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Building Competitive Advantage Through Strategic Cost Reduction
Building Competitive Advantage Through Strategic Cost Reduction
For too many firms, cutting costs is a management priority when business conditions are weak, only to be forgotten when economic growth resumes. But continually increasing operating efficiency is fundamental to success in both good times and bad. In this report, Deloitte Research presents the latest approaches to building competitive advantage by reducing costs throughout every aspect of the enterprise.
CONTENTS
Executive Summary .............................................................. 2 Introduction ........................................................................ 5 A Strategic Approach Required .............................................. 7 Crafting a Cost Reduction Program ........................................ 8 Building Blocks for a Cost Reduction Program ....................... 14 Tomorrows Agenda ............................................................ 24 About Deloitte Research ...................................................... 27
Executive Summary
Financial services institutions need to adopt a strategic approach to cost reduction that generates near-term cost savings while at the same time builds a more efficient operating model over the long term. Firms that use cost reduction to create a leaner, more efficient organization will not only survive the current difficult economic conditions, but will also prosper throughout all phases of the business cycle. The economic downturn that hit the United States and other countries in 2001 has made cost reduction the management topic of the day. Financial services firms have moved aggressively to cut expenses, including widespread layoffs. But while reduced business volumes require fewer employees, too often firms fail to take steps to permanently increase their operating efficiency. Yet in both good economic times and bad, firms that successfully increase their operating efficiency are rewarded by investors. For example, during the period of strong economic growth from 1997 to 2000, the large banks with the best efficiency ratios saw their share prices rise by an average annual rate of 13.6 percent, compared to an average annual share price increase
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A Strategic Approach Required. To reap these benefits, financial services firms need to take a strategic approach to cost reduction with the following five characteristics: 1. Linked to Strategic Goals. The first step is to reexamine a firms business strategy to ensure that it remains relevant to changing market conditions. A strategic approach then carefully aligns cost reduction initiatives with the reconfirmed strategy, rather than relying on across-the-board reductions that could undermine business objectives. 2. Comprehensive. Instead of focusing only on staff reductions, strategic cost reduction analyzes the entire organization for cost-cutting opportunities. 3. Sustainable Cost Savings. A strategic approach increases efficiency by rethinking both what the firm does and how it does it. 4. Phased Implementation. Initiatives include both quick wins and longer-term measures that are more difficult to implement but offer greater cost savings. 5. Senior Management Commitment. An essential ingredient is the full commitment of senior management, which can best be demonstrated by appointing a prominent senior executive to lead the effort.
of 9.6 percent for the 100 largest banks. However, the large banks that showed the greatest improvement in efficiency fared even better, with an average annual share price increase of 19.2 percent over the period. Firms that continue to improve their efficiency are rewarded by investors with higher share prices.
Crafting a Cost Reduction Program. A five-step methodology can help firms design a strategic cost reduction program that will create long-term gains in efficiency: 1. Reexamine Strategy. A firm first needs to review its business strategy to ensure it remains relevant and then clarify its strategic goals before designing a cost reduction program to complement them. 2. Establish the Cost Base. A cost reduction program is only as good as the data on which it is based. Firms need to gather and analyze detailed data on their current costs, as well as understand the history of management decisions that led to the current cost structure. 3. Set Cost Reduction Targets. Firms can establish the goals for a cost reduction initiative by analyzing the enterprise from three perspectives: industry best practice, an internal assessment of cost reduction opportunities, and the level of cost reduction that is assumed in the current share price. 4. Identify Potential Initiatives. A variety of techniques can be used to develop a list of potential cost reduction initiatives, including tapping management knowledge, identifying large areas of cost and their cost drivers, comparing the level of costs across the organization, and examining best practices. 5. Prioritize Initiatives. Finally, a portfolio of short-term and long-term initiatives must be created and prioritized using criteria such as the investment required, potential benefit, speed of implementation, and risks involved.
Strategic cost reduction is complex and requires a significant commitment to be successful. Before undertaking a strategic cost reduction program, a firm must ask itself some pointed questions: 1. The Devil is in the Details: Does the organization haveor is it prepared to developaccurate, detailed cost data on which to design and defend a strategic cost reduction program? 2. Best Practice: How efficient are individual business units when compared both internally and to leading competitors? 3. Investor Criteria: What are investor expectations regarding the size and speed of cost reductions? 4. Gauging Appetites: How urgent is the need to reduce costs? Does the organization have the appetite for the fundamental changes required to increase efficiency? 5. Total Commitment: Is senior management fully committed to the effort and ready to stay actively involved? What methods and measures are in place to monitor progress? Are these criteria embedded in the organization and linked to employee evaluation and compensation systems? Firms that are prepared to make the commitment to a strategic cost reduction program can not only generate short-term cost savings, they also build long-term competitive advantage by creating leaner, more efficient operations. Financial services firms that integrate an ongoing search for increased efficiency into their business cultures will be those that emerge as leaders in the years ahead.
SAMPLE INITIATIVES
Pay severance benefits from qualified pension plan Consolidate pension and benefit programs Link compensation more closely to performance
COMMENTS
Single largest expense category, often 50 percent of total expenses Reductions of 25 percent in HR administrative expenses are possible Improved HR practices can also drive desired business outcomes Difficult to achieve short-term savings due to lease contracts Savings of up to 20 percent are possible, but only if aggressively pursued; three to five years required for full implementation Additional short-term savings can be achieved quickly (30 percent or more), but are not sustainable Although larger cost reductions are possible, these are not sustainable without long-term damage Firms that maintain their level of marketing activity can gain market share Cost reductions can be substantial, although size of savings varies widely depending on the characteristics of individual firms and country tax regimes Shift to lower-cost provider, who performs function as core competency Replace fixed costs with variable costs Management time and resources freed to focus on core business activities Opportunity to generate additional revenue from strategic partnerships with vendors Outsourcing not a cure for inefficient operations Global purchasing power leveraged Increased price transparency Improved oversight to ensure that appropriate goods and services are purchased and at competitive cost Multiple operations centers resulting from acquisitions have often not been integrated Redundant IT systems can be eliminated and headcount reduced Service centers can be located where real estate and labor are less expensive Eliminating manual processes can reduce headcount Reduced interest expense on outstanding receivables Automated processes are less expensive to administer and produce fewer processing errors Zero-based evaluation of business processes can result in significant reductions in headcount Streamlined processes must not weaken risk management controls
s s
Occupancy Costs
s s s
520%
s s
Revise policies and procedures Improve monitoring and enforcement of compliance Revise policies and procedures Improve monitoring of return on spend
510%
s s
510%
Tax
Tax-efficient structuring of financing, leasing, research and development, and corporate restructuring Outsourcing aspects of major business processes Strategic partnerships with vendors
NA
Outsourcing
Up to 10%
s s
Strategic Sourcing
s s s s
Create global procurement Create uniform standards Reduce number of suppliers Improve monitoring of contract compliance Shared-service centers to achieve economies of scale
1525%
s s s
Functional Consolidation
1020%
Automation
s s s s
1520%
Reengineering
2530%
*Sustainable cost reduction that can be achieved by typical firms consistent with long-term growth. Depending on their specific circumstances, individual firms may achieve either higher or lower cost savings than these estimates. Note: These cost reduction estimates are not cumulative.
Introduction
Increasing efficiency should be a cornerstone of corporate strategy whether the economy is expanding or contracting, yet most financial services firms have only focused on cost reduction in response to the economic slowdown that began in many countries in 2001. Firms in sectors with declining business activity and revenues, such as investment banking, have announced deep cuts in personnel and other expense items to reflect reduced business volumes.While needed, these volume-related reductions dont build sustainable competitive advantage by increasing productivity. Often, they can instead be handicaps. When business picks up, headcount and expenses rise once again, and firms must bear the cost of rehiring and retraining staff. This phenomenon is most pronounced in the securities industry, which is dependent on volatile revenues from capital markets. Longer-term cost reduction programs are more common among commercial banks and insurance companies, which attempt to improve their returns through cost-cutting to compensate for their more stable, but slower-growing, revenues.There are instances of drastic cost reduction programs even in these parts of the industry, however, such as the estimated 10 percent reduction in workforce at Germanys big banks in late 2001. Today, all financial services firms are finding that several longterm trends will continue to place pressure on profits even when the economy is growing well: s Commoditization of Products. For many financial products, there is little difference in the offerings from different providers. As financial products become perceived as commodities, firms are forced to compete more on price.
s e-Commerce. The Internet has driven down margins by giving consumers the ability to easily compare offerings from multiple providers. The motto of LendingTree, which allows consumers to instantly solicit quotes from its 3,600 participating U.S. financial institutions, sums up the impact of e-commerce: When banks compete, you win. s Increased Competition. Today, banks, securities firms, and insurance companies have entered each others markets as traditional industry lines have faded. Meanwhile, financial services firms are now competing as well with nontraditional competitors, such as retail, industrial, and software firms. These long-term trends have all tended to reduce profit margins for financial services firms, making operating efficiency an essential ingredient to generating superior shareholder returns.
More efficient banks fared better. The 10 banks in the group with the best efficiency ratios (defined as the ratio of non-interest expense to operating income) had an average efficiency ratio of only 40.4 percent, and their share prices outpaced the group as a whole, growing at an annual rate of 13.6 percent. But the greatest increases in share prices occurred in the stocks of the banks that showed the greatest improvement in their efficiency ratios, rather than those that were most efficient in an absolute sense. The 10 banks with the greatest improvement in their efficiency ratios had an average ratio of just 60.8 percent better than the average ratio for the group as a whole, but far behind the average ratio for the 10 most efficient banks. Yet the average annual change in their stock prices over the period was 19.2 percentsignificantly higher than the 13.6 percent gain for the 10 most efficient banks. More efficient firms are rewarded by the market, but the key to maximizing shareholder value is increasing the efficiency of
It is not surprising that financial services firms look first to reducing headcount. Personnel costs are easily the largest expense item, exceeding 60 percent of total non-interest expenses for some institutions. Firms added employees rapidly during the 1990s to serve booming markets in such areas as online securities trading, M&A, underwriting, and IPOs. Employment in investment banks around the world swelled by four-fifths over the past decade. When revenues dropped in most lines of business, firms were left with excessive payrolls. For example, cost-income ratios for major securities firms deteriorated between 2000 and 2001. (See Exhibit 2.) Financial services firms must be especially careful to ensure that staff reductions dont damage customer service or threaten hard-won customer relationships. One approach is to use technology more creatively, but this becomes more difficult as IT employees and budgets are also being slashed.
EXHIBIT 2. COST-INCOME RATIOS ARE RISING
operations. Rather than a goal that is ultimately achieved, continually improving operating efficiency has to become a way of doing business.
6
100%
Bank A Bank B Bank C
COST-INCOME RATIO, %
90%
80%
70%
Note: Cost-income ratios for three leading banks SOURCE: DELOITTE RESEARCH
Firms also face the danger that they will lose valuable knowledge and skills that can only be replaced with significant hiring and training costs when business picks up. Some securities firms laid off employees in the financial crisis of 199899 only to find that they had to rehire them a few months later. Firms need a clear understanding of what skills they need to retain and what knowledge each employee possesses. In fact, a Watson Wyatt Worldwide study found that fewer than half the companies surveyed after the 199091 recession met their profit goals after downsizing. "The evidence that downsizing boosts productivity is very weak," Alan Blinder, former vice chairman of the Federal Reserve Board, told The Wall Street Journal Europe.
1
Even when planned with care, layoffs are at best only one element of a strategic cost reduction program. Although they reduce compensation expense, layoffs alone dont increase productivity. Firms require a strategic approach to cost reduction that will generate the short-term cost savings that investors demand, while creating a more efficient operating model over the long term.
Deloitte Research calls this new approach Strategic Flexibility first defining a range of scenarios of what the future may hold and then developing the optimum strategy to respond to each scenario.3 (See The Deloitte Research Strategic Flexibility Initiative on page 26.) Strategic initiatives that are common to all the scenarios constitute the firms core strategy, that is, initiatives that should be undertaken no matter what the future may hold. Investments to improve customer service may be part of the core strategy for many firms. On the other hand, the firms contingent strategies only make
1. Reexamine Strategy
Before designing a cost reduction program, firms need to reexamine their strategy to ensure that it remains relevant, particularly within a highly uncertain environment. Once a firm has reconfirmed and clarified its strategy, it can proceed to design a cost reduction program that complements it. A number of prominent financial services firms have been revising their strategies. AXA and ING both sold their investment banking subsidiaries to concentrate on other businesses. Zurich Financial Services ended its foray into asset management by selling Scudder to Deutsche Bank, and has announced that it will float
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sense for certain scenarios. For example, expansion into China may only make sense if China continues to open its market to foreign investment as part of its agreed entry into the World Trade Organization, the political situation remains stable, and Chinese consumers become more financially sophisticated. Core initiatives will go forward no matter what scenario comes to pass. For contingent initiatives, which are only appropriate to some scenarios, firms must be prepared to implement them if their scenarios become reality. For example, a firm may forge a strategic alliance with a Chinese firm to give it the option to expand its presence in the Chinese market if conditions warrant. Once the core and contingent strategies have been formulated, a firms cost reduction program will have to demonstrate the same flexibility. The cost reduction program will need to ensure that it preserves the capabilities required to execute the core strategy, while providing the ability to change course as required to implement contingent initiatives. Commenting on the uncertain economic environment in which firms operate today, Don Layton, head of J.P. Morgan Chases investment bank, told The Economist that you dont want to bet your life on a forecast. This makes you more interested in a flexible cost structure, and more radical in cutting.4
Zurich Re in an IPO. Merrill Lynch sold its Canadian brokerage business to Canadian Imperial Bank of Commerce, while Charles Schwab announced that it would close its online trading joint venture in Japan. Yet the rapid changes in the business environment today make developing a sound strategy more challenging than ever. The Wall Street Journal reported that Richard Kovacevich, CEO of Wells Fargo & Co., told his board that whatever budget we come up with is almost meaningless.
2
Traditionally, a firm based its strategy on its best prediction of what will occur that will affect the firms business and when it will occur. With todays increasingly uncertain futurewhether about economic growth, consumer preferences, or the impact of terrorismfirms need an approach to strategy that doesnt require them to pretend to have a clear picture of the future.
planned initiatives that are not included in the budget, such as anticipated staff reductions, increased disaster-protection and business-continuity measures, or the introduction of new products. This is also an opportunity to revisit planned initiatives and cancel any that no longer support the firms strategy or fail to meet investment thresholds. This top-line analysis then needs to be drilled down, analyzing each element of the firms costs and headcount by business line, support function, and location. The analysis should include a clear statement of any rules for allocating central and support services, such as systems development and marketing, to individual lines of business. Beyond simply quantifying the cost base, firms should also dig into the past to unearth the history of how the organization came to have its current cost structure. Each organizations cost base is inevitably a product of many regimes of corporate leadership and often numerous acquisitions. Understanding this history often helps a firm identify promising areas for cost reduction. For example, a large U.S. commercial bank was able to reduce mortgage processing costs by 30 percent once it changed a handful of archaic rules that were no longer relevant.
EXHIBIT 3. EXPENSE ITEMS: COMMERCIAL BANKS VS. SECURITIES FIRMS PERCENT, 2000 COMMERCIAL BANKS* SECURITIES FIRMS **
Compensation (salaries, incentive compensation, and benefits) Communications and IT (including outsourcing) Occupancy Advertising and Marketing Other Income Tax
*Analysis of spending of four major U.S. banks as provided in financial statements. **Analysis of spending of three major U.S. securities firms as provided in financial statements. Note: Insurance companies and real estate entities have similar expense categories, but analysis of spending is difficult given reporting differences.
Each view provides one perspective on the appropriate cost reduction targets. By examining cost reduction from all three perspectives, firms can triangulate among them to set a cost reduction target that is both achievable and acceptable to investors. (See Exhibit 4.)
Operational View
Assessment of cost reduction opportunity by organization and function Shareholder expectation imperative based on average return
1015%
711%
s Cost Structure Analysis. Where are the large areas of cost and what are the primary cost drivers? A firm can also analyze each expense line item across all functions, lines of business, and processes to identify which have the highest costs for particular expenses and which are most appropriate to reduce. A firm should also identify high-cost processes that cut across line items and lines of business, such as billing, payment, and transaction processing. This analysis can discover areas where similar or duplicate activities are being performed by different functions that could be streamlined. s Internal Comparative Analysis. How do costs compare across the organization? By comparing cost centers in the firm, a firm can identify where costs are high relative to revenues. A comparative analysis should be conducted of costs for business units, product groups, delivery channels, geographic locations, and customer segments. This analysis can discover discrepancies in staffing or expense levels, although it must always take into account the specific requirements of the products or services involved. It can also highlight areas that have significant levels of manual processes that could potentially be automated. A comparative analysis can identify the best practices that the firm should consider replicating. s External Comparative Analysis. How does the firm compare to best practices? For each area, a firm needs to assess how its performance compares to the companies exhibiting best practices. The firm should then determine what level of improvement would be required to place it at or near best practice on the relevant metrics. This phase results in a list of potential cost reduction initiatives, which can then be prioritized to create a cost reduction program.
5. Prioritize Initiatives
The final step is to prioritize the list of potential initiatives. While each firm needs to develop evaluation criteria suited to its situation, the following considerations are likely to form the core of any evaluation: s Required Investment. What is the required investment, both financially and in staff time? s Size of Benefit. What is the potential benefit if implemented? s Speed. How quickly will the expected benefits be realized? s Ease of Implementation. How easily can the initiative be implemented? Are there technical or cultural obstacles? s Risk. How significant are any risks in implementation? s Contribution to Strategy. How will the initiative affect the organizations strategic goals? s Impact on Business Continuity. How will the initiative affect the firms ability to withstand a disruptive event and maintain continuous operations? Using the criteria developed, the firm can design a program with a mix of short-term and longer-term initiatives in which each phase generates a positive return on investment and is aligned to overall business goals. A detailed business case must then be developed for each high-priority initiative, detailing the required investment, the timetable to implement and to realize savings, and the benefits promised. (See Exhibits 5 and 6.)
11
Low Short
SOURCE: DELOITTE RESEARCH
Long
CRITERIA
12
Contribution to strategy Potential size of benefit Ease of implementation Efficiency gap Speed of realization Organizational impact Priority
1
= Low
2
= Medium
1
= High
13
14
exists to turn surplus pension assets into working capital by transferring non-qualified executive pension benefits to a company's qualified plan. One large U.S. bank used this approach to realize a one-time cash-flow savings of US$6 million. When a pension plan is not over-funded, a firm can still often achieve a valuable cash-flow savings by paying benefits from the plan and then repaying over a 30-year period. In addition, the first payment may not be due for more than a year, depending on the specific date of the transaction. For a firm with a US$1 million severance payment, the annual amortized repayment over 30 years at 8 percent would be US$108,500.The reduced cash flow is especially valuable in the current economic climate.
Employee Benefits. Typically, 18 to 20 percent of compensation expense goes to employee benefits. With compensation often accounting for up to 60 percent of a financial services firms total expenses, benefits alone can account for 12 percent of total expenses. Yet, the cost of employee benefit programs has not usually been managed as aggressively as other elements of the business. Some financial services firms have four or five separate pension and benefit programs, often due to acquisitions, resulting in higher administrative costs. The level of benefits may also vary significantly across plans, increasing costs and threatening to undermine morale. By consolidating pension and benefit plans, firms can reduce both fees to vendors and internal administrative costs. Where plans differ in the level of benefits provided, firms can consider moving over time to a uniform level of benefits at a lower cost. An analysis conducted for a major U.S. insurance company found that rationalizing employee benefits could potentially realize more than US$40 million in annual savings. Compensation Structure. Compensation systems are coming under scrutiny to ensure that they support a firms strategy. A common approach is to link incentive compensation more closely with performance. Today, many firms are paying too much for poor performers and not enough for high performers. As part of this review, firms are also considering shifting short-term cash compensation to longer-term programs that serve to retain strong performers. Innovative non-qualified deferred compensation and performance-driven equity plans are two approaches that some firms are adopting. Critical to the development of these plans is their link to individual performance. Finally, firms are using strategic performance management systems that identify the critical competencies that are required to achieve the firms business goals and then linking these competencies to merit increases and promotions. Employing a range of these techniques has the potential to reduce a firms cost of sales by 3 to 6 percent.
Administrative Efficiency. Firms have the opportunity to significantly reduce their costs of HR administration, often by as much as 25 percent. As the result of mergers, acquisitions, and ERP implementations, many large financial services firms are faced with a complex web of HR technologies and systems. Some services may be outsourced to vendors, while others are managed internally on multiple legacy systems. Coordinating and rationalizing these systems and delivery models can reduce administrative costs by increasing automation and boosting the productivity of the HR function. Service levels can improve as well, with managers and employees gaining remote access to timely HR information. Additional techniques can also generate administrative savings. Employees in other departments performing HR functions can often be consolidated or eliminated. In some cases, headcount can be reduced by consolidating technology staff in HR with those supporting payroll, T&E, tuition reimbursement, and benefits collections. Consolidation of search firms at a time when little hiring is being done can provide significant negotiating leverage that will yield sustainable savings in recruitment fees when the pace of hiring picks up. Finally, some firms are reducing costs by outsourcing HR administration to an outside vendor. (See Page 18.) Training. Consolidation of training programs and use of the Internet to facilitate training (e-learning) can provide both direct and indirect savings by reducing the costs of program development and delivery and by increasing employee productivity by eliminating travel. Although these initiatives are far from simple, requiring changes in both infrastructure and business culture, they can generate significant cost reductions that can be measured in the hundreds of millions of dollars for large, global enterprises.
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liability by contesting their assessments. Property values are now declining, yet most assessed values were established when property values were higher. Seeking Business Incentives. Firms should examine the opportunity to secure business incentives from state and local governments, such as reductions or deferrals of property and sales taxes. While the potential may be highest in New York City in light of September 11th, governments around the United States are likely to be more receptive to requests for business incentives as they work to retain jobs and business activity in the midst of the economic slowdown.
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Outsourcing
Outsourcing has been a popular cost reduction strategy for years, but now firms are applying the concept more broadly and employing new outsourcing arrangements. Firms turn to outsourcing to benefit from the economies of scale that a service provider with larger volumes enjoys, while avoiding large IT investments. In addition, outsourcing allows firms to focus resources and senior management time on core business activities. But outsourcing is not a cure for an inefficient operationin many ways it is as closely linked with financial management as it is with cost reduction. To reap the maximum benefits, workflow should be streamlined before it is outsourced, and then the firm needs to work with its vendor to continually improve operations. For this reason, many firms are looking for shorter contract periods, for instance, five years rather than 10 years, so that they can change the specifications of the contract as their business evolves. Financial services firms are taking a fresh look at their operations to see if there are additional opportunities for outsourcing. Processes or functions that are not central to a firms strategy make good candidates.
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The following are just a few of the firms that have substantially reduced operating costs through outsourcing business processes: s One of the top five bank holding companies in the United States outsourced its process for issuing credit cards, which involved several groups in the firm. Although moving from an in-house to a third-party provider was complex, the change resulted in a US$6 million reduction in its total annual cost of US$30 million. s By outsourcing its IT operations, a major U.S. insurance company reduced its IT expenditures by 20 percent, while still handling increased volumes. s A European insurance companys U.K. operations saved 15 million annually by outsourcing its IT operations. New Outsourcing Models. Not only are firms outsourcing new functions, they are also employing new business models. Some firms are entering into relationships with their vendors that are more like strategic alliances than traditional vendor relationships. For example, Bank of America signed a 10-year contract for US$1.1 billion with Exult, which will assume responsibility for much of the banks human resources and administrative services, including payroll, accounts payable, and travel-related expenses. In addition to receiving a guaranteed savings of 10 percent per year, Bank of America will have access to sell financial services to the roughly half million employees of other Exult clients, like BP Amoco and Unisys Corporation. Financial services firms are also collaborating with their competitors to achieve higher volumes and economies of scale. In the United Kingdom, Barclays and Lloyds TSB (the third and fourth largest banks in the country) combined their check processing into a new company controlled by Unisys. Each bank has a 24.5 percent interest in the new company, which will not only handle their own check processing, but will also compete for business from other banks.
Business Process Outsourcing. In the past, firms have outsourced specific processing services, such as consumer payments, claims, payroll, or orders, as well as specific aspects of their information systems, such as data center operations, desktop management, and e-commerce services. Now firms are moving to outsource aspects of major business processes, such as finance, human resources, marketing, and sales. Business process outsourcing across all industries is growing at 29 percent annually, much faster than other types of outsourcing.
Strategic Sourcing
Many financial institutions pay little attention to their external spending and consequently miss out on the huge potential for cost savings provided by strategic sourcing. Savings can be achieved on a broad range of purchasing categories, including employee benefits, telecommunications, advertising and marketing materials, travel, facilities, and maintenance. (See Exhibit 7.) Procurement should always be aligned with a firms strategic goals and take into consideration such factors as service quality, corporate relationships, and competitive dynamics. While cost is never the sole consideration, firms can achieve important cost reductions by reviewing their procurement processes. Most firms purchase supplies and services from a wide variety of vendors. Price varies between vendors, and each may have different terms and conditions of sale, making analysis and comparison difficult. The purchasing process often varies, with individual departments or branches deciding which products and services to purchase, and negotiating contracts separately.The lack
of standards makes it difficult or impossible to ensure that appropriate amounts of goods and services are purchased at a competitive cost and that contracts are enforced. By making numerous individual purchases, firms forego economies of scale. Firms usually attempt to improve sourcing by increasing competitionsoliciting additional bids and negotiating harder. While these are helpful, other strategies that can unlock additional savings are often overlooked. Innovative strategies include the following: s Increasing price transparency by disaggregating bids. s Reducing complexity by establishing uniform standards. s Reducing the number of suppliers within a given category. s Improving monitoring and enforcement of contract compliance. s Creating a global procurement structure to leverage the organizations global purchasing power. s Working in partnership with key suppliers to jointly lower costs.
Users should be ordering only what they need. Exceptions should be monitored and appropriately controlled
Vendor consideration
VALUE ADD
19
The following firms illustrate the substantial savings that can be achieved by strategic sourcing: s One of the largest commercial banks in the United States was concerned to reduce its US$500 million annual procurement expense, especially since a merger had left it with duplicate vendor contracts in such areas as computer maintenance, direct marketing, and office equipment. By renegotiating duplicate vendor contracts, the firm reduced procurement expense by more than US$50 million within the first 12 months, and expects the program to yield US$80 million in annual cost savings when fully implemented. s A major U.S. commercial bank undertook an aggressive program to reduce its annual telecommunications expense, including contracts for voice, data, and wireless service. The firm analyzed best practices in the industry and reorganized its telecommunications sourcing through such initiatives as renegotiated contract rates, competitive bidding, a central contract database, and enterprise-wide sourcing. The strategic sourcing program reduced the banks total voice and data bill by 15 percent within 24 months.
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Functional Consolidation
Creating shared-service centers to centralize functions such as accounts payable, customer order processing, credit card processing, and other back-office functions can achieve significant savingsalthough moves to concentrate operations need to be balanced with concern over risks from disasters.Today, most firms maintain multiple centers for these activities, often located in each of the countries or regions where they operate. Financial services firms that have grown through mergers have often not integrated the operations and information systems of each of their acquisitions. Moving to centralize these activities drives down costs in several ways. Redundant IT systems are eliminated, leading to fewer hardware and software purchases and a lower headcount. Shared-service centers can be located wherever real estate and labor are cheapest, provided the labor force is adequate and welltrained. Firms have put these centers in such locations as India to benefit from lower operating costs. Firms can hire the best expertise centrally and make it available to its divisions and subsidiaries. Given their lower volumes, local divisions often cant justify the expense of hiring top-quality IT professionals. A major European insurance company with global operations was formed from a merger, resulting in more than 1,000 IT employees and an annual IT budget of more than US$100 million. By reducing the number of mainframe operations centers from five to two and streamlining the IT function, the firm was able to reduce its annual IT expenses by 20 percent over three years. A major investment bank made significant savings from the centralizing of a number of disparate activities into a new unit created to administer all business services. The centralization involved the merging together of real estate, human resource, procurement and financial operations into a central unit. The complex operation took 18 months and involved 4,000 staff, but the bottom-line benefits were significant with a fifth of total costs being removed.
s A global diversified financial services company headquartered in Europe established global procurement and uniform procurement processes for IT, renegotiated its fragmented IT contracts using competitive bidding, and installed a new procurement technology infrastructure. The result was a savings of approximately US$200 million in the firms annual IT procurement expense of US$1.2 billion. Strategic sourcing is a critical tool for financial institutions that want to achieve sustainable cost savings. A holistic approach to sourcing can not only reduce overall spending, but can also yield additional benefits including better service levels and improved access to the latest technologies. Strategic sourcing is more than a tactical cost reduction effort. Instead, it is integral to developing sustainable long-term competitive advantage.
Centralization also improves service. With all the data for a particular aspect of the organization in one location, gaining access to data for any location or business unit becomes easier. As a result, management reports analyzing data across the enterprise can be produced more quickly and cheaply.
The ultimate vision for securities firms is straight through processing (STP)the processing of trade information from front office to confirmation, payment, and delivery automatically, without the need for manual processes such as the re-entering of information. Our analysis found that achieving STP would result in an estimated 1520 percent reduction in annual operating
Automation
Financial services firms have opportunities to reduce headcount and administrative expenses by using technology to automate manual processes. While these projects can be complex, the cost savings are significant. Beyond increased efficiency, firms also benefit from reduced processing errors. The following are a few of the areas where financial services firms have achieved substantial cost reductions through automation. Straight Through Processing. Broker-dealers are automating trade processing to reduce settlement times to T+1, that is, settlement within one day after a trade occurs. Asset management firms are investing in order management systems that route orders to multiple brokers, and provide portfolio modeling and compliance verification.Traditional exchanges and alternative trading systems are also investing to prepare for everexpanding trade volumes. For example, one diversified financial services firm now processes almost 100 percent of its investment accounting and asset management transactions automatically. The firms automation project achieved its return on investment in 15 months and reduced total expenses by 40 percent. Another example is a global investment bank that cut the costs of processing money market transactions in half over a twoyear period by eliminating most manual processes. The project has been so successful that it has created a joint venture to offer similar back-office processing services to other banks.
expenses after the initial investment for a hypothetical brokerdealer, due to the improved labor and systems efficiencies. With STP requiring a substantial investment at a time of declining revenues, each firm will need to assess carefully its current processing environment and where it should invest limited resources. Some firms with older technology will find that they need to replace significant portions of their legacy systems to achieve STP. But other firms will be able to avoid the expense and complexity of replacing legacy systems, at least in the near term. Instead, they will upgrade existing systems and rely on the latest technologies to knit them together.These firms are turning to Webenabled tools, data warehouses, and middleware to allow multiple legacy systems to seamlessly interact and function as if they were one. e-Procurement. Many firms are going beyond simply purchasing online to automating the entire purchasing process, with data entered manually only once and then routed automatically, so that most paper is eliminated. E-procurement systems not only order goods electronically, they can automatically match the goods received with the purchase order and invoice. Some systems automatically notify the supplier that payment has been authorized so that the invoice can be eliminated and the reconciliation process simplified. Financial data are updated in real time throughout the process and can link with the firms financial systems.
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Reducing the Billing and Collection Cycle. Firms can generate significant savings by reducing the time required to set up accounts, generate invoices, and collect outstanding balances. The strategies that have proven successful include clearly defining performance goals across functions within the firm, standardizing contracts, streamlining account setup and maintenance, and automating the production and distribution of invoices. These initiatives not only reduce operating expenses, they also improve cash flow that results in increased interest revenue of approximately US$11,000 per day for each US$100 million in revenue. Travel and Entertainment Administration. Automation can reduce the 10 percent of total T&E expenses that is spent on administration. One innovation is automated reporting. An analysis by Visa International found that automated reporting systems can achieve supplier discounts of 18 percent and administrative savings of 80 percent. For example, while the cost of processing a manual expense report is about US$25, the cost drops to just a few dollars in an automated system.
Once a new process has been designed, most firms use piloting and simulation to test and optimize the design. An important consideration is that the streamlined process not weaken risk management controls or expose the firm to other liabilities. Firms then need to develop the business procedures and rules to govern the process and build the necessary infrastructure to support it. They also need to consider the impact of the redesigned process on the organization, for example, whether the need for physical facilities or for employee training will change. Redesigning a business process to eliminate unnecessary steps usually allows a firm to reduce headcount significantly. (See Exhibit 8.) In addition, streamlining processes saves additional expenses by reducing cycle time and error rates. The redesign of the telephone mortgage lending process by a major U.S. commercial bank provides a good example of what can be achieved. The bank set a goal of increasing the efficiency of its mortgage process to match best practices in the industry. In addition, it wanted the redesigned process to deepen the customer relationship and improve the banks value proposition. The bank increased efficiency and reduced errors in the
telephone mortgage lending process by reducing the number of handoffs between departments from five to two. The loan center associate who makes the loan decision now notifies the customer directly, rather than passing the decision back to the sales associate. The ultimate goal is to reduce handoffs to just onethe loan center associate will receive the application, make the decisions on lending and collateral, prepare the closing documents, and only hand off the loan to a personal banker to conduct the closing. The results have already been dramatic. The time required to make a decision on a loan application dropped an astounding 87 percent in a year and a halffrom 2.4 days to just 0.3 days. The total cycle time from loan application to closing has dropped from 36 days to 19 days. With quicker service, revenues and customer satisfaction are both up.
Some of the greatest long-term gains in operational efficiency are achieved when firms reengineer business processes to fundamentally change how work is done. Benefits from reengineering can be maximized by integrating it with other cost reduction initiatives such as strategic sourcing and automation. The approach is to take a zero-based evaluation of each business process and ask: How would the firm design this process today if it were starting from scratch? The first step is to define the core functions of the organization and the individual business units. Secondly, the uses, value, and output of each activity need to be assessed in light of the firms goals to identify steps that dont add value. A useful technique is to map each process to identify any bottlenecks, redundancies, or unnecessary handoffs.
Analysts
Credit staff
Other support
Senior bankers
Relationship bankers
MIDDLE OFFICE
BACK OFFICE
SUPPORT
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Tomorrows Agenda
Optimizing operating efficiency should be a linchpin of corporate strategy in both good economic times and bad. Too often, however, financial services firms only focus on controlling costs when they are forced to respond to a slowing economy. Many firms then rush to reduce staffing levels and other expenses to reflect reduced business volumes. Yet volume-related reductions alone leave firms no more efficient than they were before. And unless targeted carefully, cost reductions can threaten to undermine a firms business goals and value proposition. To gain long-term competitive advantage and increase shareholder value, firms need to make ongoing improvements to operating efficiency a permanent way of doing business throughout the business cycle. A strategic approach ensures that a cost reduction program generates permanent improvements in operating efficiency, while being aligned with a firms business strategy.
Strategic cost reduction is not for the faint of heartthere is little gain without pain. Before embarking on a cost reduction program, firms need to ask themselves some fundamental questions: 1. The Devil is in the Details: Does the organization haveor is it prepared to developaccurate, detailed cost data on which to design and defend a strategic cost reduction program? 2. Best Practice: How efficient are individual business units when compared both internally and to leading competitors? 3. Investor Criteria: What are investor expectations regarding the size and speed of cost reductions? 4. Gauging Appetites: How urgent is the need to reduce costs? Does the organization have the appetite for the fundamental changes required to increase efficiency? 5. Total Commitment: Is senior management fully committed to the effort and ready to stay actively involved? What methods and measures are in place to monitor progress? Are these criteria embedded in the organization and linked to employee evaluation and compensation systems? These questions are not easy to answer. But as the experiences of the financial services institutions presented in this report
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demonstrate, firms that make the organizational commitment to design, implement, and monitor a strategic cost reduction program can achieve dramatic increases in efficiency. Financial services firms that adopt a strategic approach to cost reduction that goes far beyond layoffs will not only survive the current economic slowdown, but emerge as leaders in the years ahead.
End Notes
1
"Layoffs Can Hurt Firms More Than They Help; Beware of Damage to Staff and Customer Trust," The Wall Street Journal Europe, February 22, 2001. Uncertainty Inc., The Wall Street Journal, October 16, 2001. Strategic Flexibility in the Financial Services Industry: Creating Competitive Advantage out of Competitive Turbulence, Deloitte Research, 2001. So long, banker, The Economist, October 27, 2001. "Advertising Budgets Escape the Knife," U.S. Banker, February 1, 2002.
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4 5
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Other Publications
Real Options in Real Organizations: Creating and exercising real options through corporate diversification. Chapter 2 in Innovation and Strategy, Operating Flexibility, and Foreign Investment: New Developments and Applications in Real Options. L. Trigeorgis (ed.) Oxford University Press, 2002 Real Options and Restructuring the Communications Industry, Telecom Investor, December 2001 Lead from the Center: How to manage divisions dynamically. Harvard Business Review, May 2001 Tracking Stocks and the Acquisition of Real Options, Journal of Applied Corporate Finance, Summer 2000 Hidden in Plain Sight: Hybrid diversification, economic performance, and real options in corporate strategy, in Winning Strategies in a Deconstructing World, J. Wiley & Sons, 2000
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2002 Deloitte Consulting and Deloitte & Touche LLP. All rights reserved. ISBN 1-892384-09-8 27
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