You Can’t Build a Business By Cutting Costs
Entrepreneurs tend to focus on sales. It’s not that they ignore costs; they just put winning customers first – because without customers there is no business. Somewhere along the line in many organisations, the emphasis seems to switch and the denominator manager emerges. A virtue is made of ‘trimming the fat’, reducing costs to the lowest level possible. There is talk of being ‘lean and mean’. Such positive language can conceal a potentially disastrous shift in attitude. Managers become internally-focused and short-termist. They keep an eagle-eye on this quarter’s results, slash costs and reduce spending.
I am not denying that cost-control is important, just trying to redress the balance a little.
The world is changing and organisations must adapt. An over-emphasis on costs is like a virus that slowly robs an organisation of the ability to change; it destroys imagination and enthusiasm. We need to keep in mind Peter Drucker’s statement:
“The purpose of a business is to create a customer.”
When an organisation loses sight of this simple tenet it condemns itself to ever-decreasing circles of cost-cutting and the destruction of value. Which leads onto …
The Need For Shareholder Value
Shareholders make money in two ways: dividends and share price growth. With a dividend the shareholder receives the money immediately. Share price gains are only realized when the share is sold. Whether the shareholder is interested primarily in dividends (for instance a pension fund or older individual) or share price growth, they are not only interested in this quarter’s results. Shareholders are interested in total returns.
Strange though it may seem – and despite their rhetoric to the contrary – too many companies are managed with an emphasis on short-term performance. Bonuses, commissions and incentive schemes are usually based on short-term measures – this month’s sales, annual profits. The short-term is important but often the action that increases short-term profits will lower shareholder value. Imagine that you have been appointed to a new CEO position and your remuneration package is based on this year’s net profit. If you want to maximize it, you should probably:
- cancel all training
- close the R&D department
- make customer service staff redundant
- halt non-direct marketing
- introduce short-term incentives for all staff
I am sure that I don’t need to state what the likely affects of these actions will be on long-term profitability and shareholder value. Similarly, the failure to invest in assets can destroy value. As Henry Ford said:
“If you need a machine and don’t buy it, then you will ultimately find that you have paid for it and don’t have it.”
I have mentioned several times the importance of intangibles. Intangibles don’t appear in the financial statements and yet are the main drivers of financial performance. A short-term focus using primarily accounting based measurements discourages investment in these intangible performance drivers. Professor Peter Doyle commented:
“Accounting profits encourage an excessively short-term view of business. They also encourage an under-investment in information-based assets – staff, brands, and customer and supplier relationships. In today’s information age, the accounting focus only on tangible assets makes little sense now that these intangible assets are the overwhelming source of value creation.”
Let me illustrate by comparing two strategic options for a company. Here are the profits over a five year period for the two options.
The myopic strategy shows double the profits in Year 1. Many companies would look no further and select this option. The value strategy though delivers a much higher total return over the five year period. Here is what happens under the value strategy in year one:
- investment in brand – enabling a higher price to be charged in later years because consumers recognize and value the brand
- the strong brand enables new products to be introduced more quickly
- as customer numbers grow the company begins to market to them directly, thus reducing promotion costs and increasing sales since they are marketing to existing customers who like the brand
- staff are trained in customer service – customers tell others about the great customer service, bringing in new customers
- investment in employee relations reduces labor turnover – it is a good place to work and customer service improves further
- on-going product development provides a stream of new product launches
One can see that the value approach is laying a solid foundation for future success. The actions underpinning the value approach incur costs. In the accounts these costs are treated as operating expenses. Expenses come straight off the current year’s bottom line. Hence, the profits in year one are only half those of the myopic strategy. Yet from a value perspective, with its emphasis on total returns, it is clear that value approach is the most effective strategy.
Nevertheless, we should still exercise some caution. Forecasting profits five years ahead is fraught with danger. There are many factors outside the control of any company. Managing for value does not mean that the short-term can be ignored. At the very least we need to ensure that the company will still be around to take advantage of its year one investments.
We will encounter ‘value management’ in later modules, where I will introduce a range of tools that you can use in your own business for evaluating business proposals.