Overzealous cost cutting can go beyond cutting fat and start cutting into the muscle of your business.
Capterra’s 2023 Financial Planning Survey reveals that 92% of small-to-midsize businesses (SMBs) fear the impact of high inflation on their operations.*
As a small-business owner, chances are you’re already operating lean to keep costs under control. But the prospect of a downturn or slow season may prompt you to adopt more aggressive cost-cutting measures.
While immediate cost cuts may seem like a quick fix to save money in the short term, focusing solely on this strategy can create a vicious cycle of cost cutting, degrading your product or service quality and dampening employee morale. A more sustainable approach is to not just slash costs for now but also identify cost-saving opportunities that can be sustained in the long run.
Drawing from Gartner’s research[1] and advice from Antonio Dos Santos[2], director of UK-based accounting agency Mercantile Accounting, we discuss how SMBs can strategically identify ways to reduce operating costs.
“Cost cutting isn't just a strategy; it's a culture. It's about everyone understanding and acting on the company's financial realities.”
Antonio Dos Santos
Director, Mercantile Accounting
What are operating costs?
Operating costs are the expenses incurred to run your day-to-day business operations, such as the rent of office space and salaries of employees.
Operating costs = Cost of goods sold (COGS) + Operating expenses (OPEX)
COGS means expenses directly linked with the production of your goods or services, such as raw material or labor costs. OPEX refers to all other expenses not directly linked with producing goods or services but associated with their sales, such as marketing or research and development.
Strategy #1. Decide in advance when and how to prioritize cost-cutting measures
This approach involves taking a hard look at your small business’s essential functions and expenditures to understand your cost factors and pinpoint areas where you can trim costs. This one-time cost-cutting strategy focuses on reducing or eliminating existing nonessential or unnecessary expenses—for example, a standard 5% to 10% reduction to each budget item in a quarter.
A few areas to reduce operating costs under this strategy:
Decommissioning an asset or site, say an outdated software tool
Eliminating nonessential spending such as business travel
Shifting to energy-efficient resources to power operations (Keep in mind the initial capital you’ll need to implement this measure.)
Allowing employees to work from home to save on real estate expenses
Reducing the amount of packaging costs through redesign
Changing or renegotiating contract terms with suppliers
Using external service providers or freelancers for noncore business functions
Keeping employee compensation at the same level
Reducing the number of employees
While sweeping cost cuts such as layoffs can be deployed, it’s advised to remain flexible when implementing them to ensure they’re absolutely necessary and well thought out. Not to forget, the impact of layoffs is not just immediate but also long term.
As the economy recovers and your business starts to grow again, you’ll struggle to attract and retain talent due to previous layoffs. Instead of layoffs, consider implementing salary freezes or cuts, four-day workweeks, or remote work. Voluntary layoffs and furloughs are also options you can explore.
/ CASE STUDY
How hiring contractors helped a retail business reduce operational expenses
Staffing is a big factor in cost optimization for small businesses. The choice to hire full-time workers versus contractors can affect costs significantly, especially if your operations revolve between busy and slow periods.
Consider the case of a small retail business client shared by Santos. This business operated in a cyclical industry characterized by large swings in work volume. They found themselves hiring additional staff during boom periods and struggling to meet payroll during downturns. They grappled with the big question: Should they engage full-time employees or contractors?
While contractors cost more daily, they offered flexibility during lean times, helping hedge market fluctuations. Conversely, full-time employees provided stability to operations but posed financial challenges during downturns.
Implementing a flexing staffing strategy
“We advised the business to hire contractors for high work volume periods instead of adding more full-time staff,” shares Santos. “We also told them to be open and honest with these contractors about the possibility of downsizing during lean periods. This approach is less painful than laying off full-time staff who believe they have stable jobs.” He also encouraged the business to outsource tasks such as branding, web development, legal consultation, and accounting, and keep only core functions in-house.
Santos adds, “If the situation was reversed, say we were dealing with a business in a steady industry, I would suggest they keep their staff and to keep smaller, better-equipped teams. Hiring contractors can end up costing more money in the long run than training your own staff in-house.”
Adopting this staffing strategy helped the retail business navigate several market ups and downs without having to fire anyone. They were able to reduce workforce costs and maintain operational efficiency.
/ Tech spotlight
Accounting software can scrutinize your cash flow and financial records to pinpoint where your operating expenses and costs are coming from. Its financial reporting functionality can analyze your balance sheet, income statements, and general ledger to identify cost drivers as well as the profit each driver brings to your business. Start your search with our roundup of the top 25 accounting software solutions.
Strategy #2. Optimize the use of current resources to improve performance
This is a tactical approach that goes beyond reactionary cuts and focuses on cost optimization to reduce the cost of existing resources. For example, you can use software to automate expensive business processes such as onboarding new employees or clients.
A few areas to optimize costs under this strategy:
Sharing assets or tools across departments for higher efficiency of resources
Improving the way raw materials are used to produce products
Training staff to optimize current performance
Moving operations to a more cost-effective region
Using data and analytics to re-price a product or service for maximum profitability
Moving from on-premises data centers to the cloud
Digitalizing information and automating repetitive tasks
/ Tech spotlight
Budgeting and forecasting solutions can find deviations between your planned and actual expenses to uncover where you can improve performance. These tools can create, track, and manage budgets to ensure you spend appropriately. Some tools can even analyze budget variances to understand why they may have occurred. Was it due to overspending, unexpected costs, or inaccurate budgeting?
If you are looking for a comprehensive accounting solution with built-in budgeting features, try out our free Fit Finder tool. Simply add the features you seek, and it’ll compare the top products tailored to your specific needs.
Strategy #3. Invest in new capabilities to deliver higher business value
Extend your cost optimization efforts to invest in new growth opportunities that drive value in the long term. While it’ll take you money to invest in these new opportunities, those expenses will likely be offset by the gains you see over the next few months or years.
This is a great strategy to adopt when the market is down so you can see wins when coming out of the downturn. It goes beyond using automation to optimize costs and involves rethinking the entire cost basis of your small business. For example, you can use analytics to predict changing consumer preferences to take preemptive actions.
A few areas to build long-term business value through this strategy:
Using new technology such as artificial intelligence (AI) and machine learning (ML) to improve decision-making and customer experience.
Acquiring inexpensive assets or new talent through mergers and acquisitions (M&As).
Deploying digital-only solutions to deliver products and services.
Shifting to a metered pricing model, such as periodic subscriptions, to create a new revenue stream.
/ Service spotlight
Prioritizing new initiatives can be tough when your focus is on survival. Work with experts who can see beyond the urgency of fund availability. Browse our list of expert accounting and financial advisors to discuss your unique business needs and leverage their years of expertise to identify future expansion and growth opportunities.
Comparing the three cost reduction strategies
Let’s sum up the key differences between the three cost-cutting strategies we discussed above:
Cost cutting | Cost optimization | Value optimization | |
|---|---|---|---|
What it does | Stops the bleeding | Establishes parity | Leapfrogs the competition |
Cost management focus | Eliminating and redirecting expenses | Instituting best practices and frameworks | Reinventing business
|
Example use case | Supplier contract negotiation | Chatbot-based customer self-service | Churn prediction to retain loyal customers |
Understanding your costs from the start is the key
According to Santos, when you’re trying to save money, whether you should focus on immediate cost cuts or future cost optimization will mainly depend on your production costs, profit margins, and business model.
“It’s not about needing both long-term and short-term cost-cutting strategies, but more about deciding which one you need right now.”
Antonio Dos Santos
To comprehend the factors influencing your costs:
Analyze your business expenditure. Thoroughly review each item on your financial statements to see where your money is going—the smallest and biggest chunks. Financial reporting software can help you generate an accurate and detailed breakdown of your cost and revenue streams. Here are some free options you can check out.
Identify revenue-to-expense ratio trends. If your revenue is consistently falling short of expenses, it’s a crisis. You need to act fast and take meaningful measures to control costs. But if the shortfall is happening only in certain months, it might only be seasonal fluctuations, a dip in the economy, or other temporary factors.
Consider the nature of your products or services. If you deal in low-markup products with small profit margins, such as grocery items, you’ll usually work with a tight budget. In such cases, start cost savings from the start, and sustain the practices in the long haul. On the flip side, if your business is in a high-margin industry, say luxury goods or software development, you’ve got more flexibility. When required, you can trim down nonessential costs, such as branding or research, and then put more money into them when times get better.
Move beyond defensive cost cutting to a smart cost-saving culture
Overzealous cost cutting can go beyond cutting fat and can start cutting into the muscle of your small business, which could hinder recovery. Be mindful to avoid operational cost reductions so deep that they compromise quality and trigger issues that may damage your reputation and bottom line.
As a guiding principle, always assess whether a cost cut will negatively affect your business and to what extent.
Moreover, develop a comprehensive cost optimization plan across all three cost management categories and maintain open communication lines with your team to prevent confusion and disruptions. Remember, cost optimization isn’t a one-and-done activity but an ongoing set of initiatives.
When managing your business through tough times, it’s important to gather as much information as possible. Dive deeper with these additional Capterra resources: