Fundamental solutions of crisis prevention: Why do cost reduction efforts fail?

Securing your present: Critical actions to focus on

The current economic crisis is unlike earlier downturns in that it has been neither quick in arriving nor consistent in its impact.

The financial services crash has spilled over the wider economy in different ways and at different times. No market is safe and no position secure. In this quickly changing economic environment, every business needs to continuously assess the potential impact of market conditions on the performance of its operations.

In an Ernst & Young survey of over 300 C-suite executives globally in January 2009 78% of respondents saw their companies placing increasing importance on protecting their assets.

Nearly 75% of respondents are finding ways to maintain liquidity in the current environment and 68% have implemented a top-down review of current cash management and cash flows.

According to Ernst&Young, companies need to secure their positions by identifying and resolving quickly critical issues to protect against value erosion, or to be well placed to take advantage of opportunities. A holistic review of a company’s ability to access liquidity, manage and release cash and control costs is essential to managing overall risk from changes in market forces. This review should extend beyond the business to include the health of both its supplier and customer base.

Each company must be aware and act upon warning signals such as profit warnings, breached debt covenants, major customers seeking alternative sourcing, unexpected boardroom departures or challenges retaining senior staff or a sharp increase in staff turnover.

Critical actions to focus on:

1. disposing of assets;
2. securing access to liquidity;
3. implementing cost reduction measures;
4. reviewing relationships with customers and suppliers
5. preparing for potential bids for the business;
6. managing cash effectively.

Why do cost reduction efforts fail?

Companies’ executives have always been concerned with managing and reducing costs, but being able to implement cost reductions quickly is just as vital for their business. 84% of the executives surveyed have already begun implementing an overall cost savings analysis.

When rating the most significant opportunities for cost reduction over the next 12 months, the following business functions were considered: supply chain (25% of respondents), operations (15%), sustainability programs (6%), research and development (11%), information technology (13%), sales and marketing (12%) and M&As (16%).

While most cost reduction programs do not deliver the expected benefits, most of the ones that do fail to sustain the savings beyond the initial period of management focus. Therefore the likelihood of overcoming the challenges typically seen in cost reduction programs and achieve savings can be realized by focusing on value, pace and sustainability.

Companies must first identify the maximum potential and deliver more value by carefully examining the key elements of addressable spends. Second, they must accomplish the expected savings rate by carefully balancing the pace of short- and longer-term savings through rigorous stakeholder engagements and project management. Finally, they should focus on sustainability by reducing the right costs and creating an appropriate cost reduction consciousness across the organization while also redeploying expenditures to areas that drive competitive advantage.

Improving results?

Companies must keep in mind six elements of an effective cost reduction program that will enhance competitive advantage:

1. Vision aligned with corporate strategy and supported by executives

2. Hypothesis-driven approach focusing efforts on areas with highest benefit potential.

3. Portfolio of initiatives that drives an integrated roadmap for change. A portfolio of near-term quick wins and longer-term transformational programs may help create a “self-funding” program that uses early savings to potentially help fund longer-term initiatives with higher results.

4. Experienced program management (including change management) with a proven methodology and supporting tools that drive execution and keep projects on track.

5. A robust benefit-tracking process embedded within existing processes to enforce accountability and determine whether financial value is ultimately achieved.

6. Sustainable initiative focused on transferring knowledge to induce a cost reduction culture, perform change management, and measure the results through performance management systems

Cash management

Effective cash flow management and forecasting are critical to the survival of your business. 49% of respondents indicated that better liquidity and cash management was one of the most important benefits of an enhanced risk assessment.

Conducting thorough reviews of cash management, organizing contingencies for additional cash release and considering possible assets that can be turned into cash quickly are essential actions that can help secure a business.

You should also implement tighter KPIs and associate alerts to them in order to prevent cash shortages. Recording all cash inputs and outputs in a cash management tool may increase process efficiency and provide an accurate picture of your cash position.

Liquidity and working capital management

While cash is not an issue for 26% of the executives interviewed, in order to maintain liquidity given current market conditions, 43% of the companies interviewed are currently considering alternative sources of liquidity such as disposal of assets, shut down or sale of segments/revenue streams, 35% are making an inventory of all debt covenants and monitoring covenant compliance, 33% obtained access to short-term finance facilities/credit, 29% are communicating with lenders, analysts and rating agencies proactively and 23% of the respondents are considering options to renegotiate debt covenants.

Over 50% of the survey respondents indicated that their companies were building working capital measures into the performance objectives of management.

Supplier and customer health

The impact of a failed suppliers or a customer can be devastating to a business. From all the respondents to the survey, 51% said that some key customers were in distress and 24% have already had key customers that have suffered bankruptcy. Also, 53% are seeing deterioration in the creditworthiness of customers and 55% are seeing customers delaying payment on their orders.

Although a more frequent negotiation of payment terms with suppliers allows a more flexible response to business condition, only 37% of respondents had yet started to do this, while over a quarter of them are already delaying payment to suppliers.

A centralized controlling function can provide with a complete picture of a supplier or customer. With information from central procurement about expenditures to a supplier, you can prevent impairing your business due to risky supplier’s health. As much as you can, centralize support functions to process faster the supplier transactions, thus analyzing quicker your cash position.

Divesting assets

Today the defensive divestments have become a strategic necessity for many companies and their approach will depend upon the degree of stress they are under. However, companies may evaluate multiple divestment options simultaneously in order to have the best chances of success.

In this context, 36% of respondents are identifying assets that can be turned into cash, while some 40% believe they will be undertaking divestments of non-core or non-performing assets in the next 12 months. Also, 29% of respondents plan an increased use of strategic alliances.

In a more complex and difficult M&A market, and with accelerated timeframes demanded, a rigorous, analytical portfolio management gives companies a sound basis from which to make divestment (and acquisitions) decisions that are more opportunistic. The more prepared the seller is, the better is its negotiating position and the less time a transaction should take.

After divesting an asset, you may find that certain functions have consumed too many resources to manage this asset. As much as you can, centralize functions (e.g. support) or outsource them (only after you have defined or stabilized their processes).

Other transaction options

If a divestment is not the right transaction strategy, other transaction options can help a stressed company secure its business. A merger or alliance with another troubled business could bring stability. An acquisition by a healthy business is also a distinct possibility for unhealthy companies. More than anything, each strategy requires the company to be prepared in order to ensure shareholder value is maximized.

In order to generate maximum value for shareholders, whether accepting of resisting an external bid, directors need to be able to fully explain recent revenue and profit history, and to communicate credible future strategies and forecasts. This needs to be underpinned by financial assumptions that ca be supported.

Golden rules for successful divestment in a downturn

1. Manage your portfolio – it enables sellers and buyers to mover quickly to take advantage of opportunities

2. Preparation makes a difference – vendors who prepare thoroughly before divestments receive higher returns

3. Communicate with bidder to maintaining confidence and, therefore, momentum and competitive tension

4. Think about who the potential bidders are and present the business for sale accordingly

5. Pursue multiple sale options so you can choose whichever seems most likely to deliver value

6. Construct good sale & purchase agreements and negotiate them better

7. Trade-off between time and value – a short timeframe business divestment may result in a lower value

8. Design an organized process and remain in control of the process and organization

9. Provide incentives for the buyer by researching and documenting potential operational improvements as well as synergies with the buyer’s business

10. Do not limit to financial or legal due diligence – while financial due diligence brings everything back to numbers (earnings, net debt, etc), other areas such as tax, commercial, operational, HR can often bring most value.