As secular and cyclical performance pressure mounts, leadership teams wrestle with the appropriate response. Unfortunately, most teams end up taking the easy way out, causing long-term damage to their performance. An old Italian economist holds the key to a much more promising approach.
Taking the easy way out - and paying the price
As revenues erode, cost cutting becomes a top priority for all firms. What are the favored approaches? There is the great leveler – everyone is mandated to take the same percent out of their cost base. Most can see that this makes no sense – all costs are not equal and some parts of the business are much less productive than others. Unfortunately, this tends to be the most common approach to cost reduction.
Some companies are slightly more sophisticated – they mandate the same percent reduction but then establish an appeals process where executives can make the case that their costs are different and require special treatment. This gives a release valve for the executives who are most politically adept at lobbying for their special interests but it rarely provides objective metrics to make an independent judgment about the need for exceptions to the broader rule.
Support services operating as cost centers are disproportionately targets for cost reduction in challenging times. Unfortunately, executives often fail to realize that, if these services are doing their job, they are actually critical to generating revenue and profitability.
Some companies are organized into P & L driven business units and the exercise is to prune low performing businesses – targeting them for sale or closure. This is certainly better, but it is more of a meat cleaver than scalpel approach.
What’s the result of all of this? Near-term performance improves because costs do come out of the business, but longer-term performance suffers as the consequences of unfocused cost cuts become visible.
Asking a different set of questions - the Pareto questions
So, what is the alternative? There’s one approach that can be implemented quickly. It provides an opportunity for very significant cost cutting in the near-term while at the same time strengthening the longer term performance of the business.
I first wrote about this approach over five years ago as many companies were wrestling with the aftermath of the dot com bust. It is based on a key insight by an Italian economist, Vilfredo Pareto, over one hundred years ago. Pareto discovered that much of human activity follows the 80/20 rule – 20% of the inputs often generate 80% of the results. He first noticed this during a study of wealth and income distribution in England. He discovered that 20% of the population accounted for 80% of the wealth. As he explored other domains of human activity, he realized that this was a remarkably pervasive pattern.
So, what does this have to do with cost cutting? The 80/20 rule provides the foundation for a relatively simple exercise for executives. It involves answering the following questions:
- Which 20% of the products or services generate 80% of the profitability?
- Which 20% of the customers generate 80% of the profitability?
- Which 20% of the geographies generate 80% of the profitability?
- Which 20% of the assets generate 80% of the profitability?
These are powerful and revealing questions, yet few companies today are able to answer these questions given the way their accounting and information systems are set up. As a result, the answers are generally hidden from management view. Unfortunately, the questions themselves rarely get asked.
Accounting and information systems need to be restructured to provide greater visibility along these dimensions on an ongoing basis. But, from my experience, quick and dirty approximations of the answers to these questions can be generated relatively easily – especially if management can get comfortable with “directionally correct” answers. The results are usually eye-opening. For example, one management team discovered that the product line it thought was most profitable was actually its biggest money loser.
One caution: in answering these questions, executives often focus on one financial period. Unfortunately, profitability of resources needs to be measured over a lifecycle, not a snapshot of one period. For example, one can get very misleading results by looking at customer profitability over one financial quarter. Real measures of profitability include an assessment of customer acquisition cost, the average lifetime of a customer and the margin generated from the customer for each period over that lifetime. The same principles apply to products and assets as well. Try getting that out of today’s accounting and information systems!
Leading to the more fundamental question
Once these questions have been answered, here is the question that can focus management discussions around strategic cost cutting: why are we continuing to invest in the 80% of the resources that generate only 20% of the profitability? Of course, the answer is not to mechanically cut the 80% resources that are low performing in terms of profitability, but to create a series of reasonably objective screens that can be used to test whether these resources are in fact playing a productive role. Some of these screens are:
- What is the growth profile of these resources? Many business initiatives are at an early stage of investment but have already started to show promising growth potential. The key is to focus on actual revenue and profitability growth trajectories or some other form of operational leading indicator to test growth potential.
- What are potential interdependencies between these resources and the high profitability resources? Explicit dimensions of interdependencies need to be laid out and used to test any claims in this area.
- What short-term initiatives might be taken to significantly improve the performance of these resources? Defining explicit six month milestones for operational and financial performance improvement becomes critical to ensure results.
The causes of invisible diversification
Bottom line, though, most companies spread their resources much too thinly across too many product, customer, geography and asset plays. This is a much deeper problem than the diversification across many different businesses or business units. Even within an individual business unit, portfolios of products, customers, geographies and assets have become broader and broader.
There are many reasons for this invisible diversification. In far too many cases, it is the result of incremental, near-term strategic thrusts over a long period of time that have never been rationalized. In other cases, it is the outcome of organizational fragmentation and politics and the lack of clear and uniform metrics to drive decisions on new business initiatives.
Another driver of this invisible diversification is risk aversion. We launch portfolios of initiatives to cope with risk by placing bets across a broad front. Unfortunately, most companies lack the discipline to remove bets even after the results are known.
But there is also a more fundamental economic driver of this kind of invisible diversification. Many companies have built up a large fixed cost infrastructure either on the supply chain side or on the sales and distribution side or, in too many cases, on both sides simultaneously. Once these infrastructures are in place, an insidious logic takes hold. The only way to cover these costs is to drive more volume through the infrastructures, even if the incremental volume generates minimal margins. The infrastructures begin to run the show even though they were originally deployed to support the main act. The economic logic is compelling in the short-term but can lead to deteriorating profitability over time.
The most basic question of all
The only way to escape this bind is to pull back and question the need for these fixed cost infrastructures. Thus a simple and relatively straightforward application of an 80/20 analysis can lead to a discussion of the most basic question of all: “what business are we really in?” This in turn requires a systematic framework for thinking about business unbundling, something that I have covered in other venues.
If companies want to move beyond marginal cost-cutting that can often hamper long-term performance, they would be well advised to apply the 80/20 analysis to their business. It can deliver quick and very deep cost restructuring that actually positions the business to perform far better in the future. It is a powerful tool for reframing the cost structures of the business through a new lens.
But that's not all folks
The Pareto 80/20 rule can be used to reframe the business across two other dimensions as well – growth platforms and institutional innovation – but these are topics for future posts. Let me leave you with two key messages. As competition intensifies on a global scale, companies will not be able to survive with marginal or incremental approaches to cost reduction – they must restructure and reduce costs at a much more fundamental level. Cost reduction alone is necessary but not sufficient. Without finding powerful new sources of growth and leverage – even in trying times – cost reduction alone will only shrink the business as cost savings get competed away and captured by customers.