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Are your costs too low?

Are your costs too low?

When Kraft announced it was taking over Cadbury, it wasn't long before a hefty round of cost-cutting started. But is this depressing and familiar scenario really the best way to grow a company? Jules Goddard examines the flawed assumptions inherent in efficiency drives, concluding that it is strategy, not costs, that determine competitiveness.

Within A Day of acquiring Cadbury, before the ink was dry on the contract, Irene Rosenfeld, CEO at Kraft, was announcing $2 billion of cost-cutting. How utterly predictable. How depressing. How unimaginative. But more than anything, how puzzling.

You pay £11.4 billion for a thriving company and the very first thing that you choose to announce are cuts. How on earth can Kraft really know that Cadbury's costs are too high rather than too low? What evidence does Kraft have – that presumably the board of Cadbury either did not have or that it misinterpreted – to demonstrate that the company has for years been systematically overinvesting in, say, new brand development, or advertising, or product quality, or working capital or wages?

When you acquire a company – particularly if you have Kraft's wretched track record of stodgy growth and insipid innovation – presumably you buy it for its potential to inject some imagination, energy and leadership into the system, not simply to become another victim of your own malaise.

Wouldn't it have been wonderful if instead Rosenfeld had announced: 'We're immensely proud of becoming the new owners of Cadbury and the enthusiastic stewards of its future success.

'We bought it because it is a better, more talented, more innovative company than our own. With immediate effect, we are investing $2 billion in four highly innovative, global projects that will be designed, led and managed by the existing Cadbury management. No one in Cadbury will lose their job. On the contrary, we are investing $25 million over the next three years in a development initiative to make even better use of the assets and skills of Cadbury that we believe were neglected by its management over the past 20 years.

'The Cadbury cost base is simply far too low. In our eyes, the company woefully underinvested in its extraordinary people and, as a result, surrendered market opportunities that we would say truly “belonged” to Cadbury. Over the next five years, as Kraft makes up for past shortfalls in capital investment, we will see Cadbury achieve the success that it deserves.'

My point is not that Kraft should necessarily add to Cadbury's cost base (Rosenfeld may well be doing the right thing) but merely to argue that, in business generally, there is a pathological bias in favour of cutting costs and against adding to costs – and that there can be no rational basis for this bias.

A COST STRATEGY IS A CONTRADICTION IN TERMS

If it is a strategy, defined as a unique way of adding value, then costs are simply a measure of the monetary effort required to execute it; if cost is the focus of attention, then strategic thinking is superfluous.

All that is required is the determination to cut costs. Toyota is the cost leader in its industry, not because of the ruthlessness of its costcutting but because of the radically original assumptions underpinning its production system. Its costs are the outcome of its operations strategy, not vice versa.

This strategy has involved nothing less than the wholesale reinvention of the technology of mass production. Costs are not the basis of a strategy, but the result of putting it in play. If, when executed, the strategy proves to be uncompetitive, it is invariably the strategy that is flawed, not the costs that are too high. The most prevalent source of corporate failure is management's conviction that their costs are out of line rather than that their strategy is misconceived. The majority of firms that are destroying wealth focus their attention on reducing their cost base rather than reinventing their strategy.

Napoleon argued that it was a poor general who relied upon the bravery of his troops to win battles. In the same vein, I shall suggest that it is a poor CEO who relies upon the efficiency of his operation to earn economic profits.

All genuine strategies, by definition, entail differentiation; but cost cannot be differentiated. Costs are different because strategies are different. Thus, the choice of strategy precedes the estimate of costs. Questions about performance concern not the magnitude of the cost but the strength of the strategy.

Costs are the inputs required to achieve an output. The choice of output is the task of strategy. Since outputs, in order to be competitive, must be unique, it makes no sense to compare the costs of competitors.

For example, comparing Porsche costs with Ferrari, or even Volvo costs, is meaningless. The only competitive comparison worth making is between the strategies of these companies. The only cost comparison worth making is between each company's cost base and the market's perceived value of the offering to which it gives rise. In other words, costs should be compared with prices, not with competitors.

Cost pressures are, in reality, strategic pressures in disguise. When a company finds its margins are falling, looking to the cost base for a solution, such as finding ways of slashing prices without decimating margins, is invariably mistaken. It is the business model that is being questioned, usually for being insufficiently distinct from competitors. In effect, strategy is the technique of thinking that renders cost management superfluous. An effective strategy makes operational efficiency a second-order activity.

WHY ASSUME COSTS ARE ALWAYS TOO HIGH?

There is a common prejudice that holds that business costs are more likely to be too high than too low – that taking cost out leads to higher levels of competitiveness than putting costs in. Perversely, executives speak frequently of cost-reduction strategies but rather rarely about cost-enlargement strategies. This is illogical. A level of cost is like a level of service – the aim is to find the right level, the minimum level.

Both in theory and in practice, costs tend to be treated as 'a bad thing': they are seen as being too high; they need to be cut; they are symptomatic of waste, excess, profligacy and irresponsibility. Consultants are expected to reduce costs, not add to them.

An incoming chief executive will normally want to rationalise costs, not justify them or grow them. Competitiveness is usually defined in terms of the cost base – and the lower the better. Predator companies will traditionally want to make economies in their newly acquired prey. It is a rare acquirer who is looking to 'grow the cost base'.

Why is this? Why is there an assumption that costs are biased on the high side rather than the low side?

Is there any evidence, for example, that cost-cutting strategies enrich shareholders? Do investors employ managers principally to strip out cost? Tom Peters has shown that cost-reduction strategies tend to reduce revenues at an even faster pace. At what point do – or should – shareholders step in and say: 'Enough is enough; change the strategy, not the costs.'

In capital markets, it is assumed with a high degree of reliability that share prices are unbiased estimates of the true value of the business. In other words, it is meant to be just as difficult to buy a portfolio of shares that underperform the market as outperform the market.

Why do we see costs differently? Why don't we also assume that costs are an unbiased estimate of the optimal investment in human talent, in working capital, in research and development, in advertising and sales, in investor relations, and so on?

Why do we tend to believe that managers are sloppy in their decisions on cost, systematically and wantonly paying people too much, holding excessive inventory, recruiting too many, travelling too much, over-training their staff and supporting bloated research departments?

When did you last hear a CEO proclaim: 'Our costs are simply far too low. Our plants have become alarmingly efficient. We have made too many economies in our operations. Our cost base is perilously low. We must pay our people more. We must stop skimping on inventory.

'Our suppliers must be more generously remunerated for their efforts. We must raise our cost base to something closer to the industry average.'

And yet these remarks are no sillier than their antithesis.

I shall argue that any cost carried by a business is just as likely to be too low as too high. We assume that cost levels in a business are not biased one way or another. In the case of inventory, for example, as many materials, parts and products will be understocked as over-stocked.

In the case of quality, as many products will be under-engineered as over-engineered. In the case of marketing, as many service levels will be set too low as too high. In the case of compensation, as many salaries will be too stingy as too generous.

The presumption that costs are more likely to be on the high side than the low side is simply sloppy thinking – and an insult to earlier (possibly more entrepreneurial) generations of management who once – boldly and against the odds – chose to put these costs in. The management of cost is never as easy or straightforward as simply cutting it. It is as difficult to cut costs profitably as to raise costs profitably. Disinvestment is as skilful as investment.

If firms want to be more competitive, then their strategy is as likely to include upsizing as downsizing, insourcing as outsourcing, and onshoring as off-shoring. If this were not the case, then management would be easy. We would simply keep 'taking cost out' until there were no costs left to cut. By definition, at some point, we would have over-cut costs. As a working hypothesis, wouldn't it be wise – and conformant with market theory – to assume that current levels of cost are, on average, unbiased?

If our line of reasoning is valid so far, then certain corollary arguments can also be made.

The rule for cost control should be to cut back on those existing costs that are not germane to the strategy, and invest in those costs that, if they were to exist, would strengthen the strategy.

The benchmark of competitiveness should be value, not the competition. For example, James Dyson was right to outsource his manufacturing to Malaysia because his strategy was in no way dependent on domestic manufacturing and it reduced his cost base.

But we should not be under any illusion that when the story of Dyson's global success is finally told, it will focus on his design philosophy, his entrepreneurial resilience and his world-beating products. It is unlikely to dwell on his decision to off-shore his manufacturing. Costcutting in the context of a game-changing strategy is very different from cost-cutting as the only game in town.

As a concept, cost leadership is as meaningless as price leadership, operational leadership or working capital leadership.

Cost leadership makes sense only in the context of a commodity market which, by definition, is a set of trading conditions characterised by an absence of competitive strategy.

When companies are competing on the same terms, the only differentiating variable is the cost base. The more that companies are seduced into believing that cost leadership is a viable strategy, the more commoditised markets become, the less their wealth-creating capacity and the slower the growth of the economy of which they are a part.

Recessions bring out the worst in cost-cutters. It is irrational for costs to become more important when economic conditions are difficult. If costs are important, their significance should not vary at different stages of the business cycle.

Perhaps there is an implicit assumption that costs have something to do with affordability, and that in a recession firms must cut back, not because they don't produce a return, but because there isn't enough money to go round. However, a cost is borne because it leads to sufficient revenue to cover it. Recession is a lame excuse for giving up on strategy, and choosing instead the lazy option of cost reduction.

The 'back office' invariably – and unfairly – bears the brunt of every efficiency drive and change initiative. Why should the back office provide easier pickings for cost savings than frontline services? Cutting costs in the back office is somehow regarded as less harmful or less contentious or provocative than cutting 'frontline services'.

This is illogical. It suggests that when these costs were originally put in they were hugely biased towards the back office and that therefore this degree of slack can be safely cut out. A recent monograph on public sector efficiency by the think-tank Reform reversed this logic by showing that waste is more likely to be a feature of 'frontline services'.

The emphasis that top management places on cost is inversely proportional to the trust they place in their middle managers to make responsible decisions. When dealing with costs, managers are more often assumed to be profligate than frugal – and generally to err on the side of waste, extravagance, irresponsibility and indiscipline – hence the need for supervision. Left to themselves, most managers are expected to become spendthrifts, with little concern for shareholder value, particularly when times are tough.

Indeed, the main role of senior management is seen as reining in the natural exuberance of middle management.

The traditional model of management has the unintended consequence of making cost-cutting the default option. In the standard version, top management sets the strategy and everyone else executes it.

Skilful execution is defined as the minimum cost to deliver the strategy. The only variable subject to middle management discretion is operational efficiency.

It is no surprise that many managers interpret this rule to mean 'the lower the cost base the better'.

When pressures on margins increase, better execution implies even lower costs. Managerialism has a built-in bias to interpret competition in cost terms rather than value terms.

CASE STUDIES

The moral of these stories is clear: as a business executive, you incur a cost for no other reason than to pursue a strategy; and it is the strategy, not the cost, that determines the competitiveness of your business

Managing cost through managing price: the case of Ford

Henry Ford is famous for the invention of the assembly line – but this is to misunderstand his genius, or at least to ignore his own explanation for his success. Ford got to the idea of mass production by first imagining the possibility of mass marketing.

He started with a hypothetical price, not a cost. He asked himself: 'How many cars would I sell if the price were just $500?'

The answers so excited him that he put his mind to finding a way of 'making the price'. It was this 'transitional object' that led to the assembly line. As Ted Levitt put it: 'Mass production was the result, not the cause, of his low prices.'

This is how Ford himself described his philosophy: 'Our policy is to reduce the price, extend the operations, and improve the article. You will notice that the reduction of price comes first.

'We have never considered any costs as fixed. Therefore we first reduce the price to the point where we believe more sales will result. Then we go ahead and try to make the prices. We do not bother about the costs. The new price forces the costs down.'

In short, Henry Ford did not set the price on the basis of the cost; he set the cost on the basis of the price. This was his genius.

Managing cost through managing organisational learning: the case of Toyota

The Toyota Production System has been written about extensively. One version, that of Steven Spear and H Kent Bowen, interprets the success of the system in terms of a small set of tacit rules that every worker and supervisor discovers through a process of iterative questioning and problem solving.

The rules that guide production can be simply stated:

  • Every task – its content, sequence, timing and outcome – must be specified in detail.
  • Every connection between (internal) customers and suppliers must be unambiguous and direct. For example, every request for help must come from a single, pre-specified supplier.
  • Every product must follow a simple, pre-specified path (with no forks or loops) –and at every step to a specific person or machine. For example, each type of part must follow only one production path through the plant.
  • All improvements must comply with a scientific methodology whereby problems are stated, hypotheses are formulated, experiments are conducted, and conclusions are formed – publicly and under close scrutiny by others.

Workers and supervisors absorb these rules and learn how to do their work, not by being instructed by managers but by being asked questions to which they are expected to discover the answer – questions such as:

  • How do you perform this task?
  • How do you know you're doing it correctly?
  • How do you identify defects?
  • How do you resolve problems arising from the task?

Under this form of Socratic inquiry, workers not only take ownership of their own learning but acquire the habit of critical thinking and an appetite for continuous experimentation and improvement.

It is the respect paid to the worker's desire and capacity to learn that puts energy into the system. The rules themselves are not the secret.

Toyota's cost base is managed as the outcome of a humanistic process whereby every employee shares the responsibility for the performance of the firm.

The recent crisis had little to do with Toyota's vaunted production system (particularly the principles underpinning it) and much more to do with complacency setting in (that is, the practice of these principles), particularly in the supply chain far away from Japan.

ABOUT THE AUTHOR

Jules Goddard is research fellow of the Management Innovation Lab at LBS.

[email protected]

Fig 1: How can Kraft know that Cadbury's costs are too high rather than too low?

Fig 2: Dyson's story is likely to focus on his design brilliance, rather than his business strategy


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