Wednesday, September 27, 2023

Be careful how you cut costs

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Shreya Christina
Shreya has been with for 3 years, writing copy for client websites, blog posts, EDMs and other mediums to engage readers and encourage action. By collaborating with clients, our SEO manager and the wider team, Shreya seeks to understand an audience before creating memorable, persuasive copy.

Gregory Milano is founder and CEO of Fortuna Advisors LLC and author of Curing Corporate Short-Termism, Future Growth vs. Current Earnings.

Do you find the current business environment challenging? If your answer is yes, you are not alone. Inflation drives up input costs, while many companies also face revenue headwinds from stalled real GDP growth and supply chain constraints. Profits are under pressure in almost every industry.

In my own survey of S&P 500 index companies, as of November 4, 2022, 30% of selling analysts expect to generate lower net income in the next 12 months compared to the past 12 months. On average, these struggling companies are expected to suffer a 29% drop in net income. The worst sector is real estate, where 56% of net income is expected to fall, followed by consumer durables (44%), communications services (43%) and energy (40%).

As if squeezing profits wasn’t enough, interest rates rise as the federal reserve fights inflation and higher rates further reduce the value to investors of these already diminished gains. We’ve become accustomed to falling interest rates when the economy slows to spur a recovery. But for the first time in more than four decades, the Fed’s hands are tied to high inflation.

Some companies have overcome this pressure by raising prices. On October 12, PepsiCo reported revenue and earnings per share exceeded analyst expectations. Their earnings since the beginning of the year had increased 14% compared to last year, mainly due to price increases. But most companies don’t have brands with such strong differentiation and would likely lose market share if they raised prices to compensate for inflation. So the leaders of these companies often resort to general cost-cutting to save their profits. Indeed, some see this as an opportunity to curb excess waste, thinking, as Winston Churchill (probably) said, “Never let a good crisis go to waste.”

But arbitrary cuts can have negative consequences for future performance. Everyone knows this, but many companies are still cutting back on important investments. We typically see two approaches to this problem in most boards.

• Protect the future: Some employees, often in departments such as marketing and R&D, criticize cost-cutting initiatives and point to the loss of capabilities and future opportunities that diminish the strength of the eventual recovery.

• Lean machine: Others, especially in finance and accounting, criticize inefficiency and waste and advocate for sweeping cuts, claiming little will be lost over time.

In most companies, I find that both the “Protect The Future” and “Lean Machine” factions are partly right. There are often plenty of opportunities for healthy cost savings, but also initiatives that should be left untouched so as not to sacrifice future performance.

The challenge, of course, is to identify which areas can be scrapped without significantly damaging the long-term potential of the company and which should be protected at any cost. There are many vested interests throughout the organization, so no matter what one pursues, there will always be someone warning of dire consequences. Those responsible for cost-cutting initiatives could face many sleepless nights as the various warnings from department heads echo in their heads.

While there’s no approach that makes this easy or stress-free, there are ways to make it more effective. You can start by establishing a rigorous cost categorization process to increase objectivity, as described below.

1. Investments in Intangible Assets: This includes expenses that are charged to the income statement for accounting purposes but are really an investment in the future, such as R&D, brand building advertising, and employee training. This is the primary area we want to protect, but we cannot keep projects that fail. Now is an opportune time to revisit the prospects for each of these investments and eliminate those with poor prospects for success.

2. Core Capabilities: These aspects of our business make our products and services distinctive in the eyes of customers. Consider a spacious fine dining restaurant that spans two storefronts. To reduce rental costs, they could squeeze the tables into half the floor space and stop renting the second storefront. But this makes the experience less desirable, leading to less demand. In this case, it is conceivable that the revenues fall faster than the costs. What’s worse, this can happen gradually. Revenues may be marginally down this year and the cuts may seem like a success, but over time more customers are becoming disillusioned and looking for alternatives. By the time you realize the mistake, the restaurant’s appeal may have eroded in irreversible ways.

3. Waste and Inefficiency: These are costs that can be eliminated with little loss of present or future benefits. Often here we find expenses that were once important but are now no longer, as often happens when technology makes old processes or activities obsolete. As an engineer in the 1980s, I witnessed the widespread implementation of computer aided design. Still, the efficiency gains often went unrealized at first, as many engineers were still producing design drawings at the same pace, just with more time to talk. By realigning work practices and expected outcomes, some costs can be eliminated without loss of productivity.

Categorization is helpful, but not enough, as employees still have an incentive to prefer the segments they oversee. Accountability is needed to ensure that the right decisions are made, which can be achieved by looking back later at how the cuts have turned out. For example, if someone argues against discontinuing a research project, they will have to account for its results in years to come. It would be essential for this to get managers to treat their capital as their property, which I recently wrote about. Just make sure that projects are evaluated using a reliable measure of value creation, such as economic profit, rather than incomplete measures such as return on capital, revenue growth or even EBITDA, as these often lead to unfavorable outcomes for shareholders, especially when linked to the remuneration of directors.

Inflation, declining real GDP and supply chain constraints are a perfect storm of profitability headwinds. Many companies need to take action to weather the storm and make the most of their capital. Those who think about how to cut costs could be rewarded in the coming quarters. Business Council is the leading growth and networking organization for entrepreneurs and leaders. Am I eligible?

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