This is the fifth in an 8-part series especially for new subscribers to the Creative Finance & Management email newsletter. Every week we are sending you an article aimed at helping you to think about a different aspect of the financial management of your business. This is in addition to the normal bi-weekly newsletter. We are doing it to give all new subscribers the same orientation to the way that Charis FD thinks about small business performance management. That way we can have confidence that all our subscribers have been given the benefit of foundational advice in all aspects of business performance management.

If you miss any of these articles, don't worry. They are on the Creative Finance & Management blog. Just look for the "New_Subscribers" tag.

These are the articles in the New Subscribers series:

1. The ingredients for success in Finance
2. Strategy and Planning
3. Business Change - implementing your strategic plans
4. Measurement and Management go together
5. Paralysis without analysis
6. Your Finance team - a valued asset
7. Stakeholder management - the importance of keeping people happy
8. Internal Control - 3 fallacies that add risk to your business

Here we go: ...

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Paralysis without Analysis

Over the last three articles that we've sent to you as part of our new subscriber series we've covered the points around the outside of the business performance management wheel - strategy, change, and performance measurement/reporting. There is one more thing to talk about briefly before moving on to talk about the Finance function (next time) and then other key concerns such as risk, controls and stakeholders. That is performance analysis. I like to call it performance improvement analysis.

If you've read the previous articles in the series you will have picked up the philosophy underlying my advice - be intentional and analytical. Mostly, though, we've talked about being intentional - if you mean business, then you are intentional, you know where you want the business to get to and you know how you intend to get there. And you know whether you are making progress because you are intentional about measuring performance.

Now I want to talk about being analytical.

I started writing something a bit philosophical here at first, and then I heard myself yawn! So I deleted that. Do you want to get under the skin of the performance of your business? Do you see things that are happening and wonder why? Do you wonder which of your products is really the best? Is it the one that sells the most? Do you wonder which of your customers is really the most important? Is it the one that buys the most?

Analysis is all about asking "why?" And "what if?" It can be as basic as "why have we made a loss this month?" Or it could be more complex, such as, "what if we offered early payment discounts of x%?" Or even more complex, like, "what if we paid £xmillion to buy a business?"

It doesn't have to be financial data. Other numerical analysis is useful too. In fact, if you can make it numerical or financial then it is often easier to get a qualitative understanding of the issue - i.e. is it good, bad or ok. One example of numerical analysis that I dealt with in one large group was looking at absenteeism. How many days of work did we lose through sickness? And in which locations? Which teams? Was it seasonal? Was it improving or getting worse? You may be asking, "where is the why question in that?" Well, think about, "why are our staff costs so high?" There are accepted benchmarks around, so we could tell whether the sickness absence rates were better or worse than the average for those types of people. That enabled us to focus on particular areas, ask further questions and put actions in place to improve. Reducing absenteeism eventually led to lower staff costs, because we didn't need as many people to do the work. That's another example of what we saw last time - that measurement enables you to manage and therefore improve.

Analysis enables you to drill right down to cause and effect relationships. The idea is that if you can measure and manage those cause and effect relationships then you can reduce things that drag the business down and enhance things that positively influence the business.

Many big businesses suffer from what they call, "analysis paralysis", which basically means they have gone too far. They have analysed everything and now have so much information that they can't make sense of any of it. Smaller businesses very often suffer from the reverse - "paralysis from lack of analysis"! Have a think about what information you have available in your business. How well do you really understand the cause and effect relationships?

But where do you start? Here's my suggestion: Take a key performance measure, one with strategic importance, and ask, "what would I have to do to make it better?" There may be several things you could do. Get information on what the current situation is for each of them. Then for each of those things, ask, "what would I have to do to make that better?" And keep on going through that cycle until you feel you have got somewhere close to root causes. Along the way you will have analysed your business performance and got valuable insight into the things you have to do to improve.

Here's an example: Let's say that in my business, staff costs represent 70% of the cost base. What would I have to do to make that better? Reduce headcount or reduce remuneration. Let's discount the latter for now. So we should analyse how our headcount is made up - by department, by grade, by location, etc. What would we have to do to reduce headcount in each of those categories? Reduce work or become more efficient. So let's analyse what work the people are doing and how efficient are they - what do they produce and how many do they produce per day, hour, week, month, whatever is appropriate? So with that information, what do we have to do to reduce work? Stop doing certain things - so what would be the impact? And what do we have to do to become more efficient? Do things quicker. So in order to see which things we need to do quicker, we need to analyse what activities have to be done to produce the outcome and how long each activity takes. Then we can look at the main activities and ask for each of them... you've guessed it! "What would we have to do to make that better (or quicker)?"

So to conclude, in order to manage business performance you need to measure it first. But you need to do more than that. You need to understand what the figures are telling you. And in order to understand, you need to analyse - financially, numerically and logically.

But one final word of caution - only measure things that are useful and you can act upon. If you find yourself regularly looking at figures that you do nothing with, then ask yourself what they are for... and if you can't find a satisfactory answer, STOP producing them and go and find some more useful analysis to look at!

In the next newsletter for new subscribers we'll look at your Finance resources - people, systems and processes. Are you getting the best out of them?

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Until then, take care...

If at any stage you want to talk to us, we're quite happy to give you a call to talk more about your business and the challenges you face. And you may be eligible for a free Finance Strategy Review session. To set that up either email us at enquiries@charisfd.com, remembering to leave your phone number and email address; or go to our website and complete the contact form.

Thanks again for subscribing to Creative Finance & Management. We hope you find it helpful.

© Charis Business Consulting Limited 2009

The best way to cut overhead costs in big companies

This article describes the way that the principles of Activity Based Costing were used to cut overhead costs by approximately 20% in one large group that I worked for.

Activity Based Costing is the term given to a particular way of analyzing costs in order to manage them more effectively. It arises from the premise that costs are driven by activities. In other words you don’t just decide to employ a new person or buy materials or engage a consultant for the sake of it. You do those things in order to perform activities in the business. The more complex the manufacturing process, the more things have to be done to make the product (activities), and therefore the more people and materials have to be purchased to make it.

So thinking in this way is different to the normal way of looking at costs. Normally you have a profit and loss statement that says you spent so much on employing people, so much on occupying a building, so much on raw materials, etc. Looking at things that way is not completely useless, but it only goes so far. In a sense it answers that “what?” question. What have we spent money on?

Activity Based Costing (“ABC”) goes deeper to try to answer the “why?” question. Why do we spend money? What are the things we are doing that mean we have to employ this number of people, or buy this much raw material?

Now, in my experience, ABC is usually applied to manufacturing processes and direct costs. It allows insights to be gained into the costs of products. For instance, you may find that a costly activity in the process of making a particular product is the initial set up of the equipment. Therefore, you can make that activity more efficient be lengthening production runs. ABC therefore tends to go hand in hand with process analysis, because you can’t do ABC without analyzing the process. ABC is simply putting a cost on each activity in the process. Then disciplines such as Six Sigma, Total Quality Management, etc, come in to help to identify how the process can be improved. ABC leads to product profitability analysis and customer profitability analysis. In fact, it opens up many new ways of looking at the profitability of the business.

The one thing that is normally set on one side in Activity Based Costing is overhead cost. Overhead cost is primarily fixed or long term step costs, such as business management, Finance, HR, premises, legal, insurance, and so on. Old school management accounting would have said that if I want to work out the profits of each product, then I would have to allocate some of these overheads to each product on some basis. However, when I studied ABC I was told that allocating overheads to units of product (or anything, for that matter) was pointless, since products do not drive overhead costs. So it would be misleading to say that I make £2 profit per unit of a product, because it suggests that if I double my sales of that product I can make additional profit at £2 per unit. And that’s simply never going to be true. Doubling output may not lead to doubling overheads (one would hope not normally!). Or it may lead to more than doubling overheads if the additional volume takes the business past a major step (e.g. warehouse capacity). The point was that overheads should be left out of the analysis because it distorts things by including them.

That insight was music to my ears when I first heard it! At the time my monthly management reports were divided up with a page for each product. The direct costs were easy (in my case) to put against each product. But at the bottom of each page was an overhead allocation. Guess which bit of each product profit statement drew the most attention and argument each month? Yes, the overhead allocation! How much management time and energy was being wasted over something that was, to be honest, fairly arbitrary?! Overheads should be managed differently, and product managers should not have to justify the profitability (or otherwise) or their products with overheads arbitrarily allocated to them. I came straight back from my ABC course and took the overhead allocation out of the product profitability statements! Then we really started to focus on the real issues for the products – sales, margins, operational process efficiency.

But having set aside the overheads when looking at product or customer profitability, one cannot just ignore them. Having said they should be managed separately, how should they be managed? Certainly when I studied ABC, it did not seem to provide the answer. Perhaps I missed something!

Later on in my career I worked in a large utilities group, supporting their HR function in Finance and analysis matters. Across the group we spent hundreds of millions of pounds on overheads. And when the time came to tighten the proverbial belt, we had to find a way of getting to grips with the costs of overheads in different functions across different parts of the group. For example, the costs of HR did not just consist of a central HR department. There were about 12 different central HR directorates (ranging from Talent Management and Learning and Development through to Health and Safety and Occupational Health). Then there was the group HR Service Centre. And then each business unit had its own HR functions.

At my suggestion, to tackle the challenge we used the principles of Activity Based Costing to analyse the cost base and guide the decisions over where to make cuts.

First we asked each department manager to complete an Excel template. In this they listed each activity undertaken in their department, and against each activity they put a cost and headcount. The total cost and headcount for the department had to add up to the annual budget for the department. We also asked them to complete the latest forecast.

Since that information was still a little too granular we also asked the functional heads to categorise each activity in different ways. First, the activity driver – legal/compliance requirements; services required by other parts of the business; strategic initiatives; and “other”.

Speaking for the HR function, the analysis was pulled together practically by my Management Accountant, categorised by a 3-4 person working group, consisting of a couple of BU and central HR directors and myself, and then validated by the HR Leadership Team (the Group HR Director and her direct reports, including the Group Directors and the BU HR Directors). There were more than 400 rows of information, adding up to around £75m+ if I remember correctly. But, using the activity information in the data received, my Management Accountant and I came up with reports that could show the costs summarized in a few different ways to help the rather painful discussion.

The painful discussion was, having analysed the costs and categorized the activities, going through and further marking proposed savings against each activity. This started with senior HR Directors in each business unit discussing their own straw man proposals with the BU Managing Directors and their management teams. Then more pooling of thoughts and opinions within the HR Leadership Team. Then culminating with a presentation of a proposal by the Group HR Director to the Group Executive Committee.

The target cost saving had been given at the outset – there were to be 2 or 3 different proposals – small, medium and large! In other words they wanted to know what activities would be lost or cut back if they asked for cuts of 15%, 25% and 40%. So we knew what we were aiming at, at least in terms of analysis. The unknown was what the final savings figure would have to be. Each proposal to cut activities had to be accompanied by an assessment of the impact, strategically, operationally and tactically.

So you can see that ABC can be applied to overheads very easily, and gives a valuable and effective way of examining overhead spending especially when drastic cost savings are required.

The discussions that resulted from the analysis were very focused, well-informed and pitched at the right level of detail. The decisions were made confidently, in full knowledge of the impact.

… The sting in the tail of this story is that my own department was one of those where cuts were proposed in our activities, and the process resulted in my own redundancy (amongst many others)!!

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