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How the best companies are investing to cut costs.
Randy Myers, CFO Magazine
December 1, 2000
There are tightly run ships, and then there is Apache Corp.
For every dollar of operating revenue it generated in 1999, this $2 billion (revenue) Houston oil and gas exploration and production company spent a mere 33.1 cents on operating costs, including selling, general, and administrative (SG&A) expenses. Excluding a handful of specialty financial services firms, this made Apache the leanest operator by far in CFO magazine's seventh annual Cost Management Survey (formerly the SG&A Survey).
Riding the crest of the longest economic expansion in U.S. history, one might expect relatively few companies to share Apache's focus on cost control. Yet in surveying the largest companies whose stocks are publicly traded in the United States (those with revenue of at least $750 million per year in each of the past four years), CFO and Exult Process Intelligence Center (now Hackett Collaborative Learning) found that the median company improved its costs-to-revenue ratio by 64 basis points from 1996 through 1999. That ratio is reflected in what the survey calls a company's cost management index, or CMI. It is calculated by adding a company's cost of goods sold (COGS) to its SG&A expenses, and dividing the sum by the company's operating revenue.
To be sure, this improvement reflects more than across-the-board belt-tightening of the sort that was popular just a few years ago, when cost-cutting CEOs like "Chainsaw Al" Dunlap were corporate folk heroes and many managers and investors alike seemed to believe that the only good cost was a cut cost. That platitude was debunked in 1998, when it became clear that Dunlap's closely watched effort to turn around Sunbeam Corp. collapsed in a heap of losses and led to his ouster. Today, companies are much more careful to weigh not only the risks of haphazard spending, but also the potential rewards of judicious investing.
A New Model for Cost Efficiency
All kinds of companies are investing in technology and changing their organizations in order to reduce operating costs as a percentage of sales, according to John Engquist, a director at Exult Process Intelligence Center, which crunched the numbers for this year's survey and helped to create the CMI metric. "It used to be that SG&A was just burdensome overhead; you just sliced it and sliced it and sliced it. Today, the goal is to figure out where to strategically invest to create value."
Consider the example of Cisco Systems Inc. In 1999, Cisco spent 36.7 cents on SG&A expenses for every dollar of operating revenue it generated, exceeding the median for its industry group by 340 basis points. Yet the $18.9 billion company was a veritable miser when it came to COGS, with that figure equaling just 30.9 percent of operating revenue in 1999, way below the industry median of 51.8 percent. Combine Cisco's SG&A and cost-of-sales numbers over the four years from 1996 through 1999, and the company ends up with an industry-leading CMI of 66.5 percent versus an industry median of 82.9 percent.
Cisco vice president and controller Dennis Powell says the real message behind those numbers — and a big key to the company's success — becomes clear only after you break out the company's sales costs from its general and administrative expenses. "We think our G&A costs are low at around 3 percent [of revenue], which is pretty good for any industry," says Powell. "But the bottom-line metric against which we measure ourselves is customer satisfaction. For that reason, we put a lot more cost into the sales area to make sure we've got a high level of customer satisfaction."
Even Cisco's low COGS number reflects a growth-oriented business strategy, because while it has been investing in its sales operations, the company has also been investing in Web-enabled technologies that further refine its well-known outsourced- manufacturing model. Cisco calculates that it saved just under $1 billion this year as a result of Web initiatives.
"When an order comes in, our vendors can see it as if they were part of Cisco," says Powell. "Over the past several years, we figure this has allowed them to reduce inventories by about 45 percent. Also, we're able to do integrated testing of all our products over the Web before they ship, and still allow our partners to ship and build about 60 percent of our products without physically touching them ourselves."
On the service side of the business, Powell says, 70 percent of the company's support calls are now handled over the Web rather than via a telephone call. Cisco believes this development has reduced its incoming telephone calls by 75,000 per month. Customers also download about 90 percent of the software they need from Cisco, eliminating physical shipments of software. "For us, it's not so much an issue of cutting costs, but of figuring out how productive we can be with the people we have," concludes Powell. "We are very passionate about leveraging technology to improve productivity."
Much the same strategy is employed by $17.6 billion Sun Microsystems Inc. The company ranked a close second to $88 billion IBM Corp. in the "computer systems and peripherals" industry group, posting a four-year CMI of 81.4 percent versus an industry median of 90.2 percent. But don't credit that performance to low SG&A expenses; like Cisco, the percentage of Sun's costs accounted for by those activities actually exceeds the industry norm by a wide margin.
In 1999, Sun spent 37.8 cents on SG&A expenses for every dollar of operating revenue, versus an industry median of 21.3 cents. (IBM's SG&A expenses were roughly in line with the industry norm, at 22.8 percent of operating revenue.) Where Sun made up for its big spending on SG&A was in the cost of goods sold, which in 1999 amounted to only 42.8 cents of every dollar of operating revenue, compared with an industry median of 69.3 cents. Sun vice president and treasurer George Reyes credits his firm's low figure largely to the fact that Sun owns virtually all of the intellectual property that goes into its products. "We don't write big checks to Microsoft for operating system licenses, and we don't write fat checks to Intel for microprocessor technology," notes Reyes.
That advantage, he explains, allows the company to focus most of its attention on growing its top line, a strategy that involves adding sales representatives and service professionals as well as the engineering talent needed to continue growing its body of intellectual property.
"You see this reflected in our SG&A numbers, which appear high, but, to use a medical analogy, represent good cholesterol rather than bad cholesterol," says Reyes. "We're putting as many bag-carrying, quota-bearing salespeople on the street as we can, as fast as we can."
How quickly is Sun beefing up its staff? Two-and-half years ago, Reyes notes, Sun employed about 4,000 service professionals. By the end of September 2000, it employed 10,500. Like Cisco, it tracks revenue per employee to determine whether its hiring strategy is paying off. "In the fiscal year ended June 1999, in spite of these rates of hiring, our revenue per employee increased 7 percent," says Reyes. "In fiscal 2000, it increased 9 percent. By the end of June 2000, we were just under $430,000 of revenue per employee; at the end of the September quarter, we were up to $450,000 per employee." (Data compiled by Media General Financial Services Inc., in Richmond, Virginia, indicates that the average diversified computer systems company generates about $308,000 of revenue per employee.)
Sun's top-line business focus is also paying off on the bottom line. In mid-October, Sun wowed Wall Street by reporting a 60 percent gain in fiscal first-quarter revenues and an 88 percent gain in per-share earnings, excluding one-time charges. "I think we've got a really good recipe cooking, so I don't think we're going to tinker with it," Reyes observes.
Apache Finds Black Gold
While Cisco's and Sun's Web-centric operating strategies have attracted plenty of attention, it isn't just high-tech companies that have driven down costs by investing for growth. Just look at Apache. Oh, sure, the company pinches pennies. After watching oil prices sink to a mere $10 a barrel in 1998, the company entered 1999 determined to pare $20 million from its operating budget. That led to initiatives as small, but symbolic, as eliminating company-supplied Styrofoam coffee cups, to ideas as clever as installing alarms on oil wells to alert company technicians 24 hours a day to any technical problems that shut the wells down. Now those technicians can make immediate repairs to the wells rather than allow them to stay offline overnight.
More than most companies, Apache has a fundamental incentive to be cost-conscious. While plenty of businesses complain these days that they have no pricing power, the fact is that, with sufficiently innovative products and services, they can enjoy some leverage over what they can charge. That's a luxury Apache simply doesn't have; the prices it receives for oil and gas are dictated entirely by market forces outside its control.
"We're in a commodity business," explains Apache executive vice president and CFO Roger Plank, "and anybody who is building to last — a rallying cry around here — has to pay close attention to their costs. But we do that a little differently than one might think. We pride ourselves on being a growth company in an industry that isn't growing."
And indeed Apache is. When Plank joined the company in 1981, it had about 1,200 employees. Today, it's up to about 1,600. Yet Apache has increased its annual production over that period about twentyfold. "We are basically taking our fixed costs and spreading them over a greater number of barrels of oil and million- cubic-feet of gas produced," Plank says. "Some larger companies focus a lot more attention on cutting costs; our approach to cutting costs is to increase production so that our cost per unit [of production] goes down."
Achieving that goal isn't a matter of operating magic — Apache doesn't know anything about getting oil and gas out of the ground that its competitors don't know — so much as it is a matter of minding the details. "We've been very active in the acquisition arena, and with the drill bit," Plank says. He explains that Apache gives its new acquisitions substantial bonuses to find new oil on the properties, and thus often increases production over what might be expected from the fields. In a testament to its execution of this strategy, Apache has compiled 23 consecutive years of increased production, and, according to Plank, is now the most profitable pure independent exploration and production company among the 20 peer companies against which it benchmarks its performance. (According to figures compiled by Media General, Apache generates $302,000 of income per employee per year, versus an average of $47,000 for its industry group.)
This year's cost survey turned up plenty of familiar names with a reputation for efficiency: Golden West Financial (in the banking group), Southwest Airlines (airlines), General Electric (conglomerates), Intel (electronics and semiconductors), Vastar Resources (second behind Apache in energy), and Norfolk Southern and Burlington Northern Santa Fe (shipping and railroads). But it also yielded some surprises. In the advertising and media industry group, for example, The Walt Disney Co. ranked second, just behind Cox Communications, with a four-year CMI of 65.3 percent versus an industry median of 78.7 percent.
Like other operators of film and television studios, Disney has had to grapple with the soaring cost of producing movies and TV shows, in part because of the astronomical salaries that top actors and directors now command. The company also has been sinking money into its fledgling Internet ventures, which have yet to contribute to its bottom line, while simultaneously striving to keep its renowned theme parks competitive with a slew of new entries into that market. While revenues were essentially flat from fiscal 1997 to fiscal 1999 (the company's fiscal year ends in September), growing costs helped to send Disney's profits into a downward spiral during that period, from 95 cents per fully diluted share in fiscal 1997 to 62 cents in fiscal 1999.
This fiscal year, Wall Street estimates that Disney earned about 88 cents a share, thanks in part to cost-cutting initiatives that pared expenses associated with corporate and other activities by an estimated $84 million in the first nine months of the year. "We've been on a very cost-conscious bent for a few years, and I think it's helped us quite a bit," says Disney CFO Tom Staggs. "It's [become] a fundamental approach to the way we do business. We try to make the corporate infrastructure as lean as it can be in support of our businesses."
Disney can't avoid offering comedian Tim Allen more for one movie than it would pay a midlevel manager over 20 years. But the company has been able to bring new levels of discipline to its spending in other areas, from consolidating overnight shipments of express mail to leveraging its buying power for goods and services, an activity on which it spends about $9 billion a year. At the moment, for example, the company is in the midst of a project called eSource, which will allow employees to purchase items as small as pencils and as large as computers online, via their own desktop PCs, from a wide range of vendors. The system has cost the company less than $20 million to date, Staggs says, but is expected to generate annual savings on the order of $40 million just among Disney's domestic businesses.
Meanwhile, Staggs says that Disney does try to keep its production costs reasonable. "In relation to some businesses, Hollywood probably looks a little free-spending," he concedes. "Within that spectrum, we try to be independent thinkers, and I think we have a reputation for taking a pretty pragmatic approach [to the business]. But a lot of this is about relationships with talent, and I think we maintain pretty good relationships with talent, too. You just have to do it in a way that doesn't seem arbitrary, and if you do that, you can get people to play ball with you."
As illustrated by the fate of Sunbeam, which continues to lose hundreds of millions of dollars each year, cost-cutting alone does not make a company great.
To really make sense, the data suggests, a cost-cutting mentality must be melded to a growth strategy. That's a lesson Cisco, Sun, and Apache have taken to the bank.
Randy Myers is a contributing editor of CFO.