Cost Optimization can save or destroy a company
Reducing cost is an addicting drug for its immediate dollar feedback to your pockets. You taste it once and start wanting to reduce more and more. You’ll lose features, performance, and customers, but rationalize it’s worth a certain tradeoff. Sometimes, it is a good idea. But when the spiral becomes the main focus, you are in a DANGER zone. I saw this happen 3 times, in a startup, in a medium business, and in a Fortune500. I share a story from my own experience to explain the danger and opportunity of reducing costs.
When you see at least 3 of these happening, you know doom is impending:
- Cost Optimization and Reduction become a main focus for the Company
- Leadership starts delegating more instead of engaging directly
- Company stops new investment decisions or initiatives. Catabolism > Anabolism
- Flee from reality: Company discourages or censors whistleblowers and problem solvers instead of fixing the issue they reported.
- Agency Cost increases as managers act as “employees” without skin in the game and ownership
I will never forget the day I summoned the CEO of a company I was the CTO of, and held a bitter speech.
When I joined, you were finding the perfect Christmas gift for customers, in a series of marketing campaigns. You ran hiring campaigns and projects with Universities and companies. We were growing, investing, and expanding. We released products and learned from experience. Then I raised the quality of the R&D and took on some burdens from you. I also reduced costs. I built an IoT ecosystem with zero dollar cost in infrastructure – which you approved immediately. I used expedients, like Cloud free tiers and free credits, to turn all infrastructure for free. Your default sentence became “send this hardware (or software) to Ermanno who will make it for free”. We also spotted wasteful work and fired low performers and sped up production. We invested the savings in real estate, where I persuaded you returns were higher than current R&D. All this is wonderful and you are swimming in cash now and are happy. But I am sorry. I accidentally led you astray. When we met, you used to be proactive. You got used to the quick – tangible – cash and got lazy. You were building wings. Now you are building a parachute. Profits nearly tripled this year, but the company is shrinking in the middle and long term. It’s not just about the company, but about you. You were a better entrepreneur when we met, even if the financial results hint otherwise, and this is in great part my fault. We must recover the lost enthusiasm and use that free cash to invest, or alternatively close the company.
Later I analyzed the cost of opportunity, saw the trends, the commitment, and what the group could do on the new property we had bought, so I had to recommend closing the company up. I made a convincing business case and, to his sadness, because he had to kill his own baby, the CEO saw the better opportunity. But obstinacy doesn’t do any good. We could halt all R&D and rebuild from scratch in 5 years and we’d be higher than we’d be comparing than continuing as it were. I offered to invest my own savings to speed up the real estate project. Things turned out well, and only in part thanks to me. There was also the lucky coincidence he sold assets shortly before the pandemics, when the value dropped. Needless to say we are still good friends.
Long Term and Cost of Opportunity
It’s corporate finance 101 that Financial Managers must maximize wealth, that’s the sum of present and future cash flows. Maximizing profits for the current year is easy, just cut off the R&D or all cost. But then, you hurt the long term. That’s why you maximize wealth, not profits.
Cost Reduction works when the market slows down: it’s similar to a sailor lowering the sails during a tempest. But then, get ready to set sails again. You usually shrink much faster than you build, if you’re building stably, which takes decades. Most importantly, can scale in and scale out Cloud resources, but not teams and people, which aren’t fungible. At the time of writing I am working for a company expert at hiring globally, and yet, I’m learning from experience that only certain workflows can be standardized – not all as we have strived to do.
I agree with with Daniel Kahneman that interviews and assignments are, at best, only moderately useful predictors of 5 years job performance. Better and worse workers exist, really hard to replace. I know we are sitting on top of a $5T goldmine and I wonder why we laid off some engineers instead of reassigning them to other projects. I’m not sure the group effectively signaled all opportunities to the Financial Managers.
You should always think about
- How easily you can scale in and out, and revert decisions.
- Your competence and effort at developing or building.
- The cost of opportunity – what else you can do with your money and time. Sometimes you shouldn’t fire, but reallocate to more profitable work. Others fire, but invest where you get a higher return.