What is cost optimization?

Cost optimization is an alternative to traditional cost-cutting, wherein a CFO might lower costs across the board to meet a short-term objective or respond to business conditions.

An article from Gartner¹ describes multiple issues with cost-cutting. Fewer than half of businesses achieve their cost-cutting goals in the first year. Only 11% sustain cuts over three years. Only 9% say that they can maintain their wanted pace of innovation post-cuts.

Cost optimization requires a strategy tailored to both the industry in which a business is working and its particular goals. In cloud computing and IT, for example, a business might switch from on-demand server access to a reserved instance, committing to a certain period of use in exchange for a lower rate. For supply chain logistics, cost optimization might involve consolidating the number of suppliers for a product to lower unit costs.

By its nature, the practice of cost optimization resists top-down prescriptive strategies for finding inefficiencies. Still, there are some overall best practices that organizations can keep in mind when seeking to reduce their costs. These practices include transparency and awareness of cost allocation at all levels, a focus on the tradeoffs involved in reducing costs in each business area and prioritizing reductions in the largest cost areas.

To understand the importance and effectiveness of cost optimization, one must first understand its differences from—and advantages over—traditional cost-cutting. Cost optimization is a targeted and strategic effort to maximize return on investment by minimizing unproductive spending, whereas cost-cutting is a simple cut across the board.

Consider the example of a firm failing to meet its quarterly revenue target. In a traditional cost-cutting scenario, the board would instruct the CFO to cut a flat amount of costs. The CFO would then, for example, cut 10% of the workforce across the board and freeze hiring.

While technically meeting the cost reduction target, this CFO failed to consider the secondary effects of the layoffs and hiring freeze, such as decreased morale, skill gaps and understaffing. These secondary effects could result in additional costs down the road. The business might need to rehire and retrain workers. It might miss opportunities for innovation because teams are stretched thin and underutilized in their areas of true competitive advantage.

A CFO using cost optimization strategies, on the other hand, might use Pareto analysis to identify which teams are driving most of the organization’s staffing costs. Then, the CFO can determine whether their work is creating enough value to justify the cost.

Depending on the cuts needed to meet the board’s requirements, the CFO might eliminate targeted roles, provide early retirement incentives or freeze bonuses and raises for these expensive areas. This more targeted approach helps avoid the negative secondary effects of flat cuts across the organization.

The pillars of cost optimization include increasing visibility into costs, prioritizing by cost share, maintaining an awareness of secondary effects and tradeoffs and developing a flexible, long-term vision for cost structure.

Developing a thorough understanding of the costs within an organization is the first part of making informed decisions about optimization.

The number on a balance sheet next to a product, service or employee does not always reflect its true cost. Practices such as activity-based costing (see “Cost optimization tools” for more information) can help organizations better understand the financial inputs required to produce an item or procure an employee’s services. These practices grant the organization better visibility into how profitable goods and services are at current cost.

That level of comprehensive visibility helps businesses identify not only unnecessary costs, but value. In a vacuum, one product might barely be profitable. In context, that product might serve as a loss leader that reliably induces customers to buy other products. It might be a complementary product to one with a higher profit margin (such as ink cartridges to printers). Without this second-level analysis and visibility, decision-making focused on cost-cutting might simply involve cutting production of unprofitable products.

When a business has established true visibility into its cost structure, it can prioritize the areas with highest costs for optimization.

The first step is usually to organize costs into the traditional categories:

• Fixed upfront costs such as rent.
  
  
• Variable costs such as materials and fees.
  
  
• Discretionary or scalable costs such as travel or training budgets. 

This process often reveals costs that are failing to produce any value, which are then the first targets for cuts.

Organizations typically prioritize the highest-impact, lowest-effort opportunities to cut costs. After that, optimization initiatives that require some investment or effort (such as consolidating suppliers or training on new technologies) are prioritized by how quickly they can start accruing value to the company.

Every step of the cost optimization process involves tradeoffs. Consolidating suppliers saves money, but also makes the supply chain more vulnerable. Changing from on-demand server access to a reserved instance reduces the flexibility of your cloud access and risks expensive cost overruns if traffic needs exceed server capacity. Accounting for these tradeoffs is often the difference between genuine cost optimization and mere cost cutting.

Cost optimization is an ongoing process that is more like a business practice than a discrete project. Organizations continually make sure that their optimization choices are aligned with their long-term business goals, and they run frequent spending reviews and audits to avoid unnecessary spending.

Depending on one’s goals and industry, cost optimization tools can include a combination of general strategies (such as Pareto analysis) and software such as enterprise resource planning (ERP) platforms.

The metrics that a business chooses for cost optimization depend on its goals and the industry it occupies. Still, there are a few basic categories to track for any business interested in overhauling its cost structure.

Cost as percentage of revenue is a simple measurement of expenses to earnings, and it can be used to determine how effective an individual cost is.

Say a business spends USD 50 for every USD 100 it makes one year, and then USD 60 for every USD 100 the following year. The cost ratios would be 50% and 60%, respectively. The increase might be a warning sign that costs need to be optimized.

Labor productivity is a measure of what labor earns against the investment made in it. Depending on the business model, labor productivity can be measured as revenue per employee, units produced per labor hour or various other labor-related metrics. Given that labor is frequently one of the largest drivers of cost, labor productivity can be a key benchmark for cost optimization.

IT spend as a percentage of revenue varies by industry. In relatively low-tech industries such as manufacturing, it is often 1-3% of revenue, whereas in finance it can safely be as high as 10%. Tracking IT spending over time is a good measure of whether resources are being allocated wisely.

Cost optimization practices can vary between industries and domains such as cloud computing and IT, manufacturing, healthcare, supply chain and software as a service (SaaS).

Broadly, IT cost optimization is the process of regularly evaluating all IT spend to identify and eliminate unnecessary expenditures and overprovisioning while sufficiently supporting operations. An IT cost optimization framework provides a step-by-step approach for analyzing an organization’s IT expenses (for example, hardware, software apps, cloud computing, vendor contracts, data storage) while maintaining operational efficiency and achieving broader business objectives.

Cloud cost optimization practices focus on cloud infrastructure specifically. Cloud cost optimization combines strategies, techniques, best practices and tools to:

• Help reduce cloud spending.
  
  
• Find the most cost-effective pricing models to run workloads in the cloud environment (for example, by provisioning spot instances of unused server space.
  
  
• Maximize business value.

FinOps, a portmanteau of finance and DevOps, is a cloud financial management practice that helps organizations maximize business value in their hybrid and multicloud workloads. FinOps brings procurement under the centralized control of a dedicated FinOps team that advises all stakeholders on best practices for cloud cost optimization. It creates a common language that enables organizations to efficiently operate at scale in the cloud.

Many organizations approach cloud cost optimization strategy and implementation by employing a cross-functional FinOps team with members from IT, finance and engineering. This team can help bring financial accountability to cloud spending, reduce overspending and increase cost efficiency.

Cost optimization strategies in manufacturing must account for the industry’s high fixed costs, the close connection between labor and outputs and high overhead for maintaining equipment.

Overall equipment effectiveness (OEE) is a key optimization metric used to measure the effectiveness and performance of manufacturing processes or any individual piece of equipment. OEE provides insights into how well equipment is used and how efficiently it operates in producing goods or delivering services by multiplying the equipment’s availability, performance and quality factors together.

Raw materials are usually the largest cost for manufacturers, making them a key target for optimization. Labor costs can be optimized by cross-training workers for different tasks and standardizing the manufacturing process. High overhead costs can be managed by optimizing energy consumption (load shifting or recovering and reusing heat energy, for example).

Labor is particularly expensive in healthcare because of the high level of specialization, regulations around training and the fact that workers are needed around the clock. The supply chain of drugs and medical devices is also heavily regulated and resistant to optimization, and hospitals have extremely high fixed costs.

Cost optimization strategies in healthcare include staffing the optimal number of nurses per patient, standardizing hospital supplies and tracking how often expensive hospital equipment is used. These metrics must all be balanced against ethical requirements and industry standards to satisfy stakeholders and provide the highest level of patient safety and care.

Supply chain optimization uses technology to maximize efficiency and performance in a supply network.

Key elements of supply chain optimization include:

• Up-to-the-minute inventory tracking and data.
  
  
• An order management system to customize pricing, send quotes, track orders and manage returns.
  
  
• Analytics powerful enough to forecast future demand and adjust inventory, procurement and workloads accordingly.

Because of how interdependent the supply chain is, costs cut in one area are often shifted in unpredictable ways to another. Also, transportation and logistics costs are often out of the business’ control, as in the case of tariffs or fuel prices. Businesses can optimize for cost under conditions today that do not exist tomorrow, making flexibility and resilience crucial.

Optimizing costs in an SaaS business often requires evaluating each customer relationship’s value and cost.

Considering marketing, sales and training, the cost of acquiring SaaS customers can be high. Businesses must measure acquisition expenses against the overall number of customers acquired in a business period—the higher, the better. SaaS providers calculate the lifetime value of a customer’s subscription against their acquisition cost, with a widely accepted goal of achieving a 3:1 ratio.

Cloud cost optimization is also, naturally, important for SaaS providers, requiring investment in FinOps practices, automation and autoscaling.