Activity Based Costing – Busting the Two BIG Myths of Cost Reduction

Most organisations, at some point, will need to find ways to significantly reduce spending. We are all familiar with general exhortations to spend less, as if managers willingly commit to frivolous spending and can easily “cut a little fat.” Sure, there are always some small things that can be reduced, although in practice it generally turns to deferral—pushing out spending to a future quarter in the hope that good times will return. Cutting or deferring so-called “discretionary spending” has consequences. For instance, deferred training has an impact on achieving objectives on a timely basis, reducing marketing spend or travel may have an impact on sales or retention, etc.

One technique enjoying a “re-birth” due to the use of new technologies is Zero-Based Budgeting (ZBB). The main goal of ZBB is to create transparency around “what” is spent, and more importantly, “why.” It seeks to answer questions surrounding which spending initiatives or items may be deferred or reduced without a net negative impact on business objectives (ideally on a discounted basis).

Identifying costs for targeted reduction and realising the savings are not the same thing. While the re-birth of ZBB is exciting and will help to navigate the tricky waters of cost planning, it is still important to be aware of the two main “myths” of cost reduction programs before jumping into your next planning session. Keep reading to find out what should be avoided the next time cost reduction planning comes up.

Myth 1: Costs Aren’t Always What They Appear to Be

The most insidious problem with “go away” costs is understanding the allocated costs that are often embedded in a cost structure. Consider an IT department that plans to migrate an on-premises application to a cloud application. What costs might go away? There may be ongoing license or maintenance costs that would cease (and likely be offset by new subscription costs). However, would the server (or mainframe) go away? Only when the entire hardware platform and supporting infrastructure components are removed would those costs be eliminated (remember that most server applications are virtualisation). This is an example of a reverse-step-function consideration.

In our example, let’s assume an entire server could be removed from the platform. IT shows the operating costs of the server are $1,000 per month and estimates a savings of $12,000 per year. But wait, the $1,000 isn’t one amount, it comprises a number of allocated items—a bit of network, a piece of the data centre, some portion of staff costs, and then some depreciation. Which costs would actually go away? In practice, only a small portion of costs are directly traced to the application, and costs only go away when a major step can be addressed—shutting down an entire data centre or a server farm, migrating to an outsourced facility, etc.

Myth 2: You Can “Will” Costs to Go Away

Organisations need to ensure that costs to be reduced are in fact costs that will “go away.” In many cases, costs don’t really go away; they just go on vacation. And like a good vacation, when they return, they often come home with friends, and restarting programs often costs more than if things had continued. There is lost momentum, or perhaps personnel have moved on.

A frequent target for go-away costs is personnel, since those costs are often an organisation’s largest line item. However, reducing those costs, whether through deferring hiring or aggressive down-sizing, is often difficult, particularly in tight labour markets. As tempting as it may be to reduce the size of one or more teams, unless your organisation is grossly overstaffed or you are improving the automation of the process itself, reducing personnel costs is not likely to be a long-term solution, and may actually hinder your business output.

It is critical to be able to identify the actual spending items that have changed if efforts are to be successful. Willing costs to “go away” during a planning exercise is not the same as tracking the achievement of cost reduction efforts. While organisations can measure cost changes in aggregate, it is often difficult, if not impossible, to identify the individual costs that actually were reduced. Different cost items may move in different directions, leaving only a “net” indicator.

The real enemy of sustained change is the absence of measurement. In many organisations, different costs go up and down independently, and so identifying which specific actions have yielded improvement can be difficult. Without a sustained program to identify and then measure real go-away costs, efforts to reduce costs will be fleeting, at best.

So, What Can an Organisation Do to Plan and Control Costs?

The answer lies in creating a transparent mechanism for planning and measuring costs based on the activities that an organisation consumes to sell and support its products, services, and customers. Some organisations have developed Activity-Based Cost (ABC) models that allocate costs. This is an important first step, but a more comprehensive approach includes three additional elements:

1. Strong traceback to understand the original costs that make up an allocated amount and the variability of those original cost items. This can then be aligned with the business drivers to understand the potential cost sensitivity to business volume.
2. Beyond cost allocation, the ability to plan for costs using this same ABC model.
3. The ability to track actual cost spend against ZBB “lines,” so that achievement of cost reduction initiatives can actually be measured.