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Costly Cost-Cutting: How ‘Cost Reduction’ Erodes Profits

Posted by PriceBeam on April 12, 2017


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The Financial Crisis lead to a global demand shock and firms saw their revenues plummet. To remain in business, there was an urgent need to adjust costs to the new economic environment, which resulted in downsizing and other cost-reducing initiatives. ‘Leaner, Smarter’ strategies were the new black, and for good reasons: Many incumbent firms had become complacent under the 2001-2007 economic expansion, and there was indeed lots of waste that the financial crisis forced firms to eliminate and structures that could be made more cost-effective.
Now this waste has been eliminated and the easy pickings have been dealt with. Yet, the cost-orientation that businesses were forced to acquire during the crisis seems to stick. Despite rapid topline growth, firms keep trying to reduce costs to remain competitive: after all, that’s what they have been doing since 2008. But is that really the right thing to do?

First, it is important to make a clear distinction between waste and costs. Reducing waste is always a good thing: If you have two workers doing the job of one, you should lay one off. But reducing costs -- i.e. making productive workers run twice as fast -- is rarely an optimal way to increase profits.


The Inefficient Cost-Orientation
In several industries, firms that historically have achieved great success from offering premium value to customers are now trying to compete on price by reducing costs. Especially in the airline industry, where premium airlines are downsizing and implementing cost-reducing initiatives to reach price-sensitive customer segments.
There are several reasons why bottom-line growth from cost-reduction is suboptimal.  A cost-reduction is almost always equal to a reduction in the value you provide to your customers. By reducing the number of stewardesses on a plane, you simply cannot offer the same level of attention to customers and you will inevitably damage your brand, and be forced to start competing on price.
Secondly, low-cost firms will attract primarily price-sensitive “bargain hunters” who will leave you the second a competitor can offer a lower price. Acquiring new customers is much more costly than retaining existing ones, and with a low-cost model you will almost exclusively be acquiring new customers to get business.
Finally, unless your market is elastic (which it rarely is), a lower price will not be compensated by the increase in quantity sold. Take the example of an Australian retailer who wanted to compensate for its lacking online presence by growing its brick-and-mortar market share by reducing shelf-prices on a range of beauty products by almost 30%.

If this retailer sold a lipstick at $10 before and bought it from their supplier for $5, the retailer would have to sell 5x times as much to make the same profit! Before, the retailer would have to sell 20,000 units to make a $100,000 profit: With the price decrease, they would have to sell 100,000 lipsticks to maintain profits. Does that sound plausible?
Even if their procurement professionals manage to use the increased sales to negotiate a 10% discount from the supplier, the retailer would still have to double the number of units sold.

Good Things in Life Cost Money
It is important for managers to realize that the cost-reduction they have going on now cannot be compared with that of the financial crisis: then, they eliminated non-value-adding assets and processes -- now, they are most likely removing value-adding activities that drive up willingness-to-pay. As illustrated with the example from the Australian retailer, a small price reduction requires great increases in quantity sold: increases that seem infeasible and implausible. By removing value-adding activities, however, you may very well be forced to lower their prices.
Therefore, as cost-reduction comes at the price of value, what may seem to increase profits, will eventually lead to lower profits as you are forced to lower your price to make up for the value depletion.

Topics: Pricing

Written by PriceBeam

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