Reducing costs and generating revenues are not abstractions or things a company does just to do them. Both actions must be documented carefully, in hard dollars and cents, to determine and verify the effects on the critical path.
Here’s an example: consider a company that makes electronic parts for cars (see chart below). As a public company, it gives guidance to Wall Street analysts on how much money the company will spend on the critical path and how much revenue it expects those investments to generate. In the figure below, you can see that the company planned to spend $2.608 billion on R&D, $1.256 billion on production, and $2.596 billion on Sales and Marketing. From these critical path costs, it expected to bring in $9.280 billion in revenues to both cover the total costs of $6.46 billion and produce a profit of $2.820 billion
At the end of the year, the company reports what it actually spent on the critical path. The R&D expenditures of $2.926 billion exceeded the budgeted amount by $318 million. The Production folks, however, only spent $1.208 billion and came in under budget by $48 million. The Sales and Marketing team did even better with actual costs of $2.222 billion, resulting in a $374 million under-run. These actual total critical-path costs of $6.356 billion were offset by $11.040 billion in revenues, which exceeded the forecasted numbers provided to Wall Street by $1.760 billion and resulted in a profit of $4.684 billion.
As we study this example, it is clear that employees in this company were actively reducing critical path costs and raising revenues—with one exception. The exception is the R&D group, which went significantly over budget. Keep in mind that R&D works on both today’s and tomorrow’s critical path. Without more details, we don’t know what caused its overrun.
A question that people commonly ask: “Why emphasize costs and cost cutting? Why not view these costs as investments that yield increased revenues?”
First, every dollar the company spends is a cost, regardless of what you call it. It is money the company no longer has.
Second, we separate critical path costs from non-critical path costs. The former are tied to the activities that provide the product and services your customers buy. The latter are not tied to customers. Many of these non-critical path costs fall under the heading of “costs of doing business.” For example, the costs to file much government paperwork fall into this category.
All critical path costs can be viewed as an investment. If not, then why spend that money? You might as well invest it somewhere else.
Another question often asked: “Don’t businesses have to invest more sometimes to increase revenues?” The answer is generally yes, at least in the short term, while the firm builds the business and gains market share.
However, the organization wants to optimize its investment so that it gets the best returns. Reasonable people will disagree on how to optimize. Some think that investments must produce cash flows and profits in the short term. Others are willing to invest now for returns down the road. The decision often comes down to the risk-reward profile of the investors and executives charged with running the place.
For example, the founder of Buckman Labs, a specialty chemical company, was reluctant to hire more salespeople unless he was assured that they could generate more than enough sales to cover the company’s costs. He kept his sales team small while he grew the company from a start-up to one worth $29 million over his 34 years at the helm.
When the founder died unexpectedly, his son took over the business. He believed that hiring more salespeople would drive demand for their products. This was important because the company was only using about 49% of its manufacturing capacity. Buckman’s idle capacity was similar to an airplane flying with half the seats unsold and empty. The company paid for the unused equipment and buildings, but was getting no return on it. Increased sales, the son reasoned, would put all that capacity to use making more money for the company. Over the next 16 years, the son grew the company from $29 million to $246 million. The father was more focused on costs; the son saw those costs as the way to achieve increased revenues, which in turn would better cover the costs of the company’s manufacturing equipment.
Let’s return to our electronics company example. In that example, the company was able to both reduce overall costs and increase revenues simultaneously during that year. That’s a good thing. The goal for every company is (or should be) to continue to do this over long periods of time.
As mentioned in an earlier chapter, the question facing many companies is: “Can you cut too deeply in the constant push to cut costs?” The answer is “yes.” A company can cut back its investment so much, i.e., cutting into the muscle and bone, that it starts to destroy the critical path’s capabilities to attract and retain its customers.
Sears suffered this fate when it tried for 13 years to cost-cut its way into competition with Walmart, Costco, and Amazon. Rather than invest to effectively update its stores, merchandise, and employees in order to lure customers back to the stores, Sears tried to cost-cut its way out of the problem, and sold off well-regarded assets like Craftsman Tools to raise capital. Sears fell off the critical path, lost customers to its more savvy competitors who understood what the customers wanted, and since 2009, teetered on the edge of bankruptcy as it has lost as much as $1 billion per year. By October, 2018, the fabled 125 year old company collapsed into insolvency.
Sears is a good example of a cyclical dynamic that affects most companies. Companies that are generating high returns often do not feel the pressure to reduce costs, whereas low- or no-profit companies, like Sears, usually feel the opposite.
Google is a good example of the former. Being in a quasi-monopoly position in search engines, it generates enormous profits from ads placed on its site. These profits allow it to fund high salaries, commuter busses, free gourmet meals, and generous holiday gifts for their employees, as well as investments in businesses like YouTube, Google Maps, and self-driving cars.
Google’s employee perks are viewed as necessary to attract talented workers and to keep them from bolting to other tech companies. Many Google employees confide that they have a very good life, getting paid very well to work from 10 to 5 (or 4) most days (but please don’t tell my bosses) with time off to eat good meals and go to the gym or yoga center. But, it begs the question: how does it affect today’s or tomorrow’s critical path? Google’s cash flow allows it to fund these extras, but does the critical path to the customer require it? Or is it just pure extravagance?
The best companies try to create a discipline that controls costs during the good times so that they are not forced to do it when they are on the ropes during the bad times. Some will plow the savings back into the business for future growth. Others, like Walmart during its growth years, secure customer loyalty by giving it back to customers in the form of lower prices. Some will reward shareholders through increased dividends or share buybacks. Finally, as one CEO describes, “I like to keep some powder dry so that I’ve got the cash cushion in case the world goes wrong or some great opportunity knocks on our door.”
Critical Path Action Items
What do the critical path financials look like for your company?
Create a financial flow chart, like the one above, for your company.
Which departments are reducing costs?
Are your company’s revenues rising?