BY PRASHANTH PUTHRAN
Cost-cutting means cutting down on the existing cost without investigating the existence of the same in the first place. If cost-cutting is required then it means the management has to acknowledge that there was a significant error in its ability to monitor the costs in past. Change in business model or scenario calls for cost optimisation and not cost-cutting.
Every business is built on profit, with profit being the lifeblood of business. However, companies need to be able to grow sustainably and stay profitable. The problem is that many companies are not able to do this and this is why you are reading this article.
Companies that are not able to grow sustainably and stay profitable are referred to as being in a “death spiral”.
A death spiral occurs when a company is losing profit, which causes it to cut costs, which causes it to lose further profit, which causes it to cut even more and so on.
It is the most dangerous situation a business can be in and it is very difficult to get out of a death spiral once it has started.
This article will discuss how companies can get out of a death spiral and how you can avoid it.
How companies fall into a death spiral :
There are a number of ways companies can fall into a death spiral.
1. Cutting costs :
The first way a company can fall into a death spiral is by cutting costs. This is the single biggest cause of companies being in a death spiral.
Cutting costs may be necessary, but cutting costs alone is not always the answer.
A company may choose to cut costs in order to increase its profit, but if the activity has other impacts on the business operations whereby it is impacting the business in the long run or is affecting the Sales negatively then the cost saved may not be able to justify the negative impact. Many a time Managers use cost-cutting as a quick fix for the problem without diving into the root cause of the problem.
2. Not investing in core business :
A second way a company can fall into a death spiral is by not investing in its core business.
A company that lacks the knowledge and expertise to run its core business is always at risk of falling into a death spiral.
It is very difficult for new companies to survive without having the knowledge to run its core business and if they make the wrong decisions they will inevitably fall into a death spiral.
3. Not increasing sales :
Increasing sales is another factor that can cause a company to fall into a death spiral.
Cutting costs will cause a company to have less profit and it may also affect the market making it difficult for the company to increase sales.
If the company is not able to increase its sales, it will eventually have to cut costs and the death spiral will start.
4. Not developing new products/services :
A fourth way a company can fall into a death spiral is by not developing new products and services.
Companies which depend on a single product or service will always be vulnerable to a death spiral.
If the company is not able to develop new products and services then it may have to cut costs, which means that the company will have less profit, which means that it will have less sales, which in turn will cause it to cut even more costs.
If a company is not able to develop new products and services then it will need to cut costs and this is the end of the death spiral.
When a company cuts costs, it is very important that the company does not make the wrong decision.
The wrong decision could be anything from cutting back on new product development, to cutting back on marketing or even cutting back on any other activities that is important to the business.
The wrong decision could cost a company its life, but the wrong decision is more often than not, the easier decision.
Why cost-cutting is the cause of the death spiral :
There are a number of reasons why cost cutting leads to a death spiral.
1. Lowering costs :
Lowering the costs of the business will help the business to increase its profit, which will help the business to increase its sales, which will help the business to reduce the cost of the business and so on.
This is the classic cycle of a death spiral.
However, lowering costs by cutting costs alone will not lead to the company growing sustainably and staying profitable.
2. Short term gains :
Many companies cut costs in the short term thinking that this will increase their profit and increase their sales. However, in the short term, these companies will experience a temporary increase in their profits, but in the long term this is not sustainable and their profits will go down and sales will go down.
This is why it is important for companies to make sure that when they cut costs they do not make the wrong decision.
3. Not understanding the impact of cutting costs :
A third reason why companies fall into a death spiral is that they are not understanding the impact of cutting costs.
Many companies cut costs in the short term, but this leads to a company being in a death spiral.
Most of the time companies are not looking at the long term impact of cutting costs and this is why they end up in a death spiral.
In the short term, cutting costs will boost a company’s profits, but in the long term, the company will not be able to sustain this and will have to cut costs again.
The company will end up in a death spiral.
4. Not understanding the impact of increasing sales :
A fourth reason why companies fall into a death spiral is that they do not understand the factors affecting their sales.
Increasing sales will not only increase the profits of a company, but it will also increase the value of the company.
Without knowing the factors it is difficult to be aware of the cost reduction will have a positive or negative impact on the sales. Sales are the main component in the income statement and enable profit-making for an organisation.
Increasing sales will not only increase a company’s profit, but it will also increase its value.
However, many companies fail to understand this and this is why they end up in a death spiral.
How cost optimisation can help and why.
Cost optimisation is the single most effective way to save a company from falling into a death spiral.
By reducing the impact of cutting costs the company is able to stay in a position of being able to grow sustainably and stay profitable.
Cost optimisation allows the management to do the root cause analysis and get a proper solution. Unlike cost-cutting which tends to impact the operational capabilities and demotivate the staff or in some cases leave them handicapped without the resources required to do their job effectively.
For example, cutting down on travel expenses of Sales staff may impact their movement and thereby the sales or not investing in upgraded production machinery or consumables can impact the production output and thereby result in loss of sales.
How Cost optimisation is different from cost-cutting.
Cutting costs without understanding the factors that are impacting the business is a reactive measure while cost optimisation is a proactive measure.
There are a few key differences in both Cost-cutting and Cost optimisation.
1) Cost-cutting is an operational approach to impact the financial outcome whereas Cost optimisation is a strategic approach to impact value creation.
2) Cost-cutting is adopted to address a few cost components from the financials normally when they are off budgets of forecasts. While Cost optimisation is a comprehensive process of understanding all the related components to the cost and process is the main aspect that is analysed to arrive at optimum cost.
3) While cutting costs may help a company to increase its short term profits, it may not help it to grow sustainably and stay profitable.
Cost optimisation helps a company to increase its profits in the long term as well as save money in the long term.
4) Cost optimisation is more about the people and process of the organisation, not just the resources.
Cost-cutting is more about the resources. While cost optimisation is about the people and the processes which they follow.
5) Cost-cutting is a measure that is taken after the fact of the problem. While cost optimisation is a measure that is taken before the problem emerges.
6) Cost-cutting is a measure that is done on the financials (usually of the budgets), while cost optimisation is a measure that is taken on the non-financials and financials keeping both in perspective.
7) Cost cutting does not help in the long term. Cost optimisation helps a company to have a better decision-making process in the long run.
8) Cost-cutting may be done to save money but it does not always equate to saving money. Cost-cutting may save money but it may not always be the best decision to make.
9) Cost-cutting is an operational approach to impact the financial outcome whereas Cost optimisation is a strategic approach to impact value creation.
How Cost optimisation can be implemented.
There are many tools that can be used to implement cost optimisation and all of them are very effective.
1) As the first step of Cost Optimisation, it is crucial to understand the entire business model and all the activities which is part of the business model. The understanding of the business model will help us evaluate the importance of each activity and put light on the activities which are not important but are followed as a status quo. This will enable us to identify the areas where the process improvement can be done and the costs which can be optimised to deliver savings without impacting value or deriving additional value.
2) As a second step, it is crucial to identify the factors which are contributing to the cost in the area which is identified. Once the factors are identified, a gap analysis should be carried out to understand the gap in the current situation and also the gap in the future. This analysis will help to identify the areas where the savings can be done and also the factors which can be changed to reduce the gap in the future.
3) As a third step, it is crucial to understand the impact of change on the business model and how impact can be minimised. The impact of change should be analysed and the impact on the business model and value which can be created should be understood.
4) As a fourth step, it is crucial to identify the areas which should be eliminated or should be changed to make the organisation more efficient. Any area which is not contributing to the value creation should be eliminated to save money. Any area which is contributing to the value creation but is not optimised to make the organisation more efficient should be changed to make the organisation more efficient.
5) As a fifth step, it is crucial to understand the impact of the change on the current situation and the future situation. The impact of the change on the current situation should be analysed and the impact of the change on the current situation should be understood. The impact of the change on the future should be analysed and the impact of the change on the future should be understood.
6) As a last step, the most important step is to understand the cost and benefit of the change and the entire financials should be taken into account. The cost of the change in the current situation should be compared with the cost of the change to the future and the change should be implemented only when the cost-benefit is in favour of the change. The implementation should be done in the most efficient way to minimise the impact of the change on the current situation. This helps to ensure that the change is sustainable and also impacts positively on the future situation.
Cost optimisation is a process that requires careful planning and understanding of the entire process to be implemented.
The organisation should always be working on its business model, all the activities which are part of the business model and the factors which are affecting the cost. Only then the organisation will be able to implement the right cost optimisation.
Organisations should not take a reactive approach to achieve savings by cutting costs.
By implementing cost optimisation, an organisation will be able to create value and also be sustainable.
If the cost-cutting is done in a reactive way with the expectation of saving money, then it is most likely that the organisation will not be able to sustain the process and will not be able to reap the value.
(Head of Finance | Strategist | Problem Solver | Cross-functional & Process Improvement Manager| FP&A | Driving Processes, Products)
He can be reached via email – email@example.com or a private message on LinkedIn if you would like to discuss this topic further.