Supply Chain

Cutting Costs? Don’t Look at Head Count First

Trimming non-labor costs, especially by better managing your fast-growing population of external service providers, likely will have greater impact.
David McCannSeptember 12, 2013

When you need to eliminate lots of cost in a hurry, you’ll probably pare the work force. Problem is, labor expense accounts for only one-eighth of the average company’s revenue, according to a new analysis.

FTI Consulting, a business-advisory firm, performed the analysis on behalf of Proxima Group, a provider of outsourced procurement services. FTI looked at the 1,954 publicly held U.S. companies for which Bloomberg had labor-cost data for 2009 through 2011. Companies aren’t required to report such data in their U.S. financial filings but have to in some international jurisdictions where they do business.

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Aggregating all companies in the database, labor costs – defined as those pertaining to full-time-equivalent work force but not contingent workers, as Proxima classifies those as third-party service providers – comprised 12.5 percent of revenue in 2011, down from 13.6 percent in 2009. Non-labor costs, on the other hand, were 69.9 percent of the 2011 pie, up from 66.2 percent two years earlier. (Profit, in the form of EBITDA, accounted for the rest of revenue.)

The figures are a bit skewed by outliers. Slightly more than half of the studied companies had 2011 labor costs greater than 20 percent of revenue. But in any case, there would seem to be, at least theoretically, greater opportunity to reduce non-labor costs.

The analysis further discovered that a 1 percent decrease in labor costs would have pushed up the companies’ aggregate EBITDA by 0.7 percent. The same percentage cut in non-labor expense would have created a 4.1 percent earnings bonanza.

FTI’s analysis didn’t break down non-labor costs by type of expense, but it can be assumed that costs for third-party services comprise a big and increasing share. It’s a safe bet that a big reason many companies’ in-house labor costs are dwindling is that jobs are shifting to service firms that can perform the specific functions and tasks they specialize in cheaper, as well as better and faster.

“Most executives are still very cost-conscious, which has driven a lot of the use of third-party service providers,” says Christa Deegan Manning, an analyst with Horses for Sources, a market research firm focused on business-service suppliers. “But with the economy stagnating and companies looking for growth, they’re more honing in on the ‘better.’ They’re choosing partners that can help them innovate, serve customers better and be differentiated in the market.”

At the same time, Proxima CEO Matthew Eatough knocks finance chiefs for, he says, their narrow manner of evaluating and managing suppliers. “CFOs typically are very good at understanding complex metrics around their businesses, but they tend to have a single KPI around supply management, usually a savings number,” he says. “The opportunity to set KPIs and a management agenda that go beyond savings, that really drive the company’s objectives, is enormous.”

A key point stressed by both Manning and Eatough is that if a company is motivated to drive employees’ behavior and engagement, with so much of its work being done externally the same should be true of its approach to suppliers. But management practices have not kept pace with the increasing externalization of cost, says Eatough. At many companies, he observes, “there is still an environment where the chief procurement officer is antagonistic and aggressive toward suppliers.”