Estimating Operating Improvements  601 points higher than the target, however, will not necessarily translate into bet- ter performance for the target. There are no easy rules of thumb in estimating cost and capital savings. The best estimates are based on detailed analysis. Cost and capital reduction should follow a systematic process: estimating a baseline, estimating savings for each category, and testing the results against benchmarks. Begin with a detailed baseline for cost and capital as if the two companies remained independent across the different parts of the companies’ cost struc- tures. The purpose of the baseline is to ensure that all costs of both the acquirer and target are accounted for and that you don’t run the risk of ­double-counting when you estimate savings. Make sure the baseline costs and capital require- ments are consistent with the intrinsic valuations. Now you can systematically estimate the potential cost and capital savings for each cost category of both the acquirer and the target. While there are some typical types of savings, as Exhibit 31.6 shows, you should ensure that the cost categories and savings ideas are tailored to the company and industry. For an accurate estimate of potential savings, tie the savings explicitly to operational activities in the business. For example, what is the equivalent head count re- duction responsible for the cost savings in selling, general, and administrative (SG&A) expense? What is the resulting revenue per head count? How much will distribution costs fall when trucks are fully loaded, rather than partially loaded? Are revenues sufficient to guarantee fully loaded trucks? When tying savings to operational drivers, involve experienced line man- agers in the process. An integrated team that includes both financial analysts and experienced line managers is more likely to be accurate than a pure fi- nance team is. In addition, experienced line managers often will already know details about the target. If so, you will generate insights on capacity, quality issues, and unit sales not easily found in the public domain. EXHIBIT 31.6  Sample Framework for Estimating Cost Savings Function Example Savings Research and development • Stopping redundant projects • Eliminating overlap in research personnel • Developing new products through transferred technology Procurement • Pooled purchasing • Standardizing products Manufacturing • Eliminating overcapacity • Transferring best operating practices Sales and marketing • Cross-selling products • Using common channels • Transferring best practices • Lowering combined marketing budget Distribution • Consolidating warehouses and truck routes Administration • Exploiting economies of scale in finance/accounting and other back-office functions • Consolidating strategy and leadership functions 602  Mergers and Acquisitions Consider an acquisition where the head of operations took the lead in estimating the savings from rationalizing manufacturing capacity, distribu- tion networks, and suppliers.24 His in-depth knowledge about the unusual manufacturing requirements for a key product line and looming investment needs at the target’s main plant substantially improved savings estimates. In addition, this manager conducted a due-diligence interview with the target’s head of operations, learning that the target did not have an enterprise resource planning (ERP) system. Each of these facts improved negotiations and deal structuring, for example, by permitting management to promise that the tar- get’s main European location would be retained while maintaining flexibility about the target’s main U.S. facility. Moreover, the involvement of the opera- tions manager ensured that the company was prepared to act quickly and de- cisively to capture savings following the deal’s closure. After you complete the assessment, always compare the aggregate results for the combined companies with industry benchmarks for operating margins and capital efficiency. Ask whether the resulting ROIC and growth projections make sense, given the overall expected economics of the industry. Only a fully developed integrated income statement and balance sheet will ensure that savings estimates are in line with economic reality. In particular, ensure that the ROIC for the new combination lands at the right level for the continuing value and is in line with the underlying competitive structure of the industry. The more difficult it is to sustain a competitive advantage, the more you need to scale down the performance improvements over the longer term. You’ll also find that the potential cost savings vary widely by cost category. Exhibit 31.7 presents the cost savings by category for an automotive-industry acquisition. While the overall estimated cost savings for the automotive ac- quisition were about 10 percent of total combined costs, the savings varied considerably across category. For example, although procurement costs are the single largest cost category for automotive manufacturers, most compa- nies already have the necessary scale to negotiate favorable contracts. There- fore, savings from procurement were estimated at only 5 percent. In contrast, EXHIBIT 31.7  Automotive Merger: Estimated Cost Savings % of original costs Research and development Procurement Manufacturing Marketing Sales, distribution Overhead 24 3 0 14 5 33 24 This and other examples can be found in Christofferson et al., “Where Mergers Go Wrong.”