Is your business model working? Stress test advice

“I believe cost cutting is a strategy. In too many cases, cost cutting is done as an ad-hoc, reactionary measure, in which the only guiding principle is to ‘follow the money’ over a path of least resistance. A good cost cutting program is planned and thought through as you would any other strategy…”

Ex-McKinsey consultant and turnaround manager Jurgen Leijdekker believes that cost cutting needs to be part of a company’s long-term strategy, not a reactionary measure. With a tough economy continuing he urges companies to do a stress test where the viability is tested at a revenue reduction of at least 20-30%. Ultimately this may lead to a rethinking of the entire business model.

Guiding principles of cost cutting

Cost cutting is something we’ve all encountered at some point in our working lives. As a tactic, it seems pretty straightforward, and hence is often overlooked in the business literature. Somehow, it’s seen as too crude to warrant much further thought. I believe this is unfortunate. Cost cutting can do serious damage when applied bluntly and unthinkingly, as too often is the case. Personally, I certainly held various beliefs about cost cutting which I had to unlearn over time. As I went along, here are some principles that I’ve come to value. Check these against your own experiences, and see whether some ring true:

 It’s a strategy stupid!

Firstly and most importantly, I believe cost cutting is a strategy. In too many cases, cost cutting is done as an ad-hoc, reactionary measure, in which the only guiding principle is to ‘follow the money’ over a path of least resistance. A good cost cutting program is planned and thought through as you would any other strategy; it’s mapped out in advance with input from all stake­holders; it fits the contours of your overall strategy and values, is clearly communicated to all involved and is evaluated and adjusted afterwards. Contrast that with how cost cutting is usually done: it’s often a reaction to a situation (a ‘surprise’ seemingly), it’s implemented quickly, top-down and without open and honest communication (often with a feeling of embarrassment from senior management). It’s either done bluntly across the board (“I call on all Department Heads to find 20% savings”) or weakly where it’s the easiest to cut (e.g. “no more external contractors”) and without regard for the overall strategy (“we’ve imposed an overall hiring freeze” – even though the stated long-term strategy clearly calls for beefing up our customer service team). When it’s all done, it’s often followed up with some ‘after shocks’ as management suddenly realizes that more cutting needs to be done.

Any of this sounds familiar? I’ve certainly made many of these mistakes before. Let’s keep reminding each other that cost cutting is a strategy: carefully planned, conscientiously communicated and rigorously executed.

How much is enough?

Be intelligent about setting your overall target. Too often, the answer is pretty simplistic, e.g. “we need to cut 20%”. But if cost-cutting is a strategy, it requires careful planning, right? So let’s set the objective first: is the goal to survive, to increase the ROE, or simply to ensure that we’re ‘lean’? Given the times, let’s assume we’re trying to survive right now. In this stage of the business cycle, if you’re not profitable at say 70-80% of last year’s sales, you need to take action on margin or costs.

This is the ‘stress test’ that every company should have taken in their budget rounds last year. If you haven’t yet, do it now. Just eyeballing the numbers should lead you to a discussion about where to cut, never losing sight of your long-term strategy. Again, the answer should not be a target across the board or guided by ease of implementation. Ideally you’re not just trying to survive 2009, so make sure the baby is not thrown out with the bathwater. And if you are truly just struggling for survival, you should probably look at cash more than cost. A company can be very profitable and very broke at the same time. If you watch ‘cost’ only as it shows on your P&L, you can be caught out on cash. We’ll look at this in a separate article.

 Do the numbers

 Spend some time on truly understanding your cost base. I’ve seen many companies where management lacks a sophisticated insight into their cost base. Whereas the commercial numbers are usually analyzed in-depth (growth trends, market share, product profitability, etc.) costs are often expressed very crudely (“last year we spent X on Y”, instead of “my X as a % of sales is higher than my competitor’s, and the ratio is growing still”). If you feel that you do need a deeper insight into your cost numbers, here are some tips that may be of use

First, have you ever gone through the chart of accounts? If you haven’t, brace yourself for a pretty boring but necessary exercise. In any company that I’ve come into, I went through the chart of accounts and restructured the various buckets, so that the management accounts show line items that quickly pinpoint me to my real cost issues. There are many examples; a manufacturing company where inventory losses weren’t separated between waste and shrink, a retail company where certain cost items were aggregated across locations thus preventing us to benchmark, etc. Go through your chart of accounts and make sure the categorizations will give you the insights you need, without too much digging.

 Second, start playing with lots of ratios, tables, charts, etc. The rule here is “more is more” – at least in the initial stage, I tend to look at the data from as many angles as possible, before zeroing in on a few potential issues and picking a few insightful ratios or KPIs with which to go forward.

Third, look for benchmarks. Internally, compare the overheads between different offices, the productivity between your editors, the T&E between your sales people. Next, look at your competitors. Talk to each other to get some comparisons, get data from industry associations, and dig up some of numbers on public companies in your industry. Look at any ratios that you can concoct and then translate them to your size like territory size of sales people, gross margins by product line, salary cost per FTE, etc.

Finally, check your strategy. Athough you understand now where costs are outside the norm, this should not dictate where to cut. If your strategy is to excel in customer service, then it may be fine if your high-functionality website costs more than the next guy. If you’re all about having ‘feet on the street’, perhaps it’s ok that your T&E and CRM costs are higher. But similarly, if you believe service by phone and transactions over the web is the distribution model of the future, why even have a field sales force? There’s no right or wrong cost level. There’s affordable and not affordable, there’s an even or uneven distribution among the stakeholders, and there’s aligned or inconsistent with your strategy.

 You don’t ‘need’ anything

I believe the distinction between essential and non-essential costs is a red herring. All costs are non-essential. Really? Well no, not really, but it’s a useful paradigm to live by nonetheless. It puts you in the right mindset to drive the implementation, and as a bonus, it’s more true than you might think. I’ve been surprised myself so many times that life goes on just fine without certain costs that seemed “essential”. In my case, having many outside reference cases from other companies in various industries helps. It’s fascinating to see how entire industries are joined in the belief that certain costs areessential, whereas other industries have gone without those exact same costs, simply because they’ve never known any different.

In my first job, I worked for an organization that was part of the UN system. When I came in, the staff was in uproar about the new travel directive: from now on they had to travel business class instead of first class. Next, I worked at a strategy consulting firm where domestic flights were booked economy, but always full fare, the argument being to avoid change fees. Later on, I worked for an internet startup where the management team (myself included) voted down the CFO on a proposal to stop flying business class on transatlantic flights – we sincerely felt that this would be an unacceptable impediment to our productivity upon arrival.

Fast forward to my life as a turnaround manager for private equity firms: economy flights all around (including very frequent 12-14 hour flights to the Middle East and Asia), sometimes on frequent flyer miles that are captured by the company instead of the traveller, and often staying in hotel rooms shared with colleagues. I’m not passing judgment on any of these environments. The moral of the story is simply that beliefs about which costs are only just that – beliefs.

Avoid going back for seconds

 Cut deeper than you think you have to. This is a golden rule in operational turnarounds. Why? Simply because cost cutting is hard. Therefore, you need some cushion for any set-backs during the implementation, and most importantly, you want to avoid having to go back for more. You’ll run into resistance from the team, you’ll encounter practical obstacles which you hadn’t realized were there, and most certainly you’ll find that there are delays before you see the numbers go down. Also look at it at its most basic level: you can never pinpoint exactly how much cutting you need, and if you find you’ve cut too deep, it’s not that hard to increase your spending again. So go for one round, and exaggerate the target.

 If you need more than a shave…your businessmodel.

 A final thought comes back to the ‘stress test’ I mentioned: you may just find that your business model simply doesn’t work. Particularly in turnarounds, I’ve seen various examples of companies that were bought by new owners, who bet on a cost cutting exercise to permanently turn around the business, only to find out halfway through that the very business model itself simply doesn’t work. A classic example is where your product or service has become commoditized. Margins have eroded and your competitors have moved on to new products or business models that are the new money makers. If you do your stress test and see an amount of cost cutting that looks too daunting, then don’t focus on cost cutting. Focus on your business model instead. Should you merge with a competitor? Could you reduce your headcount by 80%, close most of your offices and do everything electronically? Should you put all sales staff on commission? I ran a cost cutting exercise where we first went through 6 months of shaving here and there, until everyone involved realized that we were never going to get there without a radical change to the model. We eventually attained our target by changing to a completely new production method, which turned out to be a long-term winner. With a lower target, we would have plugged along with our cost-conscious business, only to be eventually overtaken by a new entrant who adopted the new production method from day one.



Jurgen Leijdekker has worked on the operational side of private equity since 2000: working either directly for a firm or as an independent contractor, he has driven performance improvements in portfolio companies as interim executive, as board director or in consulting roles. Jurgen has worked mostly in the US and UK and across a broad range of industries. Prior to his turnaround/operational private equity work, Jurgen was a management consultant with McKinsey&Co and an economist at the International Monetary Fund. He currently lives in New York, where he is leading the turnaround of a luxury goods manufacturer.