of the answer is to do a span of control analysis to see if you have the correct number of supervisors/managers for the rest of the employees. The ideal benchmark is between 6-9.
3. Are there opportunities to optimize compensation and benefits?
This is a very sensitive topic that should be treated with care, given that a reduction in compensation and benefits can have a demoralizing effect on team members. Benchmarking is the way to understand if compensation and benefits are in line. There are public sites and companies that can help you. Or, you can leverage Kentley Insights reports, which have benchmarks on total payroll per employee, benefits (health, pension plans, contribution plans, and other fringe benefits), and wage information by role and state.
4. Are there opportunities to reduce discretionary spend on people?
One of the easiest spends to reduce is the discretionary spend by people, such as travel, entertainment, and supplies. Demand management and proper controls are typical ways to reduce this spending.
Demand Management involves understanding all your demand for a particular cost or service, organizing the demand by priority, value, or “wants and “needs,” and addressing root causes for demand by enforcing the proper controls and reporting in place to reduce and manage the demand.
There are only two main ways to reduce costs. You either reduce the demand for the cost or reduce the per-unit cost. Typically, reducing the per unit cost through better purchasing practices and supplier negotiations can provide savings of 5-25%, but often at the sacrifice of reducing quality or service levels. Meanwhile, demand management often yields 10% to up to 50% cost savings.
Travel expenses always serve as an excellent example of demand management. I’ve seen companies reduce sales team travel expenses by 40% through good demand management while improving sales team performance. It can be as simple as forcing team members to prioritize their travel by getting sign-off on a simple Travel Request Form, which typically includes the reason for travel, the reason that a trip needs to be a personal visit (e.g., relationship building, critical decisions), what stage in the pipeline the customer is in, and the potential value of the customer. This type of Travel Request Form forces people to think critically about why they are going on a trip, the value they will get from it, and potentially other ways (e.g., videoconference, telephone conversation) to drive to the same or better decisions and relationship building.
PARTNERS & INFRASTRUCTURE
The partners and infrastructure of a company often represent a significant and ripe spend to go after in terms of cost reduction. The typical approach to reducing costs and capital associated with partners and infrastructure is rationalizing, standardizing, and optimizing.
Many companies have partners or infrastructure they no longer need or are redundant with other vendors and partners. Rationalizing the portfolio of a company’s partners is always a prudent exercise and should be done every few years. Once again, the typical portfolio rationalization approach is taking the ledger accounts, organizing them by spending per vendor and debating with managers and leaders on the strategic need versus the expense. Every time we do this with a client, there are insights and cost savings. One of the most critical aspects of the exercise is to understand where there is overlap of services or infrastructure provided by multiple partners. Consolidating to one or a few partners can offer instant leverage in renegotiation.
In the case of rationalized infrastructure, there should be an evaluation of whether or not the infrastructure can be sold to generate cash to reinvest in the business. Often, rationalized equipment, machinery, and property have value to someone else, and instead of scrapping it, there should be some diligence in trying to create value from it. Some companies even specialize in bartering, helping companies unload assets to procure needed supplies, services, or infrastructure.
Another house cleaning lever is standardizing services and infrastructure with specific partners at pre-determined coverage and service level agreements. The most straightforward example is when companies standardize travel with one or two airlines. Beyond travel, establish standard partners across as many services and types of infrastructure as possible.
The optimization of spending with a particular partner typically involves renegotiation, demand management, and, in the case of infrastructure, lifecycle management.
Renegotiate for concessions
Always try to renegotiate contracts at the end of their life or at any time. Once again, Pareto the spend by the vendor to prioritize which vendors to focus on first. Reverse auctions or RFPs are always great tools to utilize. Also, you can learn about negotiation best practices and strategies.
Once again, demand management is critical to optimizing partner and infrastructure spending. Understanding the root causes and drivers of spend and seeing if they can be reduced is the key to driving down partner and infrastructure expense. If you eliminate the demand, you eliminate the spend.
In the case of infrastructure, extending the usable life of the infrastructure through maintenance, enhancement, or repair can substantially reduce costs and capital.
For manufacturers and retailers, inventory generally represents a substantial amount of capital. The better that inventory is managed, the less capital tied up in inventory. Of course, the entire discipline of supply chain management is devoted to optimizing inventory, so we won’t cover it here. Just suffice it to say, if you have a lot of capital tied up in inventory, you should have some supply chain experts to help manage the supply and demand of the inventory.
6. HOW CAN FINANCE IMPROVE ROI ANALYSIS, BUSINESS INTELLIGENCE, CONTROLS / GOVERNANCE AND THE CASH CONVERSION CYCLE TO CONTINUOUSLY DRIVE COST AND CAPITAL EFFICIENCY?
The finance team in any company should serve a very strategic role in driving the company’s value. We call it strategic finance, where the finance team has a front-and-center role in ensuring the capital and costs of a company continuously increase its value. They do this through excellent ROI analysis, business intelligence, controls/governance, and cash conversion cycle improvement.
With a view across a company’s functions, the finance team has the best perch to evaluate the ROI potential of various projects, initiatives, headcount, and spending. Strategic finance teams help evaluate and facilitate decisions on a company’s capital and cost needs. The go-to tools for strategic finance teams are cost-benefit analysis, decision matrices, and prioritization matrices.
Strategic finance teams create and help manage companies’ financial, efficiency, and effectiveness instrumentation. They help determine the core KPIs and the balanced scorecard (if used). They are constantly analyzing the business for opportunities to drive cost and capital efficiency and overall value for the company. If your finance team isn’t providing the company with the business intelligence they need, it may be time to create this critical competency.
Governance & Controls
Governance is the system of rules, practices, and processes by which leaders decide to allocate the scarce resources of budgets, time, and people. Governance is one of the most overlooked yet essential tools for strategic finance teams. Ask yourself, “How are important decisions made in the company, and can the process be improved?” Strategic finance teams generally create transparent, clear, and just governance for decisions to minimize opportunity costs and maximize ROI.
Cash conversion cycle
Strategic finance teams continuously improve the company’s cash conversion cycle, which can significantly reduce the amount of capital needed to fund the business. The cash conversion cycle measures the time cash that leaves the business (accounts payable and inventory) takes to return to the company (accounts receivable). This is especially important for manufacturers and retailers.
The bottom line is that the more a strategic finance team can reduce the age and size of accounts receivable and inventory while increasing the age and size of accounts payable, the better the cash conversion cycle. Accounts payable are simply loans from partners and vendors, while accounts receivable are merely loans given to customers by a company. Strategic finance teams stay on top of communicating with customers with aged accounts receivables and have firm rules on even firing customers who are constantly late or delinquent in payment. Of course, stretching accounts payables can harm the business if relationships and trust are harmed. The key is to get favorable payment terms during negotiations with particular partners and vendors.
7. WHAT IS THE COST AND CAPITAL EFFICIENCY INITIATIVES ROADMAP?
A company’s cost and capital structure is core to its competitiveness in a market. It influences a company’s pricing and related revenue growth, profitability, and cash flow. We’ve gone over dozens of levers companies have at their disposal to help drive their cost and capital efficiency. To create a cost and capital strategy, you must evaluate, size, and prioritize the various cost and capital levers.