As any small business knows, costs can quickly mount up. While some firms are very diligent at monitoring these costs, ensuring that all parts of the business are as efficiently run as possible, it is easy to start to lose track of the mounting costs. This article explores the ways that cost can mount, and particle approaches for reducing costs within an organization.
Why keeping costs under control is important
While it is intuitive that profit is revenue less cost, company revenues often get disproportional attention, with much less consideration to costs. Increases in revenue are much more often celebrated than reductions in cost. However, while sales are clearly important, keeping costs under control is equally important for firms – some serial founders even opt to bootstrap their startup, treating the company as though it is cash-strapped, even if they have access to capital. Some key reasons to ensure that costs are kept in check include:
Costs quickly eat into profit margins
It is important to recognize that costs can quickly eat into your profit margin – and often easy to change. If a firm has a profit margin of 5%, it is often easier to reduce costs by about 5% such that the profit margin doubles, than it is to double the firm’s size and revenue.
Excess costs provide opportunities for new entrants
Beyond the impact that un-checked costs can have on your profit margins is that the danger that they provide an opportunity for new entrants to enter the market. Having high costs allows the possibility that a new firm, must more aware and focused on costs can enter the market and undercut your position.
Left un-checked costs can grow over time
Finally, keeping a check on costs is important because left un-checked than can steadily increase over time. Firms can develop bloat, with side projects that were never profitable continuing, as new expenditures are gradually added.
Reasons that costs in organizations can spiral
The danger of success: When profitability leads to high costs
While achieving high profitability is a key measure of organizational success, it can come with the disadvantage of allowing costs to spiral. When profit margins are high, there is little pressure to focus on costs – you can easily absorb any wastage and still maintain high firm profitability.
While unnecessary costs are wastage regardless of the firm size, their impact can become more pressing if the firm experiences periods of greater competition. Suddenly the pad that has allowed costs to spiral quickly disappears, and the firm is left having to make substantial reductions to get costs in check.
Money is plentiful, and costs are seen as a means to grow
While high-profit margins can encourage wastage, so too can a significant cash injection. Quick growth is often a target of venture capital investments, and flash with cash, it is not uncommon for VC-backed firms to quickly spend large amounts of money on customer acquisition through advertisements and discounts.
While there may be reasons why it makes sense to grow the firm quickly, a danger of having money to burn is that at least a proportion of the money is often wasted on activities that have a low return on investment. If quick growth becomes the only objective, then it is easy to lose track of whether the money is being wisely spent.
No one is actively monitoring cost
An issue underlying many firms with spiraling costs is that no one within the organization is actually monitoring the costs. When we consider the revenue of the organization, there may be an entire ‘sales and marketing’ department dedicated to increasing the revenue. When we consider cost, the responsibility is more diffuse. If top management pays attention to, then the organization may follow, but if top management does not seem concerned by the company’s cost structure, there may not be anyone in the firm who has direct responsibility for ensuring that costs are kept in check.
Fear of rocking the boat
A final component that can lead to costs gradually increasing over time is a fear of rocking the boat. Reductions in cost can be controversial – often associated with layoffs or uncertainty. Often the largest cost a firm has is their employees, and sometimes even the suggestion of needing to reduce costs can cause fear over individual careers.
Approaches for reducing organizational costs
Zero-based budgeting: Re-justifying all expenditures
One approach to focusing on cost is ‘zero-based budgeting’ – rather than using the costs from the prior year to justify the cost for the coming year, to start from scratch each time. Rather than costs as a given, to systematically review them, and look to re-justify all expenditures.
Whether you formally implement zero-based budgeting or not, the underlying principle of systematically considering all costs is an important one. Without actively examining the key costs of an organization, it is possible to justify all expenditures under the logic of “we need to” or “we have always done that”. This is a dangerous trap to fall into, as it allows wastage to remain or grow.
Setting the direction from the top
Another important factor in ensuring that costs are kept in focus is for the importance of maintaining cost control to be set and monitored by the CEO and other top management. Ultimately they influence the importance given to having a cost focus – if they emphasize minimizing costs, this is likely to translate into a greater awareness of costs within the firm.
Approval required for substantial expenditures
Another particle approach for reducing costs within an organization is to require approval for all large expenditures. Having to directly justify the costs to your boss can ensure that necessary consideration is taken to reduce the expenditures, while also allowing management to get a handle on where costs are mounting.
Monitoring the success of expenditures and tracking cost
The final component of getting costs under control is gaining an understanding of where the costs are actually arising from. Being able to clearly break down the proportion of costs associated with staff, rent, advertising, and materials can help focus efforts. Concentrating on the major sources of cost is likely to have the largest impact.
Final thoughts: Keeping a focus on cost is not easy, but failure to can be even more difficult
Like with many tough decisions, perpetually pushing them off is rarely a good approach. Costs are unlikely to decline by themselves, and ignoring them may ultimately require more substantial attention than if they are kept in check.