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Cutting costs – everyone’s at it. One of the features of severe economic conditions is a renewed focus on the containment and reduction of costs. Why is it that the first casualty in any cost-cutting exercise is a usually a very significant area of discretionary spend – the free tea and coffee provided to employees?

Research by the US Conference Board in the 1990’s suggested that efforts to cut costs were far from being universally successful. Of the companies they studied, only 33% saw a decline in costs with 30% of organizations actually experiencing increased costs. 22% of organizations terminated the wrong people and fully 80% reported a collapse in employee morale. With such a dismal record, why does the indiscriminate, across-the-board, slash-and-burn approach persist?

In 1921, the US economist Frank Knight, published a seminal work entitled “Risk, Uncertainty and Profit” in which he distinguished between risk in which the parameters are known and quantifiable and uncertainty where they are not. Imagine a jar filled with 100 marbles, 50 are white and 50 are black. Reach in and pull out a marble without looking – the chances of picking a black marble are 50%. Risk. Now imagine a jar which contains one or more marbles any number of which may be white and any number black. What are chances of picking a black marble? Uncertainty.

Recessions are fundamentally uncertain times. How long will it last? How deep will it be? Will customer-behaviour or market dynamics be irrecoverably changed? In the face of this uncertainty, managers reach for something which they can control and which appears to be action –oriented – the cost cutting memo. Recruitment freezes, overtime bans, cancelling magazine subscriptions, reducing stationary stocks, cutting sales force travel, reducing advertising spend and scaling back on R&D are the result.

Traditional cost accounting systems provide little support for those trying to adopt a more constructive and scientific approach. In 1994 in an address to the IMA in New York, Professor John Shank described traditional accounting as “at best useless and at worst dysfunctional and misleading”. The lack of direct costs in many businesses, such as service industries, and the substantial shared overheads or shared service costs means that many companies have little or no idea, at a granular level, as to the cost and profitability of customers, products, services and delivery channels. 

The methodology of Activity-Based Costing (ABC) addresses the difficulties of traditional approaches by creating the linkages between products and services, the consequent demand on activities and processes, and the consumption of cost. Understanding cost behaviour, the correlation between volumes and different costs, cost drivers, unused capacity and customer and product cost and profitability start to provide the insight required to support rational, intelligent management decision-making in the face of extreme market conditions.

Cost cutting, like the adoption of a new costing methodology, is a social issue as well as a business issue which requires a willingness and commitment to change and improve. ABC models dramatically improve the quality of decision-making by enhancing the understanding of the linkages between cost, effort and output. On-the-fly, cost cutting efforts designed to deliver short-term benefits often have limited success and may compromise the long-term sustainability of the business. Tom Peters summed it up well in Inc. Magazine in December 2008:

“Instant, mindless cutting of R&D or training or sales force travel in the face of a downturn is often counterproductive – or, rather, downright stupid. Tough times are in fact golden opportunities to get the drop, and the long-term drop at that, on those who respond to bad news by panicky across-the-board slash and burn tactics and moves that de-motivate and alienate the workforce at exactly the wrong moment.”

This article is based on a presentation given to the South African Institute of Chartered Accountants’ Strategic Management Accounting Forum in Durban on 23 February 2010.