7. Rule Three: Manage Indirect Costs Locally

As executives cut entire value chains, the direct costs of all the related deliverables throughout the company disappear. Indirect costs -- e.g., training, product research, organizational improvements, and administration -- are more difficult.

Organizations must reduce these indirect costs to appropriate levels given their now-smaller business volumes. If they don't, when they amortize indirect costs over fewer deliverables, their costs per deliverable (unit costs, or rates) will no longer be competitive.

Even this should not be treated with high-level edicts.

Rule three is: Let those who know best what's critical and what's expendable -- the managers of the organization itself -- decide cuts in indirect expenses.

The way it works is this: Customers (such as company executives) decide what they wish to buy from a business within a business. It's the job of managers within the organization to figure out the best way to supply those selected products/services at a fair price.

In doing so, managers of now-smaller groups are responsible for keeping their costs competitive. Thus, they have to scale down their indirect costs to match their reduced business volume by thoughtfully deciding what their particular group can do without.

If managers cannot rise to this challenge, the answer is not to disempower them by constraining expenses. Doing so would be shortsighted and doesn't solve the real problem.

A better answer is to either develop their entrepreneurial skills, or replace them with people who do know how to run a competitive business within a business.

How can managers calculate the amount by which their indirect costs must be reduced?

If each deliverable is priced such that it absorbs its fair share of indirect costs -- its full cost -- then when a deliverable is cut, its share of indirect costs is no longer funded. Thus, as an organization shrinks, its budget for indirect costs shrinks proportionally.

If organizations don't calculate the full cost of their products/services, then an alternate control is needed. The best approach is competitive benchmarking of unit-costs versus market rates.

A word of caution: There are limits to how far managers can reduce indirect costs, and indirect costs may not come down in proportion to direct costs.

Consider two types of indirect costs: those which scale with the size of the business (e.g., administrative support), and those which are needed regardless of the size of the business (e.g., infrastructure maintenance, training, research).

Since the latter category does not shrink when deliverables are cut, savings may not be linear. E.g., a 20 percent cut in deliverables may only lead to a 10 percent cut in indirect costs.

While it may be necessary to postpone these sustenance costs to some degree, this is a dangerous form of cutback. It can cripple an organization, undermining its ability to do even worthwhile things. An organization cannot afford to postpone any investment which will pay off within the expected timeframe of the downturn. Only long-term investments whose payoffs begin well after the downturn should be considered.