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Agefi Luxembourg

– septembre 2022
Businesses have faced enormous uncertainty since the COVID-19 pandemic started. Top management had to react and think over their short and long-term strategies taking into account that the virus could be with us for a while, leading us to work as lean as possible and simultaneously rightsizing their expenses.
Before going into details it is worthy to determine what costs reduction policy means. A costs reduction policy according to Mersereau (associate professor who worked closely with Henri Bouquin, known as the “father” of the management control) is a “managed cost reduction defined by the elimination of a constant acquisition as well as a consumption of resources and an improvement in the link between cost and added value”. This definition emphasizes the notion of a cost reduction “managed”, meaning that it is subject to objectives, measures and follow up within the framework of management control.

Moreover, this integration of cost reduction in the objectives of an entity allows to control the efficiency of a project (KPI).

In this regard, it is important to differentiate the notions of “effectiveness” from “efficiency”. Effectiveness is defined in relation to the achievement of objectives whereas efficiency is described by the ability to minimize the ways to develop and achieve the objectives.

The definition of cost reduction policy also applies on modeling the consumption of resources and the link between added value and cost. Hence, it seems more relevant to consider two types of policies. The first one is the policy with constant added value, where effort and management are related to the elimination of the internal consumption of resources. The other type of policy is related to increasing added value brought by subcontractors throughout their dedicated assignments. The latter policy is often used by the companies which are frequently using outsourcing as a way of partnership to lower their purchasing costs.

In order to be an effective costs reduction policy and not a one-off or a short-term measure, cost reduction must be part of the entity policy. Indeed, it must be part of the long-term objectives to be reached by the company. To do so, companies are subjected to implementation plans and they allocate all the resources identified as necessary for their realization.

Cost reduction policy is linked to the company’s strategy. The decision-makers assess the opportunities offered by the market as well as internal strengths in order to define the objectives and action plans accordingly. Furthermore, it is important to highlight that a costs reduction policy should be driven as a qualitative and improvement approach and not to be realized just to “improve” the result disclosed in the financial reports.

Therefore, it is a question on whether the offshoring process can be an asset or not despite the advantages and disadvantages of a cost reduction policy.

Potential benefits of cost reduction policy

Many reasons besides the COVID-19 pandemic have led companies to reduce their expenses. Indeed, cost reduction policy can be driven because of alarming and poor results, competition as well as a vision of growth. Usually, entities are accepting such policy to improve their financial results. It also can be used not only to obtain a competitive advantage on the market but also to invest earnings into various areas of growth.

Nowadays clients are more careful and picky about price and quality. Consequently, the way to attract them by lowering price or quantity is to reduce the costs. This can create more demand, more production, hence, more employment. In this regard, increasing competitive strength stimulates more exports to the industry.

In addition, cost reduction increases profit and somehow allows entities to potentially distribute more dividends to their shareholders, higher bonuses to their employees and additional benefits (i‑e: housing allowance…) in order to improve relationship between the top management and the staff.

Not always seen as a positive sign

Several techniques can be used to reduce costs such as material control, automation processes, market research, labor control (personal evaluation and merit rating), etc. However, it makes sense to communicate seamlessly towards the organization and employees as in the beginning of the cost reduction plan, it may not be appreciated by the staff. The key to reach objectives implies an active participation and cooperation of the employees.
As mentioned previously, reducing costs can lead to lower prices. Nevertheless, it is important to mention that this aspect can trigger a price war with the consequences of driving down the average market prices. Moreover, it can change a brand perception throughout its position on the market. A company with a quality-oriented brand image can risk losing customers if it changes its message through aggressive marketing practices over time.
Other danger of a cost reduction policy is that the quality may be reduced gradually and even sacrificed in the end. This matter should be carefully reviewed and followed up since it can have dramatic impacts if it is not welcomed in the market and giving away customers to the competitors as a consequence.

Furthermore, it is possible that reducing some costs may not be tangible and permanent due to the fact that the expenses may be brought back to the original cost level such as the variation price for some materials.
Lastly, it is necessary to clarify the organizational goals and objectives which are assigned to department managers as a conflict may arise between those two. Indeed, reducing costs is not always the best idea as it can lead to additional costs to the entity.
Let’s take a concrete example with a manager in the invoicing department who received the objective to decrease the number of employees in his team. He succeeded to reach this goal at first but noticed many more mistakes from the team afterward due to the fact that the number of invoices did not change and were allocated to fewer employees. Hence, they had to make several credit notes as well as calling for recovery and debt collection agencies leading to additional and unexpected costs.

Offshoring: is it a real asset?

Almost all business sectors are directly or indirectly affected by offshoring. This phenomenon consists in separating the place of some services/manufacture from their place of consumption. In most cases, companies relocate their activities in a country with lower production costs. Nevertheless, we can wonder whether the effective advantages and disadvantages of this trend.
First of all, the main reason for the development of this phenomenon is the low cost of production. Obviously, the average salary in a developed country will be more expensive than the one in a developing country.
Moreover, the competition in the offshoring market contributes to reduce the cost of production by offering affordable prices. Work flexibility is another doubtful advantage which will relieve business managers from their responsibilities as, by outsourcing its activities, an entity only needs a few employees to control and monitor the project afterward. However, controls and reviews from the headquarter team imply more time-consuming in order to identify and correct errors from the offshore team which has a limited view of what is required. In some cases, we can wonder about the effective “cost reduction”.
On the other hand, offshoring does not always mean efficiency. This should be pointed out. Somehow the quality of production will be compromised which can affect not only the level of production but also consumer safety. As a result, company’s brand reputation can significantly be damaged. Nestlé was an example with the pizza and horse meat scandals illustrating the vulnerability that arises from international outsourcing. What’s more, the environmental standards are becoming stricter which is questioning the use of offshoring due to lack of investment and compliance to meet these standards.

Furthermore, the offshoring can be risky since some countries do not possess the appropriate infrastructure to ease the implementation of costs reduction projects due to limited quality transport networks and especially because of logistic issues.
In the end, rushing into suboptimal contracts with service providers is definitely not the solution because of overpriced fees and sometimes unfavorable terms. Hence, companies should think twice on how to get more contract value with third-party service providers. Also, reading carefully the contract and especially certain terminologies, as well as getting to know what is required to exit the contract can be neglected by entities leading to additional fees, even if it sounds more reasonable to check them out. Offshoring risks are multiple. That’s why a deep and serious study should be performed before relocating any company’s activities.

A better way to think

Companies should think of restructuring their business before implementing their costs reduction policy in order to identify potential growth and take advantage of projected market place trends.
Understanding the financial situation of an entity is extremely important to analyze different scenarios depending on potential outcomes and external factors that could impact positively or negatively financial statements.
Cutting costs definitely should not be under-estimated which could lead to dramatic scenarios.

Intelligent cost reduction may take into consideration the organizational structure as a whole to make smarter savings. Indeed, applying such policy on smaller project or entity within a group could help to identify potential issues that will have a bigger impact on the entire project. Therefore, it is necessary to evaluate these options in order to avoid additional and unexpected costs, depending on the company’s industry. Finally, digitalization and automation can significantly improve processes in a fast-changing environment.

Par Julien Fournillon, Senior Consultant Square Management.
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