Many organizations believe that they have good visibility into their costs and that they are managing them in the best possible manner. The truth could be far from what is apparent on the surface, though.
The iceberg analogy is a good one in this context. What happened to the Titanic should alert businesses about what could go terribly wrong if you do not see beneath the surface to identify – and deal with – hidden costs.
Reasonably accurate (~80%) management reports delivered on time carry greater value than 100% accurate reports delivered a month late
When revenue is hard to come by and organizations battle to keep the cost-to-income ratio low or even flat compared with prior periods, hunting for potential icebergs should be right up there among management's top priorities.
The first step when setting out on this hunt is to gain a thorough understanding of where the various costs lie.
In order to enable management achieve this, it is imperative that there exists an effective cost management framework that classifies and organizes relevant cost information in an appropriate manner. This in turn necessitates that the cost report portrays costs in relation to their underlying drivers and also in relation to the value they are generating.
This article focuses on effective classification and reporting of costs, so as to help management isolate and eliminate or minimize non-productive costs. Further, it also focuses on how an organization should approach the development of action plans for cost reduction.
Principles for Classifying Costs
Generally, the cost reports of organizations could suffer from one of two problems. They may not have sufficient and relevant information, or, on the contrary, they may contain too much information. Typically, from either situation, no real action emerges.
So the question is: What is an effective way of classifying and reporting costs?
There are no easy answers, but three key principles should be followed in the process of cost classification and reporting:
Ownership: Cost should be classified in a manner that can create ownership at an individual business unit level.
Timeliness: Reasonably accurate (~80%) management reports delivered on time carry greater value than 100% accurate reports delivered a month late.
Ability to influence: Cost report should facilitate the ability to decipher which lever needs to be influenced to bring back the cost under question within acceptable levels.
Revenue and Non-Revenue Costs
The traditional approaches to cost management have proposed dissection of costs by classifying them into two buckets such as Direct/Indirect, Fixed/Variable, or Controllable/Non-Controllable.
But measuring the value of every dollar spent by the business should be one of the core objectives of the cost reports generated by the CFO’s office. The efficacy of every dollar spent should be assessed based on the return it is fetching in revenue terms.
The need of the hour, therefore, is to overlay the 'value' of costs being incurred, by categorizing them as Revenue-Generating Costs/Non-Revenue-Generating Costs.
Revenue-Generating Costs. These are costs that are expected, directly or indirectly, to create incremental revenue for the business. Such revenue is generally greater than the cost incurred (>1x, where x = cost incurred).
Examples of such costs, say in the context of a retail bank, would be:
- sales commission paid to dealers or agents, personal loan application verification costs, relationship managers' salary costs, sales team salaries etc.
- premises & utilities costs of sales teams (in full or in part as may be agreed)
- salaries of the product development teams (in full or in part as may be agreed)
Non-Revenue Generating Costs. These may be further sub-divided into Governance & Compliance Related Costs and Other Non-Revenue-Generating Costs.
Examples of Governance & Compliance Related Costs in a retail bank would be:
- Cost of mitigating credit risk
- Cost of ensuring quality assurance
- Cost of measures for fraud control
- Cost of internal audit
- Cost of complying with the Anti-Money Laundering Law
Examples of Other Non-Revenue Generating Costs in a retail bank would be:
- Cost of Human Resources, Finance, Technology, Property & Admin and other similar functions
- Costs of the CEO's office, Director's office, offices of other Management Staff and also cost of Corporate Centre (in part of in full thereof as may be agreed)
- Cost of Marketing & Support Units (in part of in full thereof as may be agreed)
- Cost of Operations (in part of in full thereof as may be agreed)
There are cost lines where there may be a need to apportion a part thereof as either revenue-generating or otherwise. The CFO may agree with the business head on a simple way of apportionment of such costs, for a pre-defined period.
Likewise, there are certain cost lines where the line of demarcation between revenue-generating and non-revenue-generating may be gray. Examples are Marketing’s outbound team's calling cost and the CEO Office's cost. For such lines, too, the CFO may, in discussion with the business head, apportion the costs between the two categories.
Watch Non-Revenue Costs
Quite obviously, a business would prefer to have a greater proportion of costs loaded in revenue-generating activities.
But non-revenue generating expenses are part of doing business. For example, there are governance and compliance related costs that every organization would need to incur, in order to fulfill either a regulatory or an internal policy requirement.
These may be uncontrollable to an extent. But it would be prudent for finance to keep a close watch on such costs.
The sub-category of other non-revenue generating expenses must be under constant watch by the CFO's office as well. Left unattended, this category can accumulate sufficient waste for the management to work upon.
If the proportion of non-revenue generating costs to total costs is greater than the revenue-generating costs, then the organization needs to take a hard look at its cost base. It may have to go back to the drawing board to redefine what its cost base needs to look like, given future growth aspirations.
Categorizing all costs as either revenue generating or non-revenue generating is certainly not an easy task. There are various reasons for this, including those linked with system capability, definitional ambiguity or strength of reporting framework.
However, this will help the CFO set the ball rolling, so that the right questions will start getting asked of cost owners.
Over time, the utility of such a classification may be strengthened by way of automation or even changing reporting structures at a fundamental level.
Other Courses of Action
An organization should also aim to achieve one or more of the following objectives as it implements cost reduction and productivity improvement measures:
Re-direct costs to front-end. Increase the proportion of revenue-generating costs. Review regional/central overheads by assessing the need for central support functions and the size of support teams vis-à-vis sales teams.
Reduce cycle time of processes. Conduct end-to-end process reviews for all key processes across. Aim to improve efficiency by at least 10%. The greater the efficiency, the lower the waste.
Direct every dollar towards shareholder value creation. Is every incremental dollar being spent creating shareholder value? Review every expenditure proposal in this light.
Discontinue unprofitable initiatives/campaigns. Work out the profitability of campaigns and discontinue the unprofitable ones. Review new campaign proposals vis-à-vis similar past campaigns.
Restructure legacy-driven costs. Challenge historical costs such as technology costs, which can be a sizeable fixed spending.
Dealing with Legacies
Many organizations suffer from the legacy of a huge cost base inherited from the past or through an acquisition. The larger the organization, the more complex its hierarchal structure is likely to be, and therefore the more time consuming the exercise of completely resizing the organization can be.
For instance, technology costs are often sizeable, non-controllable costs due to the complex nature of IT architecture and set-up. Sadly, there are no quick solutions here.
Having said that, there have been instances of large organizations that have set out to make significant changes around technology in order to bring down costs over time. By simplifying the IT infrastructure and organization, they aim to reduce overall costs.
The sooner an organization embarks on such a change, the better positioned it will be to protect its return to shareholders in the years to come.
These organizations can look at new market entrants to see the benefits of establishing a relatively variable cost model with minimum fixed costs or overheads. These market entrants have the advantage of:
- building a "hire as your grow" model, thereby minimizing staff costs
- operating from home or fully equipped ready-to-use business centers, thereby not having to commit rentals for a long period into the future or for that matter expend huge cash to own a building
- operating on cloud platforms that house their servers, rather than owning them, and using enterprise software on a pay-as-you-use basis
Established organizations would do themselves a favor by expediting the process of revisiting and where necessary re-engineering their cost base to stay profitable and competitive in a dynamic & uncertain business environment.
About the Author
Ramesh Narasimhan is the founder and Principal of Singapore-based Value Consulting Asia, which provides CFO advisory and implementation services. He is also a Senior Director at StraitsBridge Advisors, a specialist firm providing advisory and execution support for CFOs in banks and financial firms.
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