With the demand for traditional office supplies weakening, market leader Staples (SPLS) is taking steps to realign its business model. As I talked about in my review of Staples' recent earnings report, the company is adding new categories of products and focusing heavily on e-commerce, allowing it to stay one step ahead of rival Office Depot (ODP 0.72%). But another key step being taken is cost reduction, something that has worked well for consumer electronics retailer Best Buy (BBY -0.25%), and Staples is making progress in three different areas on that front.

Smaller stores
When demand for office supplies was strong, big stores made sense. But as demand for certain categories has weakened, these big stores have been left with large amounts of floor space dedicated to unprofitable products. This reduces the revenue per square foot, bringing the profitability of some stores down with it.

Staples is trying to fix this problem by converting these big stores into smaller stores. With some stores as big as 24,000 square feet, cutting the footprint can dramatically lower the fixed costs while removing unproductive space completely. Staples has converted a total of 21 stores to its new 12,000 square foot format, about half of which match the original prototype store exactly. The plan is to continue to convert or relocate stores as their leases come up for renewal.

So far Staples has seen success with this new store size. A goal of the company was to retain at least 95% of sales compared to the larger predecessor stores, and it has achieved this goal rather quickly. By eliminating categories with poor performance and adding new products with greater demand, Staples has found the formula to reduce costs significantly while retaining most of its sales. Over the next few years, as an increasing number of stores are converted over to the 12,000 square foot format, Staples' costs should come down considerably.

One place Staples may be looking for inspiration is consumer-electronics retailer Best Buy. Best Buy used to dedicate a huge amount of floor space to low-margin CDs and DVDs, but now the company has largely removed these products and installed store-within-a-store concepts from Microsoft and Samsung. This is a far more profitable use of floor space, and it should help the retailer grow sales this holiday season.

Cutting jobs
Along with reducing the size of stores, Staples has also been reducing its headcount. In the third quarter, Staples eliminated 1,400 positions across the company, most notably 15% of vice presidents and directors in North America. Chief executive officer Ronald Sargant explained during the company's conference call that Staples had gotten too slow compared to its rivals, and that too many people at the vice president level slowed down decision making. This is similar to what Best Buy has been doing over the past year, eliminating layers of management which only served to slow down decision making.

Along with this, Staples has been consolidating and simplifying its corporate structure. Before the changes, the company had separate human resources, finance, and marketing groups for each business unit. These were consolidated into single groups, reducing unnecessary costs and removing more friction from the decision-making process.

Faster decisions will be critical for Staples after its two main rivals, Office Max and Office Depot, have merged. Disruptions caused while the two companies are integrating could create opportunities for Staples, and the company will need to make decisions quickly and efficiently in order to properly take advantage. Gaining market share in both the retail and contract businesses is possible for Staples here, and the company will be going after every opportunity that it sees.

Eliminating debt
Staples is on pace to pay around $120 million per year of interest on its debt based on the third quarter, but this number will be roughly cut in half in January. About $867 million of the nearly $2 billion of Staples' total debt is due at that time, and the company plans to use some of its $1.4 billion of cash to pay off this debt. This means that the annual interest expense will be reduced by between $50 million and $60 million, a significant savings.

The bottom line
Staples is aggressively taking costs out of its business as it adjusts to lower demand for its core office products. By adopting a smaller store design, cutting out unnecessary management jobs, and greatly reducing its debt, Staples should continue to generate plenty of free cash flow. The next step is returning to growth, likely at least a few quarters down the road, but a leaner cost structure should help Staples compete more effectively.