A shift in recent years in the kinds of overhead costs companies are incurring demands a reconsideration of the way such costs are understood and managed, according to the latest work from finance research and advisory firm CEB.
Traditionally, companies incurred general and administrative (G&A) costs for what might be called “rules-based” work, or transactional activities like accounts payable, payroll and the IT help desk, and calendar-centric ones like budgeting and workforce planning. Those are still present, of course, but according to quantitative and qualitative research performed this year by CEB, they comprise only 49% of G&A costs for a typical large company.
The larger, 51% share of overhead spend is for “judgment-based” work, including ad-hoc activities like analytics and non-standard reporting and initiative-based efforts like systems integration and new-product feasibility studies, CEB says.
CEB’s research consisted of a quantitative survey of 100 companies about their overhead spend and practices, and qualitative interviews with 102 senior finance executives (about 60 companies were represented in both groups).
Categorizing overhead costs by type of work done, as CEB suggests is useful, is a departure from the historical norm of grouping them by discipline — IT, HR, purchasing, real estate, etc. “Rules-based work is easier to automate, standardize and centralize,” says Eisha Armstrong, a CEB managing director. “Judgment-based work is more knowledge-intensive and ambiguous.”
CEB further breaks down G&A spend as follows: among the 49% that is rules-based, 25% is for transactional work and 24% for calendar-centric activities; among the 51% that is judgment-based, 29% is for ad-hoc work and 22% is related to initiatives.
“For some companies, this shift has taken place over the past 10 years or so, but probably over the past five or six years for the average company,” says Armstrong. “Nevertheless, CFOs are having a light-bulb moment when we show them that breakdown. They know functions are entering the realm of more value-added work, but are surprised at how much of their non-finance G&A spend falls into the judgment-based category.”
CFOs also know the heat is on to control overhead costs. Asked to rate the degree of pressure they’re under on that score, on a 1-7 scale where 7 was the greatest pressure, 73% of survey participants pinpointed it at 6 or 7. Yet, while 89% of them gave a 6 or 7 rating for the degree of rigor with which they’re managing the costs of rules-based work, only 22% said so for judgment-based work.
They’re under pressure because overhead costs are rising. According to a CEB analysis of the S&P 500 and S&P Euro 350 companies, marketing budgets were up 6.5% in 2013 compared with 2012, while IT costs rose by 5.0%, legal costs by 2.8%, procurement costs by 2.5% and finance costs by 2.3%.
Driving the sizable increase in marketing expense are recent innovations in digital marketing, causing an explosion in the number of ways companies have to market their products and services, Armstrong says.
But more generally, increased complexity is to blame. There is geographic complexity: there are more ad-hoc requests for information and analysis relating to country-specific issues, still more analysis is needed as markets become more heterogeneous, and there is more variable work, driven by greater economic and market volatility. And there is organizational complexity: more work to integrate acquisitions, more customized analysis to support matrixed decision making, and more collaboration to support such matrices.
The complexity is part of the reason that companies are shockingly lacking in confidence that their G&A spend is appropriate. Only 23% of survey participants said they were confident their finance spending was judicious — and that was more than said so for legal (17%), HR (15%), IT (15%), procurement (9%) and marketing (8%).
In fact, according to CEB’s analysis, complexity is now an even bigger cost driver than company size. By performing regression analyses on the quantitative survey data that used functional costs as the dependent variable and revenue and complexity as independent variables, the research firm calculated that complexity is behind 58% of overhead spending, compared with 42% for revenue volume.
The other reason for finance executives’ lack of confidence regarding overhead spend comes back to the increase in judgment-based work, Armstrong observes. “Finance is no longer just about transaction processing and closing the books,” she says. “It’s also about analyzing data. Real estate is not just about making sure you have enough office space and cubicles, it’s also about transforming the workplace so it’s more collaborative and productive. IT isn’t just about ‘Does my laptop work and can I connect to the network?’ It’s also about evolving business models to take advantage of new technology.
“So,” she continues, “a lot of overhead functions have transformed from what you might call back-office, standard-service factories to look a lot more like professional services firms, because they’re doing so much more decision-support work. That’s a big reason we think confidence about overhead spend is so low — the nature of the work we do has changed.”
To manage the efficiency of judgment-based work, companies must re-orient traditional budgeting, measurement, benchmarking and controls to the new nature of the work (see diagram at the end of the article; click on the image to make it larger).
Measurement: This was discussed above. You can measure expenses using the categories in your general ledger, but it might be more informative to also measure them based on the type of work that’s being done.
Budgeting: In the past, Armstrong says, finance would think about whether it had the correct level of overhead spend based on what it had historically and how it thought revenue would change: “My revenues are going to go up 10%, so my overhead spend should go up by 3%, because that’s what’s happened historically.” Now we should say, “Yes, we’re going to grow in revenue, but we’re also going to go into four new countries and support three new currencies and two new languages. So we actually need 5% G&A growth.”
Performance management: In the past finance thought, for example, that HR was efficient because its costs were 3% of revenue, and the benchmark average for peer companies was 4%. “That kind of thinking is fine, when you’re just looking at transactional and calendar-centric work,” Armstrong says. “But when you start talking about the value that function is providing in decision support, you can’t just look at cost-comparative tiers. You have to have some way of measuring the impact that cost has and the value it’s creating.”
Control: CEB refers to this internally as “man versus machine.” In the past finance would try to control overhead expenses by relying heavily on automation, centralization and standardization. But to control the costs of judgment-based work, you have to change people’s expectations or their behavior. “Either internal customers have to get used to receiving less of the expensive judgment-based services they demand, or overhead functions have to improve their expertise to do the same amount of work in less time,” says Armstrong. “Or both.”