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According to our latest survey, companies have been diligently pruning overhead, leaving them primed to capitalize on an economic recovery.
Lori Calabro, CFO Magazine
February 1, 2004
Anyone worried that cost-conscious companies have eliminated muscle as well as fat should take heart from the findings of our latest Cost Management Survey. Ever since the New Economy bubble burst, companies have diligently and methodically pruned budgets. Head counts have been reduced. Offices have been closed. Departments have been consolidated. And everything from payroll to accounts payable has either been outsourced or moved offshore. Yet until recently, companies often lacked the flexibility to cut costs in concert with declining revenues, because they didn't distinguish between fixed costs and variable ones. As a result, their moves did little to improve operating profits, as reflected in cost-to-revenue ratios. And some were left in a poor position to take advantage of new growth opportunities once conditions improved.
No longer, according to the findings of the 10th annual Cost Management Survey, a joint effort of CFO magazine and business-process consulting firm Gunn Partners that ranks the largest publicly traded North American companies (those with revenues of at least $750 million per year from 1998 through 2002) according to their five-year cost management index (CMI). After turning up in 2001, the median CMI—calculated by adding a company's cost of goods sold to its selling, general, and administrative (SG&A) expenses and dividing the sum by operating revenue—fell in 2002, according to Gunn.
In fact, the survey found that the median CMI was 83 percent that year, compared with 87 percent in 2001 and 85.3 percent in 2000. And over five years, companies recorded a CMI of 82.5, compared with 85.7 last year.
While companies have long cut costs in the face of weak demand, Calvin Yee, a director with Houston-based Gunn, says those efforts have only recently achieved significant savings in fixed costs in SG&A. Essentially, he says, companies have at last put a moratorium on "overhead spending for the sake of it." And that has produced a "more-flexible cost base." As a consequence, says Yee, companies are now better able to seek the rewards of judicious investing. After all, he notes, "not all costs are bad at the end of the day."
Picking Their Spots
Nowhere is the new focus more apparent than at once-profligate Metro-Goldwyn-Mayer Inc., which now sports a five-year CMI of 45 percent, compared with an industry median of 78 percent. That, says CFO Dan Taylor, reflects "some pretty dramatic changes at the company." Following the naming of Alex Yemenidjian to the roles of chairman and CEO in 1999, for example, head count was reduced by 10 percent and independent distribution of films through United International Pictures ended in favor of self-distribution, a move that "turned a fixed cost into a variable [cost]," says Taylor. The result, he explains, is that overhead (including fees) as a percent of revenue was reduced from 27 percent in 1997 to between 11 and 12 percent in 2003, where, he says, "it will stay for the foreseeable future."
Now, says Taylor, MGM, which Time Warner Inc. is rumored to be interested in acquiring, is not "looking for further cost reductions," and is ready to invest in new opportunities. Still, any new investment must work "within that [overhead] framework," he insists. "We are not going to throw money at the wrong places." His spending criteria, for example, include a 13 percent internal rate of return for any new film projects.
In telecom, another industry known for lavish spending, the leanest operators have also focused on fixed costs to help exploit growth opportunities. Chicago-based U.S. Cellular Corp., for example, completed a nationwide billing system last year that was largely responsible for a $25 million savings in SG&A in the third quarter of 2003. That, despite an already low CMI in 2002 of 68 percent, compared with an overall industry average of 81. Meanwhile, however, U.S. Cellular is entering the final year of an approximate $400 million upgrade to its network. Says Meyers: "We have to balance out revenue-generating and our cost-related projects."
That balance is also evident at American Axle & Manufacturing Inc., which recorded one of the automotive industry's greatest improvements in five-year CMI, reducing it by 721 basis points. "If you don't focus on taking costs out, you'll get burned by other factors," says executive vice president of finance and CFO Robin J. Adams, who is committed to holding all costs steady—except for an annual R&D increase of 10 percent. Still, says Adams, the key to AAM's business "is the ability to replace the new product portfolio." And that requires constant investment in new technology and the maintenance of quality equipment. "We are committed to never cutting our product technology," he says.
Even for utilities, cuts in fixed costs go hand in hand with growth initiatives. Consider $6 billion Sempra Energy, a product of the merger between Pacific Enterprises and Enova Corp. in 1998. Granted, the company's five-year CMI of 38 percent, compared with the industry median of 64 percent, reflects the basis for the merger, which projected cost savings totaling some $1.2 billion over 10 years. At the same time, says executive vice president and CFO Neal Schmale, Sempra, because of its two California utilities, is also beholden to the regulatory process, which "is very rigorous in terms of cost justification."
Yet while Schmale says that cost control will remain a priority in 2004, it will also work to complete two LNG (liquefied natural gas) facilities to grow the unregulated side of its business. For Sempra, as for all companies, says Gunn's Yee, the question is "how to prudently make investments in a way that is scalable and not a huge financial commitment." But as this year's Cost Management Survey shows, a growing number of companies besides Sempra now at least have the wherewithal to consider the question.
Lori Calabro is a deputy editor of CFO.
How the CMI* compares in 40 industries, 1998-2002.
Median (in %)
|Advertising, Media & Publishing||77.9|
|Aerospace & Defense||86.6|
|Autos & Auto-parts Manufacturers||89.1|
|Autos & Auto-parts Manufacturers||89.1|
|Computer Software & Services||81.0|
|Computer Systems & Peripherals||90.2|
|Construction & Housing||90.2|
|Cosmetics & Personal Care||85.3|
|Diversified Financial Services||85.2|
|Drugs & Biotechnology||75.0|
|Electronics & Semiconductors||80.6|
|Electrical Equipment & Components||86.3|
|Factory Equipment & Heavy Machinery||87.8|
|Food & Food Products||90.7|
|Leisure, Entertainment & Restaurants||73.1|
|Steels, Metals & Mining||88.7|
|Oil & Gas||77.3|
|Shipping, Railroads & Air Transport||85.5|
|Textiles, Apprael & Footwear||89.2|
*CMI = (COGS + SG&A) / revenues
Source: Gunn Partners