When Do Cost Savings Become Liabilities by TAA

KPMG LLP Shared Services and Outsourcing Advisory

When Do Cost Savings Become Liabilities? by Steve Silen, Director, KPMG Advisory Services

Have you ever been asked or mandated by the senior management of your firm to: • Reduce costs across the board by X% • Keep costs flat next year and absorb inflation • Cut capital funds by $X • Downsize staff by X% • Defer maintenance until next year • Freeze hiring • Suspend training programs for the year • Cut travel costs by X%? If so, did you do exactly as asked, taking the position that management knows what it wants and that it’s not your role to question its directives? And did you agree to the reduce costs without having any idea how you would do it, or whether such reductions were realistic? Or, did you evaluate the benefits and risks of doing so before agreeing? And if you felt that the risks would outweigh the benefits, did you push back? If not, why not? Obviously all firms should be looking for ways to improve their bottom line. But there are risks when cost reductions are not well thought out. In fact, cutting costs too deeply may result in a long-term liability despite the short-term savings. To bring this concept to life, a simple example is your personal automobile. To save money in the short-term, you might choose to delay changing the oil, replacing a balding tire, or investigating a strange engine noise. But in the long run, these choices could result in major and costly car repairs, or an accident causing injury to yourself and others. The same holds true regarding business decisions that you make every day on your job. You must move beyond a shortterm mindset and instead understand and focus on the longterm impact of cost cutting measures, even though your firm Shared Services and Outsourcing Advisory / February 2012

may be facing financially challenging times or shareholder pressure. In this article we will explore this subject through the eyes of a Real Estate and Facilities Management (REFM) organization. Specifically, we will examine three areas – deferring maintenance, cutting REFM capital, and cutting facilities management (FM) staff – in which cost saving measures, if not properly implemented, may become liabilities. Deferring Maintenance To maintain the functionality and operational integrity of their physical assets, firms budget operating and capital funds to maintain, repair and replace their equipment. In difficult economic and business climates, equipment maintenance costs become a target for reduction. Some argue that there is not a big risk to deferring maintenance as it will eventually get done. This is especially true when the deferment will only jump from fourth quarter to first quarter of the following year in order to hit year-end cost targets. One could also argue that maintenance schedules and protocols should not be changed since they are usually defined by the manufacturer, industry standards or regulatory requirements. There are risk-based tools available to help companies evaluate deferred maintenance options and minimize the risk of failure, including calculating a facility condition index (FCI) to assess the health of a building. But when equipment is in need of maintenance, deferring it does not change the fact that maintenance is required.

“Too often when reading published incident investigation reports from firms that have had incidents – some catastrophic – a common root cause was that the firm put cost savings ahead of what needed to be done to properly maintain or replace its equipment and avoid harm to people and the environment.”

Maintenance-related incidents may cause operational downtime and damage to assets. If the building is not fully operational for a period of time, extra costs will be incurred to implement business continuity plans, and business unit (BU) targets may not be fully met because of the disruption. A system failure typically costs more than the cost of the maintenance that could have prevented the failure, especially if equipment is replaced before expiration of its useful life. And a significant incident will be far more costly, especially if there is loss of life, harm to the environment or a major fire or explosion – fines, lawsuits, reputational damage, loss of business, drop in stock price, and in the most extreme case, even bankruptcy. In a sense, deferring maintenance creates an “operate to fail” environment. The underlying messages, “we can let things go around here”, and “we don’t have to follow rules”, not only impact facilities and equipment, but can also permeate other areas of the firm, including regulatory compliance, safety practices, deadlines, budgets, service delivery, etc. To avoid this type of dangerous culture, firms need to have an effective maintenance program and must comply with it. Those with responsibility for maintaining buildings and equipment, regardless of their level or in-house or outsourcing service provider status, need to speak up if they believe the effectiveness of the maintenance program is being jeopardized. Doing so will guard against deferring maintenance just to save money, and ensure that a cost saving does not result in a liability. Unfortunately, too often people who know the operations choose not speak up, as they feel they are in an environment in which their voice will go unheard, or that they should not question upper management. But one of the last things you want to hear after an incident is:

“I knew the cost cuts were too deep and we should not have deferred the maintenance. Management does not care to hear my views so I did not speak up. But I knew it was an accident about to happen.” Thus, creating an environment in which everyone is encouraged to voice their concerns should be at the top of management’s agenda. Cutting Capital Firms usually follow a disciplined process to ensure that all required capital is identified, evaluated, prioritized and approved for funding in the years in which it will be required. Ideally, the capital plan will be for three to five years to avoid cash requirement surprises. An example of how capital projects may be prioritized is illustrated in the following table:

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Priority

Capital Request

• Life safety • Code compliance • Legal liability • Prior binding commitment • Environment, health and safety (EHS)

• Security systems • Critical systems beyond useful life or potential of failure • Operationally required

• Building/space renovation • Business growth – new buildings • New operations • New technology

• Replacements when repairs are no longer costeffective • Operational savings • Building efficiency/energy conservation

Priority 1 - Required changes – human life protection, regulatory compliance, and legal obligations Priority 2 - Operational importance Priority 3 - Strategic importance Priority 4 - Cost saving opportunities So you have gone through this prioritization process, have a good, properly endorsed long-term capital plan, and now management asks for the plan to be cut by $X. What do you do?

“Capital should never be arbitrarily cut.” One could argue that Priority 1 capital projects should never be eliminated since doing so will immediately create a liability. But there may be opportunities to re-examine the cost estimates and evaluate if there are ways to reduce costs while still fully meeting requirements. The same could be said for Priority 2 capital requests. The only difference is that the liability may not be as immediate for Priority 1 projects…but they may still be as costly. Priority 3 and 4 capital requests allow for more flexibility on what can and cannot be cut from the capital plan. Priority 3 requests provide the funds necessary to support the business’ strategic needs, while Priority 4 requests generate cost savings. On the surface, neither appears to create a liability if deferred, but instead to have an impact on revenue, the business’ ability to meet its needs and grow, and ability to continue to reduce operating costs. But while they may be good targets to cut, they must still be carefully reviewed and evaluated for the amount of risk associated with deferring capital expenditures. Those that hold significant liability should not be deferred.

The evaluation process is made easier if standardized capital project requests are utilized when projects are initially submitted, and each request is scored. The best capital request forms contain information such as a statement of the problem, how the project remedies the problem, options considered, costs, required cash flow, benefits, risks if not funded, and prioritization score. There is typically much debate on what should be cut, and people taking positions that “my capital project is more important than yours.” Firms must conduct a fair process to ensure that the right choices are made, rather than letting the “squeaky wheel” person or the largest BU always win. Bottom line is that the impact of any changes to the capital plan must be evaluated so that all risks are understood to avoid liabilities. New capital requests with a higher priority should move ahead of those that do not. The prioritization of capital funding should not be on a first-come, first-served basis. Cutting FM Staff There are many types of FM staff, ranging from those who operate and maintain the building, (hard services), to those whose primary function is to provide building services, such as janitorial, food, mailroom, reprographics, etc., (soft services). For the purpose of this article, I make no distinction between in-house or outsourced FM workers. As we all know, headcount reduction is a very common method firms use to remain competitive during challenging economic times, and the FM department is no exception. The trick is to ensure staff cuts do not go so deep that they result in non-compliance with regulatory requirements, incidents, harm to people or the environment, failure to meet company contractual obligations, loss of revenue, etc. Reduction in building engineers and maintenance staff carries a significant risk as the primary mission of these people is to ensure the building and its equipment is operational and properly maintained. If done incorrectly, these staff reductions will be costly and similar to those outlined in the deferred maintenance section. Reductions in soft services positions will usually impact service delivery quality, rather than create a liability. But this is not always the case. For instance, a reduction in soft service staff may result in: • Increased safety incidents because staff is rushed • A key payment or permit-related form being sent out late from the mailroom (and sometimes causing a late receipt penalty) • A health and safety violation in the kitchen because certain activities were not performed • A proposal deadline being missed because reproduction could not make the copies on time

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So, regardless of the position, the impact of eliminating it must be fully evaluated before changes are implemented. The business units that operate at the facilities managed by the FM group expect them to be fully operational and staffed to provide the services required to achieve their business objectives. Even though management may give you a short decision-making timeline, you must follow a systematic process to ensure all options are evaluated to guard against the short-term savings related to staffing cuts resulting in future costs that will erode the savings. Examples of questions you should consider as part of the evaluation process include: • Is this position critical? • Is the function truly needed? • Does the person performing this position have unique skills? • Can he/she be easily replaced? • Why can or can’t this position be eliminated? • Are there other options? • How will the staff reduction impact the current operation? • What are the risks? • What is the short-term and long-term impact? Beyond the possibility of lawsuits by those who will be losing their jobs – and its likely your legal and HR departments have an established process to ensure that staff reductions are done in a fair manner following appropriate procedures – there are many other potential liabilities associated with staff reductions. One key issue is lack of effective knowledge transfer. In some cases, existing operating procedures are weak but the buildings are appropriately operated because of the knowledge of the staff members. They may have performed their jobs for a long time, and much of the important information about operating and maintaining the building may reside in their heads. They may tout:

“I do not need procedures. I have operated and maintained the equipment for years. I know what needs to be done and when and can identify problems before they occur. Because of me, we have never had any incidents or downtime.” Without adequate documentation, the loss of these people puts the operation at risk and increases the potential for equipment failures and incidents. At a minimum, there should be an appropriate time period to transfer knowledge and create the required documentation before these individuals’ last day at your company.

Liabilities may also occur if the organization is not staffed correctly. While downsizing provides an opportunity to improve operational efficiency, streamline operations, and eliminate unnecessary activities, firms often take a “do more with less” stance. The downside of this approach is that it creates an environment in which people are stressed, take short cuts, do not thoroughly perform their activities, and consistently operate in catch-up mode. A better approach is to re-engineer your existing processes to best accommodate the new staffing level. This includes evaluating the current processes and developing a roadmap to achieve an improved future state. Often the creation of process flow diagrams and Responsible, Accountable, Consult, and Inform (RACI) charts are useful to provide appropriate documentation and ensure everyone clearly understands their new roles and how they will interface with each other.

“Focusing on process improvements is key to making downsizing a ‘rightsizing’ exercise and minimizing the risk of staffing reductions becoming a liability.” Another potential liability is retained employees’ reduced morale and trust in management after a downsizing. The remaining staff members may even start spending part of their day looking for other opportunities for fear they will be next to be let go. This may result in people that you do not want to lose leaving, or remaining but performing just the minimum requirements of their jobs. To reduce the likelihood of this happening, management needs to re-earn their trust and work hard to keep it. To do so, they must ensure they focus an appropriate amount of their time on people versus tasks. They should engage the retained staff in the path forward and actively solicit their ideas. There should be active and frequent communication to keep everyone informed as to what is going on and what is ahead. Successes should be celebrated so everyone knows their contributions are valued. Lastly, some firms will use outsourcing as an opportunity to reduce their in-house FM staff and their FM-related costs. This is particularly inviting since outsourcing typically generates an annual savings of seven-20 percent. There are a lot of benefits to going down this road, but a structured approach must be followed to evaluate options and risks to ensure it is the right choice. Some of what needs to be done is described in an article that I wrote entitled, Integrated Facilities Management (IFM) Success Factors.

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Conclusion When do cost savings become liabilities? The answer is when: • Cuts are arbitrary • The impact of the cost savings is not fully understood or evaluated • The process is rushed • People do not speak up • Management does not listen • Reductions are too deep • There is poor knowledge transfer • Management is too focused on short-term performance • Management expects more to be done with less • Risks outweigh benefits • Likelihood of an incident is significantly increased One incident can take away in an instant all of the good things that a company is doing, and potentially ruin its reputation and financial health. Doing what is right to protect human life, the environment, and company assets should not be compromised. Anyone can cut costs. The trick is to know which costs to cut, how to cut them, and ensure the impact is clearly understood and evaluated. Often, the use of an outside consultant is needed to help identify cost saving opportunities, evaluate risks and improve existing processes. All, if done right, will help ensure that cost savings do not become liabilities.

For information and research on outsourcing, shared services and internal improvement, visit the KPMG Shared Services and Outsourcing Institute at http://www.kpmginstitutes.com/shared-servicesoutsourcing-institute/.

About the Author Steve is a Director within KPMG’s Shared Services and Outsourcing Advisory practice. He has an excellent track record across the full life cycle of Real Estate and Facilities Management, including strategic asset planning, portfolio optimization, shared services, outsourcing, and business process assessment and improvement initiatives.

Contact us Steve Silen Shared Services and Outsourcing Advisory, Real Estate and Facilities Management Director T: +1 951 852 8140 E: ssilen@kpmg.com www.kpmg.com

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