Choosing Which Operating Expenses to Cut During a Downturn
by Doc Rich
According to nearly all data measures, the U.S. economy is undergoing an economic slowdown, possibly a recession. The current slowdown is a normal part of the business cycle. Business cycles are evident throughout the history of recorded economic data.
A business cycle merely demonstrates the fact that economic activity fluctuates around a long-run growth trend. The cycle involves periods of relatively rapid growth (expansion) followed by periods of relative stagnation (contraction). Unfortunately, business cycles are impossible to predict, especially in duration. Some business downturns have lasted for months and some have lasted for many years. One fact that is consistent is that nearly all businesses suffer a slowdown in sales during economic downturns.
The most common response to a business slowdown is to cut expenses to maintain profit levels. Although this response is completely rational, companies must carefully choose which expenditures to cut. Excessive cuts in the wrong areas can cause problems that continue into the expansion phase of the business cycle.
Business costs are classified as either cost of goods sold (COGS) or operating expenses. COGS are strictly variable costs. As unit sales decline, COGS declines. Operating expenses are the costs associated with running a business. They are not directly tied to sales and they do not directly decrease as sales decrease. As such, they are more or less fixed costs in nature, particularly in the short run. Some examples of operating expenses are management salaries and benefits, rent, insurance, property taxes, utilities, general office expenses, travel, supplies, advertising, repairs and maintenance, and research and development.
Note that some of the cost items in this list are more fixed than others. In fact, the last three items, spending on advertising, repairs and maintenance, and research and development, are often referred to as "discretionary" operating expenses. These expenditures are fairly easy to cut in response to a slowdown in sales due to an economic contraction.
However, special care must be taken when deciding to cut these spending items, as these expenditures represent future business and operating capacity for the company. Advertising is necessary to maintain markets and provide product differentiation, repairs and maintenance to ensure production stability and capacity, and R&D to maintain product quality and produce future delineation from competitors. In fact, viewed in these terms, consideration should be given to increasing spending in these areas in response to a slowdown in order to maintain current markets as well as to ensure optimal and strategic positioning when the contraction ends and the early stages of the next expansion begins.
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