As leaders steer their businesses through the fog of the coronavirus pandemic, fear and uncertainty are often two unwelcome, but likely, drivers of business decisions. COVID-19 related disruption is causing widespread panic. When companies sense a financial pitfall, it’s tempting to cut costs—and to do so promptly. However, aimless, short-term cost-cutting initiatives that are not connected to a strategy can cause irreparable damage in the long term.
Strategy must be the driver for cutting costs—not an afterthought. Research reveals that most companies’ large-scale cuts are unrelated to their strategies. By narrowly focusing on cutting costs for today, companies are neglecting the critical insights that lead to sustainable expense reduction for the future.
When margins are squeezed, many companies’ knee-jerk reaction is to cut expenses that are easy to pinpoint, often eliminating fixed costs such as head count and overhead. Careless cost-cutting initiatives, such as head-count reductions, can have negative implications to morale and operations. In addition to unforeseen opportunity costs, cutting fixed costs yields a lesser impact on profitability than decreasing variable costs.
For example, Coltivar research revealed that by decreasing fixed costs by 1%, nonresidential builders experience a mere 1.7% positive impact on profitability. In contrast, by reducing variable costs by 1%, nonresidential builders can capture a 25.1% positive impact on the bottom line.
Cost-cutting initiatives must be driven by accurate data and work in tandem with a larger umbrella strategy. It’s a quick fix to lay off 10% of the workforce. It’s an effective solution to determine how to innovate the delivery model to be leaner, more productive and more impactful. Effective cost management calls for a strategic program that regularly evaluates opportunities to redesign, restructure and reallocate in your firm.
A cost management program allows you to analyze your strategy and align your budget to make informed cost-cutting decisions. Examining your strategy components, organizational advantages and activities can reveal where and how you generate value for the customer and capture value for your company. In doing so, you can use data and strategy to prioritize important investments.
Examine Organizational Advantages
The goal of this high-level analysis is to understand your advantages, defined as unique conditions or elements that position your organization ahead of its rivals. The following three sources of advantages allow companies to create and capture outsized value.
- Positional—A company’s market focus and customers’ perception of your brand and offerings.
- Asset—A company’s possession of a scarce (tangible or intangible) resource that provides unique benefits for the customer and/or the company. Assets are differentiated elements that can be bought, sold or traded, such as a technology platform or a patent.
- Capability—A unique power or ability to create assets and capture higher profits. Capabilities are the defining strengths and skill sets that help an organization compete and win.
Identify Related Activities
Once you are aligned around your organization’s advantages, you can pinpoint the activities that support them. One layer down from advantages, activities are the distinct and measurable tasks, units of work or steps in a process that an organization engages in to deliver products, services and experiences to customers. They are the DNA of a business.
Categorize Your Costs
Disentangling your firm’s budget entails aligning costs to activities and advantages and classifying expenses into cost distinctions to assess risks, opportunities and trade-offs to determine the appropriate path forward.
Strategic vs. Nonstrategic
Strategic costs directly contribute to building advantages and enhancing activities, while nonstrategic do not. Determining whether a cost is strategic or not requires you to have a strategy. Strategy revolves around making decisions about trade-offs and allocating scarce resources. Therefore, in their simplest form, costs are reflections of the decisions that leaders make about where to invest and disburse resources.
Once you have defined your company’s advantages and activities, assign costs to them and determine which are strategic by understanding the areas where investment increases your chances of winning in the market. In short, consider whether the cost is worth it. For example, if your company’s location is its positional advantage, moving buildings to reduce the rental expense would diminish or destroy this advantage. The higher rent fee is justified by its contribution to your overall strategy. When evaluating costs tied to advantages and activities, companies must focus on reinvention—not reduction. In seeking to reinvent your business to drive cost efficiency, consider the following questions.
- How can we implement lean working processes?
- Can we leverage software and technology to digitize this activity?
- Can we outsource this activity?
- Are there ways to incorporate analytics for data-driven decision-making?
Initial mapping may not result in clean-cut strategic versus nonstrategic categorization. However, it will help companies view their costs through a different, more deliberate lens. The approach will also spark important leadership conversations as you explore whether costs advance the business strategy and/or determine alternate ways to perform activities more efficiently and effectively.
The outcome of these conversations will guide the path forward. If the cost is avoidable and does not support the strategy, consider eliminating it. This holistic approach informs cost reduction and allocation, saving your business unnecessary expenses in the near term, while strengthening your business for the post-COVID-19 economy through prioritized strategic investments.
Avoidable vs. Nonavoidable
Avoidable costs are variable expenses that can be easily eliminated without penalty to your business (either operationally or contractually). Avoidable costs are not fundamental to your operations. Therefore, cutting these costs should not cause significant or listing detriment to the business. When determining whether a cost is unavoidable, consider whether the cost:
- Positively impacts the customer
- Makes operations easier, more efficient or more effective
- Is earning your desired ROI
Opportunity costs are the benefits your organization forgoes when choosing an alternate option. For example, reducing expenses for employee training, on the surface, may appear to minimally impact short-term operations. However, the intangible impact of this cost cut goes deeper.
The failure to train employees disables your company from building the capabilities critical to strategic success. Additionally, training and development opportunities wdirectly correlate with long-term employee attraction, engagement and retention. The opportunity cost of eliminating training is much higher than the incremental cost savings a company would receive by terminating training and development.
As we continue to navigate this unprecedented pandemic, the volatile economy will pressure businesses to think about operations and strategy in new ways. It is imperative for leaders to step back and see the big picture through the haze of uncertainty.
In connecting cost management to your strategy, you will identify the costs that fuel your growth, differentiation and resilience and eliminate those that do not contribute to your success. Reframe necessary costs as important investments. Change your mindset. Rather than cut back, consider how to move forward.