What is the Cost Reduction Process? Meaning and Steps

What is the cost reduction process and what is it all about? Find out with Tipalti’s modern expense management tools.

The cost reduction process is a business practice nearly all organizations should plan for in order to keep growing and profiting.

Whether you’re dealing with market downturns or anticipating future financial losses, a well-executed cost reduction strategy is what you need to save on the budget and maintain profitability. Two-thirds of all companies worldwide expect to undergo a cost reduction process in response to growing financial pressures.

But a poorly configured cost reduction process can mess with your internal operations and even end up costing your company more in the long run. 

Discover how successful management teams deal with financial uncertainty through meticulous cost reduction strategies and find out what you can do to power your business through dire financial situations.

What Is a Cost Reduction Process?

Cost reduction is the business practice of reducing expenditures to increase profits. The complicated part is identifying which expenses get the cut, which aren’t providing sufficient value for your budget, and what process optimizations you can make to improve spending efficiency.

Cost cutting may involve “trimming the fat” off the budget. A business might reduce pay, close facilities, or cut spending on professional services like consulting. But more involved changes include streamlining your product lineup to make better use of raw materials and shifting operations or personnel among departments to lower costs. It’s a far more dynamic procedure than it initially sounds and is rarely as simple as merely cutting expenses.

While most management teams see cost reduction as a short-term strategy for temporary market shifts, other cost reduction tactics aim to boost long-term profitability as well. Companies often turn to cost reduction before or during periods of financial instability to maintain profitability or provide for shareholders demanding a return on investment.

Why Is a Cost Reduction Process So Important?

A lot can go wrong in cost reduction, and messy implementation can ruin an otherwise excellent effort. Accidentally cutting critical expenses can reduce the quality of your products, make the job harder for your employees, jeopardize your operations, and actually lower your profits in the end.

For instance, poorly planned cost reduction:

  • Frustrates employees. When you cut spending on essential tools and services, internal employees may not be well-equipped to handle their tasks, restricting productivity.
  • Risks a labor shortage. Removing employees is a typical cost reduction tactic, but doing so too often puts you at risk of a staff shortage. You’ll also have to pay unemployment benefits, cover rehiring costs, and potentially lower employee morale. And if you lose a critical employee by accident, you risk overworking your current staff.
  • Results in poor customer experiences. The quality of your product or service may plummet with excessive cost-cutting, resulting in poor customer satisfaction rates.

It’s no wonder then why 2 out of every 5 businesses mess up. Cost reduction must be a formal, well-planned-out strategy within the organization that emphasizes long-term sustainability and has the support of upper management and internal stakeholders. Changing spending policies “on the spot” rarely generates desired results.

The strategic approach to cost reduction is unique to every business, as each one has its own spending habits, preferences, and market circumstances. These factors all impact how cost reduction functions within a company.

Cost reduction takes plenty of deliberation, but the advantages of succeeding are clear. You get more out of your budget and can function as a more efficient competitor in your industry.

What Does a Successful Cost Reduction Initiative Look Like?

Cost reduction must go beyond simply removing purchases from the company invoice. While cutting spending can certainly help, experienced management teams understand the importance of optimizing spending policies and operations to get more value out of the budget. They approach cost reduction while ensuring that the business has a solid foundation on which to operate despite lower expenditures.

The Goals of Cost Reduction

The general idea is to reduce unnecessary “bad” costs so that the business can redirect funds into “good” spending that enables better productivity. More specifically, cost reduction aims to:

  • Consolidate purchasing across the organization, optimizing procurement when multiple departments or teams need the same resources.
  • Reduce waste by eliminating spending on products, vendors, or processes that aren’t “pulling their weight.” For instance, you might cancel subscription services you aren’t using to optimize the supply chain.
  • Improve quality control methods to reduce the chance of product returns from dissatisfied customers.
  • Substitute more expensive procurement with cheaper options, especially if consumer demand calls for lower-cost solutions.
  • Outsource specific tasks to contract work. For example, accounting tasks might go to a specialized accounting firm, which can do the job more efficiently.
  • Repurpose existing tools and services in new ways to negate the need to purchase more.
  • Optimize your workflows to cut down on redundancies, increasing efficiency and lowering operational costs.
  • Utilize technology to monitor business operations and scan for cost reduction opportunities.

A cost reduction program doesn’t necessarily have to touch on all these points. It must address only the strategies that benefit your specific organization the most.

Pinpointing and Categorizing Expenditures

The first step in any cost reduction procedure is identifying which expenses your analysts should be inspecting. Costs are many and varied in businesses today, ranging from the price of raw materials in a factory to the budget allocated for professional services like consulting and marketing.

To make sense of this vast amount of data, categorize your expenditures as you discover them. Most companies deal with:

  • Essential costs are necessary to keep the gears turning. The business can’t avoid these critical operating expenses, but you can still look for opportunities to optimize your spending in this area.
  • Positive costs go towards organizational growth and are important for the overall business strategy. They mainly focus on helping the business meet the needs of its customer base.
  • Negative costs are a waste of resources and do not contribute sufficiently to the growth strategy. For example, if you’re spending too much on a low-return product line, it may be time to pare down spending in that area.
  • Distinguishing costs make your company unique and define how it differentiates itself from its competition. Think about what you offer to your customers that nobody else can. Spending a little extra in this category can be beneficial, as it emphasizes your market advantage.

Your analysts must find ways to mitigate negative costs while boosting or optimizing other expenditures. These categories of expenses show how cost reduction is a strategic and data-driven process.

Including a Spend Analysis

Spend analysis, also known as a cost reduction analysis, is a form of procurement optimization and a crucial step toward managing business expenses.

Analysts must evaluate historical spending systematically to get a holistic view of the company’s financial activities. This information enables them to:

  • Find new ways to reduce procurement costs.
  • Prioritize cost reduction opportunities by how much the business can save.
  • Manage risks related to cost reduction.
  • Enable visibility into corporate spending.
  • Strengthen supplier relationships, communication, and contract compliance.

Spend analysts or procurement managers can identify which vendors are most valuable to you and which are underperforming. They can determine what long-term contracts are most critical to your operations and search for the most significant opportunities for cost reduction in your procurement system.

Developing a Tailored Strategy for Your Company

Collecting all this spending data won’t make an impact if you don’t align it with a cost reduction strategy. A strategy must be both clear and understandable by anybody within an organization.

What roles and tasks does everybody have in an overall cost reduction program? What returns can you expect compared to the risks? How does the strategy change over time in the face of market fluctuations, changes in consumer demand, and the introduction of new technologies and competition? And how do the relationships between your business departments impact cost analysis? For instance, one might attribute high spending in the accounting department to an inefficient procurement policy.

We call cost reduction a business strategy because it’s a full-time effort, not a one-and-done deal. A strategy needs to go beyond cutting small costs for marginal gains. Sweeping changes are also vital, such as streamlining product lineups or even pulling entirely out of a market if it isn’t providing you with sufficient returns. Be creative about cost reduction by researching what your customers value in your brand and determining which forms of spending aren’t contributing to those demands.

A strategy also requires buy-in from upper management and accountability from everyone, not just the procurement or finance teams. Treat it like a business transformation where searching for savings opportunities becomes an integral part of the company culture. Find ways to incentivize employees to improve their spending habits accordingly.

And like any other business strategy, cost reduction is never static. So review and update your efforts regularly to evaluate new savings opportunities as they come up.

Cost Reduction: One Step at a Time

Understanding what cost reduction aims to achieve is the easy part. Putting a planned-out strategy into action takes data analysis, spending control and governance, and comprehensive supplier relationship management. This step-by-step breakdown will jump-start your efforts to mitigate expenses while reducing risks related to cost reduction.

1. Define Your Goals

Begin with defining your ambitions for this cost reduction program; by how much do you intend to boost the budget? The target depends on the organization’s minimum operating budget and long-term profitability goals.

But don’t just write down the first arbitrary number that comes to mind. Double-check that your goals are mathematically achievable and realistic based on actual spending data. Most of your workforce will ignore them otherwise, as they won’t take it seriously.

2. Assess the Potential for Cost Reduction

Goal-setting is much easier when you complement it with cost analysis, the practice of identifying and categorizing expenses and determining what business activities drive the most spending.

A cost analyst might use internal benchmarks to compare how one department’s spending compares to another and whether any differences are justifiable given returns on investment. External benchmarking is also useful to compare the business’s performance with that of similar competitors in the market.

Remember our discussion of “distinguishing” costs earlier? Keep those in mind, as it’s sometimes wise to spend more than your competition in certain areas if they contribute to what customers value in your brand.

3. Gather Spending Intelligence

The next step is to gather representatives from across the company. The leaders of each department are more likely to know the intricacies of purchasing habits, operating expenses, overhead costs, and other details specific to that part of the business.

Try to gauge insights from all teams in different sectors. The more input you have, the more likely your cost reduction measures will benefit everyone.

Once you’ve collected spending intelligence, work on sharing the data effectively so the entire company can utilize it for more informed spending decisions. This “democratization” of the data builds transparency and ensures everyone trusts that the cost reduction program is for the benefit of the company as a whole.

4. Pinpoint Reduction Opportunities

Sift through the spending analytics with a fine-toothed comb to discover areas where you can make spending cuts. Ambitious cost reduction initiatives need multiple opportunities, so let your analysts take their time to achieve their goals.

A common pain point, especially for businesses without centralized procurement systems, is maverick spend. Go through the transaction history for areas of uncontrolled spending and find ways to redirect those funds toward more strategic procurement plans.

For example, employees might use the company credit card for smaller purchases since it’s fast and convenient, but those small amounts add up. Encourage them to choose from preferred suppliers or consolidate their purchases to take advantage of bulk pricing.

Another area to focus your attention on is travel costs, as employees attending remote meetings, seminars, and events will require compensation. Not all travel is avoidable, but you can encourage more frugal spending on these trips by cleaning up the company’s travel policy and spending guidelines. Better planning is also an avenue to take. Late reservations being notoriously expensive, try to book hotels, restaurants, and venues in advance.

Also think about potential consequences: if you were to act on a cost-saving opportunity, what would be its impact on your current workflow? Could your changes cause problems for certain business processes?

Once you have a list of cost reduction opportunities, prioritize them by importance and practicality. Focus efforts on ones that will save the most or ones that are easy or quick to implement.

5. Develop Your Cost Reduction Program

It takes the combined efforts of project managers, department heads, and procurement teams to develop a successful cost reduction program. When it’s time to sit down and develop a cost reduction program, start with:

  • Developing initiatives. What can you do about problematic areas of spending? Using quantitative data and qualitative feedback from employees, come up with solutions and policies to make better use of funds.
  • Discussing the changes. Discuss with other department representatives to analyze the effectiveness of proposed solutions. What potential side effects might ensue from them? And are there other ways to approach cost reduction?
  • Prioritizing each step. Which solutions should get the most attention first? The ones that result in the most considerable savings are a natural choice, but you can also aim for the ones that are easiest to accomplish to get the program started on the right foot.
  • Assign leadership roles. Executing cost reduction in the field requires a dedicated team and a project manager, whose responsibilities include using data insights effectively and ensuring that steps taken result in tangible savings.

The intention is to create a foundation for the rest of the company. The entire workforce should quickly understand the goals and enthusiastically follow these new solutions.

6. Get Everyone on Board

Cost reduction relies heavily on cooperation between key individuals and stakeholders, especially those who face the largest impact from changes in spending. Employees are often reluctant to participate, as cost reduction can easily compromise the tools and services they depend on and negatively impact their operations. It’s important to emphasize their concerns when designing cost reduction initiatives.

Be careful not to make discussions too antagonistic; spenders shouldn’t be under pressure to explain why certain costs are so high. Instead, talk about the impetus behind the spending and brainstorm adjustments that can mitigate the expenditures without compromising workflows.

A corollary to cost reduction is forming a culture of accountability. All departments must play a role in spending management, not just the procurement or finance teams. Putting cost reduction in a silo all by itself makes employees feel “left out” as if their efforts don’t matter. Workers must feel confident in their place in overall cost reduction.

The final component to include is the company’s list of suppliers. Procurement contributes to cost reduction by negotiating with high-value contractors and creating more favorable contract terms. We’ll discuss the vital role of procurement later.

7. Establish a Structure of Governance

Governance is how a business controls its operations through policies, processes, and role assignments. Who is responsible for which tasks, and what processes must they follow to achieve their goals?

A specific and clear model makes cost reduction an intentional effort rather than a nebulous ideal. In the context of cost reduction, governance determines who undergoes the following tasks and how:

  • Who monitors spending data and identifies cost reduction opportunities?
  • Who will implement changes in the workflow for a more productive use of resources?
  • How should the company negotiate more favorable vendor contracts?
  • What tools should the company use to accelerate cost reduction?

Communicate with employees exactly what changes are necessary and why they’re important, but don’t force them to change their purchasing habits without a back-and-forth discussion.

Be ready to explain the differences in cost between using one vendor’s offerings over another’s, for instance. Show employees the spending data and determine together whether any tweaks to procurement are worth the savings. A collaborative approach is more likely to succeed.

Governance also covers how employees do their jobs. Preventing tasks from overlapping cuts down on redundant work and can indirectly result in lower operating costs.

Governance is the fastest way to harness spending data and convert it into tangible cost reduction steps for your employees to follow. For this reason, smaller businesses looking to jump-start a cost reduction program should turn to governance first. At the next meeting, use the opportunity to set clear spending expectations.

8. Inspect and Manage Business Processes

Another discipline that plays into cost reduction is business process management (BPM). A complete understanding of internal processes enables spend analysts to fish out novel opportunities and ensure cost-effectiveness. BPM specifically:

  • Identifies processes that consume most of the budget and may require optimization.
  • Highlights critical business functions that cost managers must be careful with when designing reduction measures.
  • Contributes extra spending data for use with spend analysis.
  • Details the relationship between processes. Inter-dependencies among business functions highlight how spending cuts in one area can impact another.

This last point is why BPM calls for a process map—a holistic view of all business processes, how they all connect together, and what their associated expenses are. A process map can help optimize operations by showing where unnecessary or redundant processes lie and where similar business functions can consolidate their spending.

A cost manager is interested in whether a process is contributing to customer satisfaction or supporting internal operations. If one isn’t providing any value, then it’s time to curb the expenditures wasted on it. If there are more efficient ways to approach a business process, then making adjustments accordingly can also result in cost savings.

9. Take Charge of Supplier Contracts

A significant pitfall many businesses fall into during cost reduction is a lack of systematic supplier management. You can easily overpay for vital raw materials and services when you don’t negotiate your agreements and payment terms with third parties first.

Fostering positive, long-term relationships is the goal here, as they help you get higher quality goods and services at better prices. A vendor can work cohesively with your teams to help your company get more value from its purchases.

But don’t be afraid to jump ship whenever necessary. If another supplier offers better prices, better quality, or more favorable contract terms, be ready to switch over. Cost reduction relies heavily on your procurement teams’ ability to monitor price fluctuations and optimize procurement spending.

10. Invest in Inventory Management

Just like supplier relationships, inventory management helps keep costs low. Generally reducing inventory levels contributes to lower spending and healthier cash flow, though you run the risk of insufficient stock. A lack of inventory can result in operational hold-ups, unfulfilled tasks, and frustrated customers.

Cost reduction must involve inventory management in this sense, striking a balance between ensuring sufficient stock while keeping spending at reasonable levels. Don’t restock whenever possible; make sure the replacements are necessary first. For example, you don’t need to buy raw materials throughout the year for a seasonal product line.

Inventory management itself can be a challenge for many businesses. There are plenty of suppliers and products to track and paperwork to sift through, hence why software is popular for optimizing this business process.

11. Follow Through

Even the smartest strategies can fail at the execution stage. So spare no expense in figuring out and testing your cost reduction strategy before putting it into action. Things can fall apart quickly if the details aren’t thorough enough.

Have the cost reduction team oversee the strategy’s implementation at every step, ensuring the organization meets objectives and follows schedules and deadlines.

And remember that cost reduction is never a “set it and forget it” process. Plan to make continuous improvements in the future to ensure long-term financial health for your business.

Tips and Tricks for Cost Reduction

We’ll end with some extra tactics to get your cost reduction program off on the right foot.

  • Look for alternatives sometimes instead of cutting costs entirely. For instance, allowing some employees to work from home might reduce office maintenance costs. Software can cut out repetitive tasks from the workflow to free up working hours.
  • Be ready for the unexpected. If your cost reduction target is to save 5%, aim for 10%. This extra buffer ensures you meet your goal despite potential setbacks.
  • Don’t overlook anything. The many steps we’ve talked about above are cogs in a machine. If you miss out on one aspect, it can compromise your entire cost reduction program. For example, a strong governance structure without the right data to back it up becomes aimless. A comprehensive set of goals will fail if you do not effectively communicate them to your teams.
  • Invest in technology. Cost reduction heavily depends on procurement optimization, supplier relationship management, and spending visibility. Business software tailored specifically for these tasks is a worthwhile investment.

Getting Started with Your Cost Reduction Process

Cost reduction might sound like a daunting prospect, but any organization, regardless of industry or size, can achieve it through a well-thought-out and formalized program.

Smart, data-backed business decisions, deep communication with internal stakeholders, meticulous supplier and inventory management, and comprehensive controls and governance can all come together to boost the business budget without putting your operations at risk.

Cost reduction’s firm reliance on procurement policy calls for a centralized procurement platform where businesses can optimize their spending and manage third-party vendor partnerships. That’s why it’s essential to find the right partnerships to grow and support your cost reduction program over the long-term.

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