As cyclical growth returns to many industrial sectors, few executives expect a repeat of the easy ride they enjoyed in the late 1990s. Opportunities abound, but most leading industries must face up to a prolonged period of extreme competition.¹ Signs of the new turbulence are everywhere. Pharmaceutical companies have recently seen their margins and market values plummet by 25 percent or more, companies in traditional manufacturing sectors (such as the automotive industry) are losing ground to rivals from developing countries, and high-tech companies must contend with the growing power of Asian competitors as well as slowing demand.

Such pressures mean that many businesses desperately need a new approach to managing costs—one that reduces them over the long term. Much has been written about how to cut operating costs through "lean" and other techniques but not about how to apply disciplined cost reduction thinking to overhead functions, including finance, human resources, IT, and legal. No company can sustain a long-term program without tackling these areas, whose costs typically match the profit margins of most of today's corporations and are often growing faster than revenues.

The process of lowering overhead costs sustainably is deeper and more subtle than most companies realize. The tactical margin improvements that might be enough to meet a one-off quarterly earnings gap or to compensate for a delayed product launch will not bring about deeply embedded change, while more broadly ambitious cost reduction programs often lose their impetus after the initial effort. Companies that truly transform their approach to overhead costs, by contrast, design sustainability into the heart of their programs, aligning their costs with their strategies and maintaining a strong commitment to the effort. Only in this way can companies thrive during a competitive era in which they must simultaneously cut costs and increase revenues.

Why most overhead-cost programs fail

Programs to reduce overhead costs may well be the most difficult form of organizational change to maintain, for four reasons. First, these programs, by their very nature, tend to dampen morale by disrupting daily work rhythms and generating "noise" that filters up the management chain, especially when head counts are cut. Second, managers invariably want to enlarge the business, not trim it; the temptation for them is always to switch the focus back to expansion. Third, all companies operate within an economic cycle. Overhead-cost programs are often born in economic downturns, but as growth revives, managers find it easier to avoid difficult decisions. Finally, managers in general closely track how operating costs change but quite often fail to pay attention to overhead costs. The result: cost increases that mount over time.

Our own research into companies that have undertaken cost reduction programs highlights the difficulties and indicates just how few companies stay the course (see sidebar "The scale of the cost challenge"). Top managers at one leading multinational, for instance, endorsed a long list of proposed cuts in overhead—until talk turned to the future of the company jet. It takes strong leadership to resist such pressures.

Even initiatives led by committed executives can falter because of poor sequencing and inadequate design. Sustainable initiatives must always be harnessed to long-term strategic objectives: only after determining which overhead activities truly support business priorities should managers focus on driving out inefficiencies. To do otherwise risks eliminating strategically important overhead activities that must then be restored or failing to cut nonstrategic activities adequately. Either error makes cost cutting the enemy of top-line growth and undermines the effort's sustainability.

Any failure to sustain a cost-cutting program results in more than just unchanged or higher costs; overall it can weaken a company's resolve to deal with difficult issues and undermine management's credibility. Take the global bank that embarked on an ambitious "support function redesign" to reduce overhead costs by 25 percent. Line managers were made accountable for achieving this target—and duly met it. The bank, though, lost much more in the process. Managers failed to understand the program's rationale or to respect the benchmarks. They were given no tools or training to help them target and eliminate waste. And there was too little analysis of what made costs balloon in the first place. The net result was fewer people doing more work in the same old way, leading to a vicious spiral of declining morale, quality, and productivity. Parts of the bank ground to a halt. Two years later, costs are on their way back up and employees feel wronged. It might be difficult for this bank to commit itself to cutting overhead costs again.

The fundamentals of cost transformation

Three related factors determine the cost structure of an organization's support functions: capabilities specify what an organization can do (for example, generate specific types of financial reports), demand indicates the extent to which those capabilities are used (how often reports are generated), and efficiency shapes how well they are delivered (the quality, timeliness, and cost of providing reports).

Companies looking to remove overhead costs in the long term must consider these three factors in sequence. Executives eager to deal with inefficiencies frequently jump straight in, ignoring broader questions about capabilities and demand. But the right setup is a vital first step to maintaining momentum. Then, once the program is under way, committed leaders must guard against complacency and lapses back into bad habits.

Shape capabilities to strategy

Cost-cutting measures that hinder a company's growth objectives will probably be reversed, while those that sharpen its strategic focus and create support functions that clearly add value to the operating units are likely to be retained. Thus companies must examine the "what" (the value created by each organizational unit) before analyzing the "how" (the way the organization seeks to deliver that value). A global entertainment business, for example, discovered that it was turning huge amounts of customer data into managerial reports that had little impact on the direction and development of the business. Most companies can find similar waste in all of their functions but particularly in finance, human resources, and IT.

There is no magic formula for the process of finding waste: only detailed scrutiny will reveal which activities to keep and which to cut. Even companies in the same industry can have sharply different overhead profiles if their strategies are distinct. Take two competing retailers. One defines being first in any market as critical to its strategy and thus pays a premium for its real-estate professionals. The other limits its market-entry risk by locating stores only where other retailers have already proved successful. It regards its real-estate staff as an important, but mainly transactional, group.

In some cases, capability reviews can highlight opportunities to reshape functions radically. One European chemical company, for instance, reduced the number of staff members in its business-development function to 40, from 240. Because the company also sharpened its focus on exactly what it required to drive revenue, however, its overall performance rose rather than fell.

Moreover, a company that shows its employees how the reshaping of capabilities will help it to sustain itself, survive, and grow focuses their attention on the positive aspects of change. To undergo the discomfort associated with any cost initiative, employees must understand what's in it for them. Without some visualization of the way the underlying goals are linked to overall corporate strategy, a cost program can deteriorate into a "race for the numbers" and, in the process, lose the support of the workforce.

Reduce demand for services

Once companies decide which capabilities are essential to their strategies, they can turn their attention to demand—that is, to how often those capabilities are used. Optimizing the delivery of overhead activities before assessing demand for them risks misjudging both the total amount of work to be done and the level of staffing needed.

Companies can best control demand in three ways.

Remove internal management centers and layers. Over time, organic growth and geographic expansion tend to produce cost anomalies in reporting relationships and spans of control, particularly when companies move into smaller countries or set up smaller operating units and replicate operating structures appropriate to larger ones. Simple ratios of staff to managers generally highlight these discrepancies.

One global professional-services firm identified an opportunity to reduce substantially the number of profit-and-loss accounts it used, by drawing its professionals into broader groups of pooled expertise. The delayering drove down costs, eliminated the need for smaller and highly dispersed finance and human-resources teams across a broad range of locations, and enhanced the professionalism of the people who remained.

Cut time intervals and the number of end products. A leading US financial-services company boosted its performance by redesigning its strategic-planning process: business unit plans were reduced to 5 pages, from 80, and the strategic-planning cycle was trimmed to six weeks, from four months. Shorter documents generated more dialogue, and a shorter planning cycle produced a strategy more responsive to the market. Planning teams could focus solely on the core elements essential to performance—an approach that opened up time to concentrate on implementation.

A diversified global technology company identified a range of demand-management savings by reviewing its support functions. Payrolls for some employees were changed from weekly to every other week, a number of groups started to close their books quarterly rather than monthly, and a broad range of financial summaries was reshaped, greatly reducing the resources they used. Eliminating reports that were no longer critical to business activities or were duplicated unnecessarily for different parts of the organization offered similar opportunities.

Address attitudes and behavior. Dealing with mind-sets and the behavior they generate is a critical component of managing demand. A large US automotive company, for example, found that it had many more staff members employed in support functions than its rivals did. It turned out that a large number were spending a good deal of time fielding questions from the CEO and that each function was building capabilities to meet his expectations. Once the CEO understood the ramifications of his inquisitiveness, he evaluated his requests more carefully, which made it possible to redeploy a number of skilled people. Furthermore, the CEO's willingness to change his own ways sent a strong signal to employees.

Franchise organizations offer particularly useful insights into managing demand. A franchiser treads a difficult line between providing what its franchisees think they want and offering what it believes will generate the most income. Faced with a host of specific one-off requests, sophisticated franchisers set clear boundaries for the services they will provide and make the financial implications of each demand clear to the franchisee. The IT department of a fast-food franchiser, for instance, managed demand for IT services by sending its franchisees answers to Frequently Asked Questions. It then imposed a small service charge for calls to IT support, with the result that it received many fewer of them.

Make delivery more efficient

Once companies figure out which of their overhead capabilities to cut and reduce internal demand for overhead support, they should address their efficiency in delivering the remaining overhead activities. As the exhibit shows, proper sequencing is again essential to long-term success. To avoid missing substantial savings opportunities, companies must again ask "where" and "by whom" before evaluating "how" a given activity is to be delivered.

Can costs be cut by consolidating activities? Scale benefits often result from the consolidation of activities; those requiring the services of many employees only part of the time can be concentrated by creating shared services that use fewer employees, cut costs, and improve quality. Businesses that haven't reorganized themselves recently may find significant opportunities of this kind, notably in finance but also in the communications, human-resources, legal, and real-estate functions. The CFO of a large North American financial institution, for example, found that he had many more finance professionals than he had realized; some worked in locations with their own finance language, reporting processes, and career paths. Reorganizing the finance function as a shared service not only saved money but also provided a more transparent career path for the finance professionals, thereby increasing their commitment to the business and enhancing their expertise.

Can costs be cut by moving activities to new locations or organizations? Once the opportunity to aggregate an activity has been identified, debate can turn to the best place to deliver it and whether it should be outsourced. This novel option can improve its effectiveness as well as provide continuing cost reductions that many organizations find hard to match in house. Moreover, the larger the block of services offered to an outsourcer and the better management understands the cost of providing them internally, the more favorable its negotiating position should be.

Can activities be further improved? The previous questions define the "who" and the "where" of delivering functional services. When these broad parameters have been set, the focus can shift to optimizing the execution of each activity—the "how." Analytical techniques such as activity value analysis and process redesign usually come into play at this stage to identify the root causes of any barriers to improved performance. Although many traditional cost cutters start here to seek quick wins from process improvements, overlooking the preliminary steps compromises a program's long-term sustainability.

An important aim at this point is to introduce a cost reduction approach that everyone can embrace. Building an environment that has a common language, analytical tools, and enabling metrics, as well as the rapid decision-making authority needed to sustain change, requires a commitment to create and develop the appropriate skills and practices.

Does the change cut personnel costs? Most overhead-cost initiatives involve reducing head counts or reallocating personnel. The rigorous upfront capability analysis already completed highlights opportunities to retain and redeploy as much talent as possible, thus preserving the skills and experience that embody the organization's institutional knowledge. Only after these opportunities have been exhausted should labor-force-restructuring tools be brought to bear. In support functions, this stage must be handled with particular care: specialized procurement professionals or IT developers, for example, are harder to redeploy than are many operations employees.

Sustainability: An elusive goal

Ultimately, the sustainability of cost reductions depends on the resolve of senior management. Executives must stay the course as the economy improves and continue to be generous with their own time and effort. The leaders of a global packaging business, for instance, attended a two-week "boot camp" to acquire cost-cutting skills and then kept in touch with the program's progress by attending regular progress reviews—a commitment seen elsewhere in the organization as a litmus test for the company's continuing resolve.

A common approach is also essential. The CFO and chief administrative officer of one large technology company agreed on the magnitude of the change needed but not on how to accomplish it. Their differences ultimately eroded commitment to the program and its sustainability.

Senior executives can use operational plans and budgets to keep up the pressure. In some companies, managers are expected to submit budgets without any growth in funding; new investments must be financed through cost reductions. Other organizations insert "collaborative conflict" into the cost-cutting process through the use of zero-sum budgeting: if one function cannot reach its high target, it must gain agreement from another unit to take on that burden. Still other organizations focus their leadership teams on the sustainability of a cost opportunity by using frameworks similar to the one in the sidebar "Confronting the threats to sustainability."

Well-designed and well-executed programs can enable companies to sustain cost reductions. An early concentration on strategic capabilities and on controlling demand builds the foundation for the longer term, enhancing the commitment and excitement of employees across the organization and positioning it for high-margin growth.