(FORTUNE Magazine) – WHEN Anthony J.F. ''Tony'' O'Reilly, the chief executive of H.J. Heinz Co., called the company's 100 top managers to Pittsburgh in February for what was billed as the Low-Cost Operator Conference, most of them expected to hear some corporate cheerleading about turning off the lights and then to adjourn for cocktails. After all, Heinz was already enjoying several varieties of success, thanks to singular devotion to lowering costs. By management's reckoning, the company reigned as market share leader and low-cost producer, at least among branded competitors, in ketchup, frozen French fries, vinegar, and cat food. Profits had increased an average of 17% a year for five years. In the year just past, Heinz earned 22% on shareholders' equity. O'Reilly's surprising message to his managers in February: it isn't enough. The food industry is in big trouble, the chief executive told them, and for Heinz, ''the party is over.'' It was a sobering statement from an Irishman, a former big-league rugby player, and a man who normally opens a business meeting as if it were the Tonight show. The industry problems he recounted are nothing new: little or no growth in the number of units being sold, intense pressure on operating-profit margins, and low return on capital. But the high inflation of a few years back at least allowed manufacturers to jack up prices, whether their underlying costs went up or not. Now that option is gone. Company executives say they will have to fight hard to stand out from the rest of the industry and keep the price-earnings multiple of around 14 that Heinz stock currently commands. They think the company will have to rack up superior sales growth of 8% to 12% a year, vs. 5% in the past 12 months, while continuing to ratchet down costs. O'Reilly and his colleagues plan to expand the company's overall operating margin -- operating profit as a percent of sales -- two percentage points in two years, to 13.5%. Based on last year's | sales, those two points would produce an increase of about $80 million in pretax income. The company intends to put the dollars gained into a pool called the Super Fund to bankroll its hottest new products while they're still two years from market. ''We just spent $20 million introducing instant baby food,'' says J. W. Connolly, president of Heinz USA. ''You can only do so many of those at that price, and we have a few more waiting in the wings.'' Heinz's new strategy begins with the premise that traditional approaches and standards of cost containment aren't good enough anymore. ''We're changing the rules,'' says Connolly. O'Reilly expects to be the low-cost competitor in the company's six biggest products worldwide: besides the already low-cost ketchup, French fries, and cat food, those include tuna, baby food, and soup. The kicker is that O'Reilly wants to be low cost on what Heinz's executives call a zero-budget basis. ''Everything goes out the window,'' O'Reilly explains. ''What we're saying to our people is: 'Okay, if you were going to start a ketchup business today, how, precisely, would you go about doing it? What would your costs be?' '' Presumably, those costs would be lowest in the industry. Low-cost operations are particularly crucial to a company like Heinz, which charges a premium price for staples such as ketchup and vinegar. The company's ability to command the premium depends on the degree to which it can differentiate its products from those of competitors offering lower prices. Persuading the consumer of the difference takes lots of advertising. Between 1980 and 1984 the company increased its gross profit rate -- sales less the cost of goods -- to 38.1% of sales from 35.2%, generating about $115 million in additional gross profit. About half of that came from lower costs, the rest from price increases. Heinz plowed 60% of the proceeds back into marketing, mostly into advertising. That strategy helped Heinz gobble up additional market share -- in ketchup attaining a record 50% of unit sales at retail; in frozen French fries, pushing its preeminent share up to 52%. In the years before the current team of executives took over, Heinz's approach to managing costs concentrated on procuring enough cheap raw materials -- basically foodstuffs -- to keep its factories humming; other parts of the cost-control recipe, such as holding down manufacturing costs, were secondary. Then, as now, though, raw materials accounted for less than half the total production costs. When he became president in 1973, O'Reilly took as his first mission getting managers of the different product lines to begin whittling away at costs. ''The culture has been chip, chip, chip,'' says Tom Halford, vice president of manufacturing for Heinz Canada. Over the past five years Heinz USA eliminated up to $4 million in expenses each year with such steps as getting rid of the back label from large bottles. The company has institutionalized this kind of thinking in a corporate Profitability Improvement Program. Under the aegis of PIP, Heinz has organized teams of managers from different disciplines to identify and assign priorities to projects with major cost- saving potential. At Ore-Ida, the division that produces frozen French fries, PIP projects included coming up with new processes to peel potatoes and designing systems to re-use water from one processing area in another and to reclaim heat from blanching ovens. Another program, called People Excellence Products, encourages hourly employees to form their own cost and quality control teams. The combined efforts under such programs have netted impressive results: over the past ten years Ore-Ida increased its output of French fries per 100 pounds of potatoes from 43 pounds to 53 pounds. The division had sales of about $650 million last year, about 15% of Heinz's total. In years to come, Heinz will need lots more of what O'Reilly calls ''nickel and diming it'' in the factory if it's to get close to the chief executive's zero-budget ideal. Heinz has to look inward for profit because the company has already pushed to the limit the premium consumers will pay for its products. Competitors are going in the other direction. Last year Del Monte discounted ketchup as much as 50% per case in a battle for market share with Hunt, causing the prices of the brand-name versions of America's greatest sauce to occasionally fall below the private label price. These days consumers expect a bargain in brand-name ketchup. With Hunt now a part of the Beatrice empire, the possibility of a renewed market share battle looms. ''Suppose your competitors are willing to accept a lower margin permanently?'' O'Reilly asks oracularly. HEINZ will also be feeling more heat in markets where it isn't nearly so strong. The top four products of Heinz USA -- ketchup, soup, baby food, and vinegar -- account for about 60% of the division's sales. But the U.S. operation has some also-rans too, such as mustard. Increasingly retailers have been marking third- and fourth-place brands on their shelves for execution. ''Those brands are in for tough times,'' says Connolly. ''You don't market your way out of that.'' Imports represent another threat. European producers, particularly countries that subsidize agriculture, can periodically land products such as tomato paste in the U.S. for less than the cost of producing them stateside. O'Reilly says flatly, ''Europe will target U.S. food producers.'' He has reason to be concerned. Imports gutted the profitability of Heinz's Star-Kist Foods division and filleted its low-cost status in the process. Imports of water-packed tuna, which has become more popular than oil-packed, increased 77% from 1981 through 1983, sending the retail price down 18%. Richard Beattie, the Star-Kist division's president, says, ''We were faced with lowering costs out of desperation.'' Star-Kist found about $7 million in net savings in what became known as the Hershey solution -- Hershey downsized its chocolate bar when the price of cocoa soared. By reducing the height of a standard seven-ounce can by 2%, Star-Kist decreased the can's volume 5%. The company still met government weight standards because it had been overfilling. The Hershey solution was not enough. In October 1984, Star-Kist took the most traumatic cut to date, closing its huge headquarters plant on Terminal Island, California, after the U.S. International Trade Commission refused to restrain water-packed tuna imports. The company shifted production to expanded offshore plants in Puerto Rico and Samoa, where workers are paid one-fifth to one-half as much as on the U.S. mainland. The company estimates that by such measures it has lowered costs about $5 per case of tuna. Star-Kist, with sales of about $1 billion last year, accounted for nearly 25% of the company's revenues and earnings. The division will have to do better if it's to approach the zero-budget ideal, and here, as elsewhere in the company, automation will figure large in the cost-cutting effort. Until now, tuna processing has defied automation, principally because the fish refuse to present themselves in a standard size. Heinz says it's now on the verge of automating parts of the process, which may bring costs closer to those of imports. The company's biggest investment in automation will come in the United Kingdom. Sales there -- mostly of soups, beans, pasta, and baby food -- account for about 14% of Heinz's total. Until recently, the company thought it was beating all comers on cost. Over the past five years a program of consolidating factories and renegotiating work rules eliminated about 2,000 of 7,000 jobs. But when the company took a harder look last year it found that less labor-intensive competitors with more automated facilities could produce each of its principal products more cheaply. At the same time, Heinz was beset by powerful retailers -- four grocery chains control about 50% of the total market. They were pressuring the company's margins and elbowing Heinz and other brand-name manufacturers off the shelves in favor of their own private labels. Heinz is going to spend $110 million to automate its largest plant in the U.K. The company expects to double production-line speeds to 800 cans per minute while reducing the number of canning lines in the plant from 13 to five. The plans also call for more bulk processing: soup vats will double in capacity to 600 gallons; tomato paste will be delivered in 300-gallon bags rather than five-kilo cans. About half the investment will pay for what the British call planned redundancies, buying out workers currently on the lines, which will save about $24 million a year by 1990. Overall the renovation should eliminate 1,200 jobs. The company is also dispensing with some traditions. In British plants workers used to shut canning lines down for tea breaks. Only recently have the lines operated continuously while the workers take staggered breaks. THE HONCHOS back at headquarters have also set new standards for cost cutting by publicly attacking a sacred corporate cow -- marketing. Heinz's marketing expenditures have risen more than 20% a year, faster than profits, and with some remarkable results. On the back of heavy media outlays the company has increased market shares in some of the dullest foodstuffs extant. O'Reilly is convinced, though, that an ''unconscious conspiracy'' exists between brand groups and advertising agencies, and it begins and ends with a single imperative: spend -- spend at a level consistent with market share, spend more to defend market share, and spend that amount squared to increase it. ''I'll be goddamned if I'm going to take last year and add 10%,'' he says. He has warned the company's marketers that he will cut their budget first if profits begin to lag. Some brands already seem to be doing well despite decreases in advertising. Heinz's research indicates that 15-second TV commercials reach 75% to 80% as many people as 30-second versions. So Heinz is moving away from half-minute commercials to a pair of 15s, despite the protests of ad agencies and networks. If Heinz's operating managers need any further incentive to save, O'Reilly's determination to eliminate one layer of management should spur action. The idea is to force decision-making further down the hierarchy, under what the company calls the principle of subsidiarity. Compensation is structured accordingly. ''We pay very little money for coming to work,'' says O'Reilly. About two-thirds of the pay of each of the top 300 managers takes the form of performance incentives based on everything from brand profitability to corporate return on shareholders' equity. To further power the drive to cut costs, some of the Super Fund money will be distributed as bonuses to those who survive the pruning of the managerial ranks. Of his plans for the $100 million or more in savings that operating managers are expected to produce, O'Reilly says, ''We're going to spend it on the fast two-year-olds in the stable.'' In the U.S., the Weight Watchers frozen entree and dessert lines are the front-runners right now, and the company is looking for specialty products to fill in the health and diet areas. One contender is Chico-San, a rice cake product from a California manufacturer Heinz acquired last year. Heinz, like most food-processing companies, has an undistinguished record in new product introductions. So far this year, it has gambled biggest on a newly launched line of dried instant baby food that Heinz managers hope will shake Gerber's hold on the infant nutrition business. While it's still early in the competition, Heinz executives profess themselves delighted with their product's performance. O'Reilly may have to hedge his bet on baby food -- the market is constantly changing -- but he is clearly doubling up on the favorites. One of them, a new ''gourmet'' cat food called Amore, is purring along at twice the growth rate of the company's alley cat version, Nine Lives. For both their spending and cost-cutting plans to work, O'Reilly and his cohorts believe the company needs to create what Star-Kist President Beattie calls ''an ongoing feeling of desperation.'' Boasts of being the low-cost producer rank high on the charts of corporate cheap talk, right up there with ''market driven'' and ''a concern with quality.'' O'Reilly is wary. Sounding the right, slightly desperate note, the chief executive observes, ''Once you think you are low cost, that's the minute you start to lose it.'' BOX: INVESTOR'S SNAPSHOT HEINZ SALES (LATEST FOUR QUARTERS) $4.0 BILLION CHANGE FROM YEAR EARLIER UP 6% NET PROFIT $261.0 MILLION CHANGE UP 12% RETURN ON COMMON STOCKHOLDERS' EQUITY 22% FIVE-YEAR AVERAGE 18% RECENT SHARE PRICE $52.50 PRICE/EARNINGS MULTIPLE 14 TOTAL RETURN TO INVESTORS (12 MONTHS TO 5/24) 65% PRINCIPAL MARKET NYSE Explanatory notes: page 138