Cutting the right costs

Last week, I discussed seven decision-making errors business leaders make that get them into trouble. One of them – taking action when doing nothing would be better – got a little bit of short shrift since I wanted to dive deeper into it today. That is because to me the classic example of strategic mistakes in decision-making happens when a company tries to cut costs that it better not touch.

As we head into another recession, most companies see their revenue base at risk and need to think about reducing costs to remain profitable. In some instances, where the last five to ten years have been particularly successful, there may be a lot of fat to cut, and cost-cutting can be done relatively easily. I think the decision by Meta to let 11,000 people go and by Amazon to let 10,000 people go fall into this category.

But the truth is many companies don’t have too much fat, to begin with. This means that a company has to prioritise its cost-cutting targets and that is where things can go horribly wrong. Cut the wrong stuff and you endanger the long-term performance of your business and in particular the ability to gain market share in the recovery that will inevitably come after the recession.

Consulting firm Gartner has a list of seven mistakes to avoid when reducing costs that makes intuitive sense. Here I want to focus on two of them that I find particularly common:

Making blanket cuts with unrealistic targets. That is the famous Goldman Sachs cull of letting 1% to 5% of people go every year. In a recession, that quickly becomes a lawnmower cut of some 10% or more of staff in an effort to quickly reduce costs. Except that if you let too many people go or act indiscriminately, you may alienate your entire workforce and start losing better people.

This study has examined the impact cost-cutting measures had on employee motivation and the relationship between employees and their employers. To no surprise, letting people go is a violation of the trust employees put in their employers. Even small things that seemingly make no difference like a reduction in the availability of training or some other fringe benefits can have a long-lasting impact and reduce employee morale.

I remember how in the financial crisis my then-employer stopped the food cart that was coming through each afternoon to offer fruit and snacks to employees. You couldn’t have made people more furious. By cutting a tiny amount of costs, the company reduced employee morale (and I dare say employee productivity) significantly because people knew the cut costs made no difference to the bottom line but a huge difference to their everyday well-being at the job. The study mentioned above found that by cutting this indiscriminately, employee complaints in the long run rose and the firm was at risk of increasing costs from employee turnover and legal complaints.

A simple solution to avoid these outcomes is to include employees in the decision where to cut costs and thus create buy-in from them and make them understand the trade-offs the company faces.

A second area where I find cost-cutting is done wrong is cutting investment in innovation and long-term growth. This study looked at how different companies cut costs during the financial crisis of 2008. They were able to differentiate between cutting costs in research and development (R&D) and corporate social responsibility initiatives (CSR) on the one hand and a reduction in capex and the workforce on the other. The crucial result, in my view, is shown in the chat below where the profitability of the companies after the recession ended (2010-2011) is shown in comparison to the profitability of companies not impacted by the credit crisis. Companies that cut employees and capes during the crisis but left R&D and investments in CSR unchanged performed much better than companies that cut in all areas, increasing their ROA by 2.8% vs. a control group unaffected by the financial crisis.  

Of course, when a recession comes, it is time to tighten the belt, but business leaders must be cognisant that every time they cut costs, it will have an impact somewhere. Cutting costs needs to be done in a smart way and leaving some areas alone is part of the task.

Improvement of ROA after the financial crisis and actions taken during the crisis

Source: Flammer and Ioannou (2020)