Indirect costs can significantly undermine the profitability of organizations.
The difficulty in identifying, locating, consolidating and controlling overhead costs leads many managers to neglect the negative impact this has on the balance sheets of their organizations. On the other hand, competition and the increasing pressure on price makes it increasingly difficult to achieve the profitability expected by shareholders.
What are the solutions to this situation?
We have seen the enemy, and it is us
During the Spanish Civil War (1936-39), General Francisco Franco, leader of the fascist coup of the Republic, was preparing to march on Madrid with four columns of troops coming from different parts of the country. One of his closest generals remarked that "the fifth column is waiting to greet us inside the city," referring to groups that, although formally linked to loyalists, would collaborate with the coup.
The "fifth column" expression ceased to be used only in the military context and came to designate those individuals or groups who attack from the inside, practicing subversive and treacherous actions in favor of a rival group.
Indirect costs can become as perverse as the fifth column. They are within organizations and often surreptitiously sabotage the entire team's efforts. With continued pressure on profit margins and increasing efforts to maintain sales volume, managers are left wringing their hands searching for an answer.
Difficulties in increasing the top line can be balanced by intensely and intelligently focusing on high-impact areas aimed at decreasing the bottom line, helping to mitigate the challenges of cash flow, expanding profit margins and exploiting emerging opportunities.
The largest and most persistent negative contributors to the growth of profit margins are indirect costs, which are defined loosely as all costs that are not directly incorporated into the manufactured product or service sold. It is a wide range of sheltered expenses in different accounting categories such as travel, consulting and legal services, office supplies, communication, rental cars and MRO, to name just a few of the primary ones.
The consequence of not addressing overhead with a firm approach affects not only profit margins but also considerable loss of productivity.
The size of the problem
Indirect costs can add up to 50 percent of total expenditures in industrial enterprises and 90 percent in service companies, and consume up to 80 percent of procurement efforts and resources. Organizations will realize the huge negative impact this has upon profits.
The question then often becomes, "How could this situation have occurred for so long undetected?" And most surprising is to see that the organization continues to ignore opportunities that could quickly help their profit margins recover.
Most organizations have fought successfully to manage their spending on direct materials, extracting maximum benefits from their supply chains. Why then are excessive indirect costs neglected when they can have an equal or greater impact on profit?
Indirect costs can escape the rigors and surveillance normally applied to direct purchases. In the case of indirect spend, there is no consolidation and centralization of controls, there are the no bills of materials (BOMs) or part numbers. These costs are scattered throughout the organization and influenced by a wide range of individuals and groups. Any approach that is conducted from only a financial perspective is often too late and will likeley fail. It.
Some factors to consider in attacking this problem are:
- Some indirect costs have remained so long without being challenged that they may have become institutionalized
- Individuals and groups feel empowered and are reluctant to adapt to the rules and process control
- "Special relations of trust" with the sellers may exist
- General lack of specialization and expertise in commodities (category management) that individually represent low-value purchases
All of the above are combined with the difficulty of visualizing the problem on a consolidated basis. It is difficult to have all the information in one place. The ERP system will not be able to consolidate the whole situation. Different nomenclatures and classifications combine to hide the same expense from different business units, diluting its importance to the whole and keeping them below the radar.
The effort pays off
In addition to the benefits that have been expressed, more effective management of indirect purchases brings amazing productivity gains. Organizations become lighter, thinner (lean) and focused on cash generation and margin recovery, even without substantial changes in the top line (increments of sales).
Studies conducted by Michigan State University indicate that a more focused management of shopping as a whole — not only in direct or indirect — brings overwhelming results:
- 25 percent cost reduction
- 50 percent reduction in delivery times
- 18 percent inventory reduction
- 93 percent reduction in noncompliance of suppliers
The results are rewarding, and efforts are definitely worth it. The question is: How?
The path is not easy and can create considerable organizational stress. Among the four factors that hinder a more aggressive approach to the subject as previously indicated is enormous cultural resistance. There is an emotional component that permeates the organization.
Individuals consider their indirect purchases to be their "rights," and any effort to curtail the practice would be an encroachment into their private domains. Spending is power. Nowhere are emotions so easily ignited.
For these reasons, the more successful practitioners have realized using agents external to the organization is effective and almost necessary to achieve progress. The challenge is to change behavior and to institutionalize organizational and administrative arrangements so as to prevent the accumulation of unnecessary costs and margin squeeze.
There is no ready recipe, and each organization has a unique situation. However, the most successful efforts at controlling indirect spend do have some features in common. The analysis of each activity as a separate value chain of the organization is one approach. Analyze all activity from start to finish, and determine if the right combination of management involvement, individuals, technology and processes is in place.
Putting the plan to action
Are any companies following these guidelines? With no clear examples that connect actions and results, this article would run the risk of becoming a tangle of ethereal theories with no connection to reality. Let's take a look at a recent successful example in the approach to cost management.
Recently, the Brazilian trio who heads the fund 3G Capital caused great fanfare in the corporate world by merging Heinz with Kraft Foods in a $46 billion deal to form a joint operation with revenues of $29.1 billion annually.
The market response was immediate. Kraft experienced a dramatic increase of more than 30 percent in value.
Overall, financial market analysts estimate the structures of American companies often swell in times of plenty and pay a high price by failing to adjust their operations to the more restrictive setting. Minority shareholders question the benefits and bonuses of top executives, alleging that they are incompatible to the generated results.
Since 2013, when 3G and Berkshire Hathaway took over, Heinz cut large and small expenses the same way. There were 7,000 direct jobs cut, many in management level. Six obsolete factories were closed, including the first plant of Heinz, where it all began. The offices that took care of global operations and the American operations have been consolidated in a single physical space that is smaller than each of the individual operations was beforehand.
The use of private business jets has become a legend. It is known that they were used in the past, but no one remembers when and where. The product portfolio was also trimmed, removing from circulation some tired brands.
In smaller expenses, the most emblematic was the restriction of printing. Each employee can only print 200 copies per month, using both sides of paper. Color copies are subject to permission. Picture this in your company, and you will see the strength and importance of the cultural factor in managing overhead costs.
The founder of the New England Consulting Group, Gary Stibel, defined the 3G's performance as follows: "When they see something that isn't working, they eliminate it. It's a very healthy diet for the company, whether it's in food, beverage or otherwise, and it does work."
The new Kraft/Heinz organization is expected to cut $1.5 billion by 2017, only by the rationalization of duplicate operations. The consolidation of headquarters, now divided between Pittsburgh and Chicago, will be a matter of time. It's always good to remember that there are no tangible benefits at first, according to a study at Michigan State University, but the cost of rationalization will create a much more efficient new company.
Improved margins in Heinz were made without a substantial increase in revenue. The growing preference among Americans for a healthier diet has hindered the growth of the bottom line.
What is the magic tool?
The main tool is zero-based budgeting . The budget for a new fiscal year begins completely reset, instead of using figures for the previous year as base and achieving timely adjustments. The introduction of any expenditure involves the analysis of the impact of its result on the specific value chain within the organization.
Suppliers are under pressure to have their contracts reviewed, employees have the opportunity to align with the organization's strategy, and leadership is strengthened. Everything happens at once, before the start of the game.
If you are supply chain area manager and do not want to see a fifth column develping and tarnishing profits, focusing on the management of indirect costs is essential to preserving the margins of the enterprise.
