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n looking for ways to cut costssomething most companies still need to do despite
the good economic timesmost managers reach for the head-count hatchet. Theres
good reason: the markets usually roar with approval. When Eastman Kodak, for
example, announced three years ago that it would lay off 10,000 people, saving an annual
$400 million in payroll, its market capitalization rose by $2 billion within a few days.
Similar stories have played out hundreds of times in the past decade.
But cutting costs doesnt have to be such a bloody process. In my consulting experience
over the past 13 years with more than 200 companies in varied industries, I have seen
compelling evidence that a company can almost always create far more sustainable value
by sensibly reducing its capital expenditures. How? Not by postponing or eliminating big
spending projects, which are usually less than 20% of the budget anyway, but by
conducting a rigorous, disciplined evaluation of the small-ticket items that usually get
rubber-stamped. Those little requests often prove to be unnecessaryin some cases they
duplicate other requestsor gold plated. But few managers have the time, energy, or
inclination to ask about them. They should.
value in the marketplace. In fact, according to my research, a permanent 15% cut in the
planned level of capital spending could boost some companies market capitalizations by
as much as 30%. Better still, the company gets to keep the headsmake that brainsthat
might have been fired. Paying more attention to small items in the capital budget creates
that business raritya win-win situation. (For more on the advantages of cutting capital
spending, see the table Capex Dollars Versus Job Dollars.)
In this article, well look in detail at each phase and its questions. None of the questions, to
be sure, will sound wildly unfamiliar. But when did you last go to the trouble of asking
such questions about a decision involving less than $5 million? The answer may be
Never, which likely means youve been spending more than you should have.
But its not just engineers. Anyone at a middle or low level in an organization is likely to be
risk averse, which causes overspending. No frontline manager wants to be blamed for
having ordered too few spare parts when a crucial piece of machinery breaks down and
creates a product shortage. Overspending may also result from unit managers attempts to
protect their turfa low budget request this year may lead to the unit being short-changed
the next.
Lets turn to what senior managers can do to root out the wastethe eight questions they
can ask during the budgeting cycle. First, lets examine the three questions that can help
get the budget process off to a better start. (For a visual explanation of the questions, see
the exhibit Bringing Discipline to Capital Budgets at AnyCorp.)
Bringing Discipline to Capital Budgets at AnyCorp Eight questions and a postmortem can
help senior executives conduct a solid evaluation of small-ticket capital budget items.
Cutting the capital budget increases cash flow, which can have a huge impact on a
companys value in the marketplace.
As all Bostonians know, theres no one right way to make New England clam chowder. But
whatever the details of the recipe, cooks will always need clams, milk, and potatoes. Its
much the same with capital spending. There are three questions that should always be part
of the mix when unit managers are cooking up a proposal:
Managers who must make investments to comply with environmental, health, and safety
regulations tend to be afraid theyll be blamed for underspending if something goes wrong.
This sometimes irrational fear prevents them from thinking as clearly or imaginatively as
they should about how to save money on compliance, so they gold plate their investment
requests. But a company should plan such expenses with the same rigor it brings to its tax
obligations. A good way to combat conservative and costly compliance is to require unit
managers to compare their proposals with the practices of other companies.
Are the trade-offs between profits and capital spending well understood?
In some companies, no amount of prior consideration will stop managers from sending in
requests for new assets. In such cases, it usually turns out that the company suffers from a
financial culture that places earnings above all other performance measures. Take the
example of a certain telecommunications company. Its network designers insisted on using
extra thick telegraph poles and specified that they be placed five feet closer together than
required by law. Such a distribution system, they declared, would be better able to
withstand falling tree limbs during storms. Asked why the company didnt trim the trees
instead, the engineers replied that the cost of trimming would reduce the companys
profitability, while the extra capital investment would not, since it wouldnt appear in the
earnings statement! Our analysis, which capitalized the after-tax cost of the extra annual
maintenance so that it could be compared with the capital cost of the distribution system,
showed that the stronger distribution system was several times more expensive.
Conducting a Postmortem
When all is said and done, even the most careful budgeting process is fallible. Whats more,
in a fast-paced marketplace like the Internet you can lose out by taking time to probe
deeply as you make decisions on capital spending. Thats why managers need to
supplement budget supervision with regular audits of units capital spending. There are
three rules to follow in conducting such inquiries:
Be inclusive.
Many companies leave their audits to people in the finance department, who often
confront workers in an adversarial manner. Thats wrong. Audit teams should always
include employees from the departments being reviewed. For a company to unearth the
kind of overspending Ive been talking about, its essential that the people who know most
about the operations buy into the process. At the same time, the team needs to have some
organizational authority. It is, after all, going to be asking embarrassing questions. The
team should therefore report to a senior executive who has the muscle to clear obstacles
from its path and make any changes it may recommend.
A good audit can turn up surprising horrors. One of my favorite stories is about a
telecommunications company I was advising eight years ago. In the course of reviewing
the companys capital spending, I came across an internal rule specifying that all cables be
laid at a depth of two meters. I asked the head of engineering about it, and he said that at
two meters, the cable network would be protected against a thermonuclear magnetic
impulse created by the explosion of a hydrogen bomb. Fair enough, I replied, but what
happens to your customers when the bomb goes off? The company saved $80 million a
year by reducing its cable depth to one meter. If you make the eight questions and an audit
a part of your companys small-item capital budgeting process, you may well find a lot of
buried treasure.
A version of this article appeared in the SeptemberOctober 2000 issue of Harvard Business Review.
A version of this article appeared in the SeptemberOctober 2000 issue of Harvard Business Review.
Tom Copeland (tom_copeland@monitor.com) is the managing director of corporate finance at the Monitor
Group, a consulting firm based in Cambridge, Massachusetts, and is the author, with V. Antikarov, of Real
Options: A Practitioners Guide (Thomson, 2003).
COSTS |
BUDGETING |
DOWNSIZING
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