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Cost Cutting—Even in Lean Times—Can Be Counterproductive
August 5, 2008

Dr. Joe Webb, director of WhatTheyThink’s Economics and Research Center, had an interesting column last week on the often knee-jerk reaction of companies to cut costs when business gets bad—and why that’s probably a not such a good idea:

Cost Cutting is a Downhill Street with a Cliff at the End

There is a perception that the way to survive in a difficult or slow economy is to cut costs. It's understandable, but it’s a misunderstanding of what costs are.

Costs and expenses are different. A cost is an outlay from which you expect some kind of return. This is why the income statement has a section “cost of goods sold.” You don’t produce something unless it will be sold. An expense is any other outlay. This is why factory labor is a cost, and sales and administrative payroll is an expense.

Costs emanate from the capital investment decisions that owners make.

Dr. Webb is talking specifically about the printing industry, but there’s a lesson here that transcends any single industry. Sure, all businesses are different with their own dynamics, but fundamental economic principles don’t change. (And actually this is what got the printing industry in trouble to begin with, as many thought that somehow printers were “above the fray” and immune from technological, social, and economic changes. Guess what: they weren’t.)

The point to remember is that “costs” are a function of the capital investment decisions a company makes, and those decisions are in turn a function of what business the decision maker thinks s/he is in. In the case of a printer, that would be the press, which is purchased at a given time with an expectation of a certain level of demand for the types of materials it can print. In any other manufacturing facility, it’s the equipment that is used to make the products the company produces, which is also based on an expectation of a certain level of demand for those products. In service industries, those capital investments can be computers and software. It can be equipment and supplies you need to provide the service effectively. And again, these investment decisions are driven by what you perceive to be the demand for your services.

With that born in mind, think about Dr. Webb’s comment:

So to change costs, companies have to change the nature of their core capital investment base, and can’t really nibble around the edges with a cut here and a spending reduction there.

Cost cutting, as described by many managers, does not change the core nature of their business operations.

Markets change and evolve over time, just like anything else. Manufacturing industries can often get into trouble because their equipment is designed to last for a very long time, and responding to a changing market can be like trying to get an oil freighter to turn on a dime. Service industries may have the luxury of being a bit more nimble. For example, one of the interesting trends we used to see in the old TrendWatch Graphic Arts surveys of design and production professionals—especially those doing Web design and development—was that when business was bad, they increased their investment. That is, they took advantage of sluggish business conditions to buy new software, learn new skills, and hone their chops so they could expand into offering new types of services. Note that this is  different from simply laying low and waiting for the economy to improve of its own accord.

Because, as Dr. Webb says:

There are still executives who think that a stronger economy will change their business. It can’t and it won’t.

The old phrase, “A rising tide lifts all boats” is not especially apt; think of the Titanic, which ain’t gonna get raised no matter how high the tide rises.

Without changing the orientation of one’s entire business, cost cutting, then, can only ever really be “cosmetic.” That is, a nip here, a tuck there, and in the long run may do more harm than good. One only has to look at the publishing industry to see the financial equivalent of a “bad facelift.” Some publishing companies have been in cost-cutting mode for so long, they no longer know how to make money, and can only ever try to save it. Is that really a good business strategy?

So what’s the solution? I’ll pass the mic to Dr. Webb for one idea:

These are good times to put that blank sheet of paper in front of you and rethink your business from scratch, only if you have the courage to act on it....Higher costs may actually be the answer if those costs produce what the marketplace wants.

Depending on your industry, you may not have to start over from scratch, but the key is to give serious thought to what your business is, what it does, and what the expected level of demand for it from the marketplace was, is, and will likely be. And do your investment plans—your costs—need to change accordingly?

Posted by Richard Romano on August 5, 2008 | Comments (0)