What Is Cost Cutting?

Cost cutting refers to measures implemented by a company to reduce its expenses and improve profitability. Cost cutting measures are typically implemented during times of financial distress for a company or during economic downturns. They can also be enacted if a company's management expects profitability issues in the future, where cost cutting can then become part of the business strategy.

Key Takeaways

  • Cost cutting is a measure taken by a company to reduce its expenses and improve profitability.
  • When a company is in financial distress or there is an economic downturn is when companies are most likely to enact cost cutting measures.
  • Cost cutting measures can include laying off employees, closing facilities, downsizing offices, and streamlining the supply chain.
  • When embarking on cost cutting it's important to have a cost cutting strategy that classifies costs as bad costs, good costs, and best costs.
  • As part of a cost cutting strategy, it's important for a company not to over cut costs, leaving it unprepared for increased demand or in a position where it may incur more costs.

Understanding Cost Cutting

Shareholders who seek maximum monetary returns on their investments in a company expect that management will maintain growth in profits. When the business cycle is on an upswing, companies are generally able to generate profit growth. However, on a downswing, profits may fall and if they stay down for prolonged periods, management would feel the pressure from shareholders to cut costs in an effort to prop up the bottom line.

Cost cutting measures may include laying off employees, reducing employee pay, closing facilities, streamlining the supply chain, downsizing to a smaller office, or moving to a less expensive building or area, reducing or eliminating outside professional services, such as advertising agencies and contractors, etc.

Implementing new technology can also be seen as a cost cutting method. For example, a new machine may replace a certain number of employees, cutting labor costs, where the cost of the machine is made up after a certain period of time of not incurring labor costs.

Cost Cutting Strategy

When embarking on cost cutting, it's important to implement a strategy before arbitrarily cutting costs. Some costs are necessary, so it's important to classify costs into good costs, bad costs, and best costs.

Good costs focus on the company's growth and are aligned with the company's customers and how to meet the needs of those customers. Bad costs are those that do not match up with the company's growth strategy, and waste resources. When bad costs are cut, they can free up resources that can be used in a more productive capacity. Best costs are the costs associated with what makes a company unique, how it differentiates itself from the competition, and how it provides true value to its customers.

Once a company is able to allocate its cost into one of the above classifications, it will make it easier to focus on cutting bad costs and maximizing on best costs.

It's also important to note that cost cutting doesn't necessarily mean completely cutting a cost. It can also refer to optimization and efficiency. Optimizing productivity actually reduces costs, so it's important to measure productivity. Today there are apps that allow companies to monitor the productivity of employees as well as time spent on different work and projects.

Risks of Too Much Cost Cutting

Because salaries and wages are such a large expense, many companies look to layoffs first as a cost cutting measure when times are lean. However, there are many real or potential costs associated with firing people, including severance pay, unemployment benefits, rehiring costs, wrongful termination lawsuits, lowering of morale, and the risk of overworking remaining employees.

Additionally, if the business turns around faster than management had expected, the company could find itself with a shortage of labor, placing the company at a competitive disadvantage in an improving business environment. Also, if a factory was closed in a recent round of cost cutting, the company may not have sufficient production capacity to respond to a sudden increase in orders. This all factors into ensuring a company has a sound and adaptable cost cutting strategy.