One objective of middle market companies that never changes is to constantly reduce their costs and thereby improve their bottom line and cash retention. Manufacturing companies need to take a different approach to service provider costs. Here’s how.
In the manufacturing environment much of the cost reduction effort takes the form of reducing the costs of key material inputs. Manufacturing companies typically require their major raw materials suppliers to re-bid periodically—usually every year but in some cases every two to three years. A common practice is to split these purchases between two or three suppliers. The low cost supplier is allocated an increased share of purchases—but not all of them. This serves to maintain price competition and avoid dependency on a single source of supply. A strategy of keeping suppliers hungry for more of your business while enabling prime suppliers to have a large chunk of it helps to keep costs low. It is a well tried process and it really works!
The Service Provider Side of Cost Reduction
As for the services component of corporate costs, a competitive pricing approach, as Borat might say, yields “Not so much”. Why aren’t service provider costs amenable to the same approach as the cost of materials? Part of the reason is that the switching costs for changing service providers tend to be much greater. With services you are paying for quality as well as quantity. Especially with services that require integrating your intellectual capital with the service provider’s, the value you get tends to increase over time. So it doesn’t make a lot of sense to change your legal team, bank, insurance provider or auditor every year. Does that mean you shouldn’t compare the deal you are currently getting from a service provider to the deal you could be getting from another? Of course not, but a different approach is going to be required. I would however suggest two stipulations.
Firstly, the gain has to be worth the cost in disruption if you were to decide to change the service supplier. I would suggest a rule of thumb: the initial cost reduction has to be at least 25%. Second, there has to be a defined plan to maintain and even increase the cost savings over time. You should be seeking not a one year wonder but a 25% reduction that stands the test of time.
How to Drive a Successful Program for Reducing What You Pay to Service Providers
To drive a successful cost reduction program, the CFO should not play the “Lone Ranger.” After the CFO has performed the initial scan to identify potential cost reductions, he or she will need to get the full backing from the CEO. The strength of current relationships with incumbent service providers may produce some early push back. Lawyers, bankers, insurance providers and auditors are generally not distant suppliers but interact frequently with your company. Aim to create a conservative, comprehensive projection of the anticipated cost saving. The savings can be expressed in terms of impact on net profit growth for the year or on the management bonus program. After all, at this stage, all you are doing is an analysis. This should help to disarm opposition from those in the company who have a vested interest in the status quo. In subsequent blog articles I will examine specific areas of savings in legal, banking, insurance and auditing expenses where I have achieved a 25% cost reduction using these strategies.
About the Author
Peter Duff is a versatile operating executive with a long record of accomplishments running a wide range of companies. As an EVP, COO and CFO, he has been responsible for significant improvements achieved in revenue, margins, expense and cash levels. Contact or learn more about Peter here.
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