Portfolio Approach to Cutting Costs

The renewed and particularly intense focus on performance improvement and cost
reduction in utilities is traceable to three compelling drivers of change:

• Strong capital market demands
• Selective opportunities for growth
• Increasing performance expectations for regulated business

As Wall Street increases its scrutiny on energy, and utility companies become
more reliant on raising capital from the financial markets, short- and medium-term
financial performance and shareholder value become all-important. The fall of
the trading market and continued uncertainty in the marketplace have exacerbated
utilities’ deteriorating financial conditions and have precipitated creditworthiness
challenges throughout the industry.

The capital markets will continue to dissect the industry and its players,
demanding strong balance sheet management and consistent, stable earnings. Top
players are looking for ways to achieve scale economies, both through best-in-class
operations and supplier consolidation. They are also motivated by a strong desire
for earnings growth — internally, through cost management, as well as externally,
through acquisition.

Put simply, utilities are looking for sensible ways to grow and leverage their
businesses, consistent with their overall business strategies. The trend toward
outsourcing — from tree trimming to plant construction, from HR to finance
— provides several avenues for utility performance improvement, improved
resource utilization, and cost reduction.

New enabling technologies, such as customer information systems and risk-management
systems, will assist in enhancing performance in new businesses, enabling the
utility to keep a close eye on and drive efficiencies from the core business.
Taken together, the three drivers of change are generating substantial momentum
for performance improvement and cost reduction in utilities.

The Portfolio Approach

There are many approaches to improving the bottom line. The truth of the matter
is that the approach that works for one company may not get the best results
for another. Why? Because each company has a different strategy, operations,
health, and culture that can drive the decision variables regarding which approach
to use.

This article will focus on where to look for cost reduction opportunities and
the various approaches that have been successful across industries. We have
observed that companies often draw from a mix of approaches to develop the programs
to realize their goals, driven by an overall business strategy. The mix of approaches
helps develop a portfolio of projects from both a top-down and bottom-up approach.

Before we focus on specific approaches, let us take a quick look at some of
the opportunity levers companies use to drive cost-performance improvement.
These are the areas that typically yield potential large opportunities. Benchmarking
and diagnostics can be used to identify priority areas for your company.

Shared Services or Outsourcing

Each company has core competencies it must do well to be successful in delivering
its products or services to its customers. Non-core areas present opportunities
to consider shared services, or outsourcing, where the transaction-related activities
of the function are the core competency of a new unit or vendor.

Areas to consider include: customer relationship management, finance, human
resources, information technology (infrastructure, network and applications
maintenance), procurement, and facilities management. Each should be evaluated
from both a business case perspective and from a strategic perspective to determine
what makes sense for your organization.

Organization

It is obvious that the success of an organization to a large part comes from
its people. Organizing effectively, with the right skills and tools combined
with a sound business model and processes to deliver the strategy, is important.
Many organizations are hampered by a “silo” or “stovepipe” organizational structure,
where processes are suboptimal within the silo.

It is critical to: look at processes from a customer point of view, migrating
to best practices in procedures and technology; and effectively organize around
processes with the right customer-driven performance measures and job functions
to get the organization aligned and moving in the right direction. The costs
should come down, and revenues and service levels should improve.

Capital and Expenses

Don’t forget the balance sheet and how you spend money. On the balance sheet
side, receivables, payables, inventories, and assets are a source of cash that
is often overlooked. Targeted programs for eliminating revenue leakage, paying
per contract terms, reducing inventories through better supply chain management,
and eliminating unneeded assets can improve your working capital situation and
cash flow. Expenses can be attacked by evaluating expense policies and complying
with them.

Better procurement processes and contracts can lead to significant benefits
by curtailing unneeded spending or improving unit costs through strategic sourcing
initiatives. Often, recent mergers and acquisitions create many of these issues,
where companies fall short on integrating best practices between the two legacy
organizations.

Operations

Operational priorities and a tight rein on cost control govern many of the
current and priority initiatives within utilities. This requires a thorough
examination of strategies, skill sets, and processes. Value chain analysis also
becomes critical as companies prioritize areas ripe for improvement and enhanced
efficiencies.

The final step consists of building the necessary process and technology infrastructure.
Establishing a standard architecture for operational processes, information
technologies, and management competencies optimizes a company’s ability to succeed
in driving meaningful, enduring improvements to operations.

The utility industry today is focused on driving cash flow, balance sheet strength,
and return on invested capital through balanced, integrated operations between
the regulated and merchant businesses.

On the regulated side, utilities are seeking ways to enhance earnings stability
and growth. Low-cost operations and regulatory innovation are key to creating
premier regulated franchises. Operational excellence, best-in-class transmission
and distribution (T&D) cost position, and solid regulatory relationships remain
critical success factors. More than ever, our clients are renewing their focus
on extracting optimum value from regulated operations.

New and improved processes are being implemented to maintain and improve system
reliability and customer satisfaction, and organizational structures are being
transformed to meet emerging requirements of the T&D businesses from state and
FERC regulators. Further efficiencies are being sought from back-office operations
such as HR and finance.

For merchant businesses, low-cost generation, enhanced market share at acceptable
levels of risk, and aggressive risk management remain key to developing and
sustaining best-in-class merchant capabilities. Leading utilities are implementing
unique work management processes and solutions to enhance efficiencies within
their generation businesses. Processes are being redesigned within the generation
and trading businesses to mitigate risk to the organization and decrease potential
adverse impact on earnings.

Improvement Approaches

Now that we’ve covered some areas to examine, how should we go about defining
the specific programs to improve cost performance? We have chosen to focus on
three approaches that have yielded results across various industries:

• Budget cuts
• Business process redesign
• Six Sigma

Old Reliable — Budget Cuts

This is a top-down approach where you know there is fat to be trimmed and you
need a forcing function to do it. Rather than across-the-board cuts, most companies
today conduct benchmarking studies to identify target spending or staffing levels
for various functions and then “bake” them into the budgets. Then, you leave
it up to the organizations responsible to figure out how to get there.

The advantage is it is relatively easy to set the new spending levels, but
they are often arrived at through negotiation. Without an underlying structured
method, it can get the desired results, but it may suboptimize operations since
it usually takes a functional view rather than a process view. Also, there is
often little consideration for the customer.

Process Re-engineering

Many companies use this method, first made popular in the early 1990s, because
it focuses on how a company conducts business to deliver products and services.
Makes sense. It is important to start with the business model and how the processes
support the business model. Since this method is not bound by organization,
it focuses on tangible improvement and reduced waste in business processes through
process changes, elimination of steps, or improved technology and organizational
alignment.

With the development of industry-tailored software packages with industry best
practice processes already included, there is an emerging trend to re-engineer
to the plain vanilla, industry-standard software solutions that can reduce ongoing
system maintenance and upgrade costs.

The key is to customize industry-standard solutions only where you need to
for competitive reasons. It is important to verify that re-engineering teams
have a solid outside perspective so that they can consider breakthrough improvements
and determine that the teams focus on implementation and process measures to
drive the changes into the organization.

Six Sigma

Six Sigma has emerged since the mid-1990s, most notably through the visibility
it has been given by companies such as General Electric and Motorola. It is
a highly structured, process-based approach that is culturally driven using
statistical tools to evaluate process performance. In this approach, certified
Six Sigma black belts address specific improvement projects from start to finish.
It involves a heavy investment in training and usually does not pay back for
two or more years.

However, Six Sigma tends to generate a lot of organizational buy-in and develops
strong process-based and problem-solving skills in the organization.

Successful performance improvement is dependent on developing the right projects
and effectively implementing them. We suggest that you look across your organization
through process-driven approaches, and you should expect to develop a portfolio
of projects.

Which Is Best?

The approach you choose will depend on your specific situation, where you are
in terms of improving your performance, the speed of implementation needed,
and your desire to engage in a top-down or bottom-up approach. Our experience
is that you will likely need more than one approach to achieve your desired
results.

Regardless of the path you take, make sure you engage the organization, create
strong accountability, and measure your progress.