Many leaders turn to an old standby in times of economic uncertainty: cost cutting. Costs are, to a large extent, controllable in a world where so much feels out of our hands. However, cutting costs solely for the purpose of realizing short-term savings is myopic. Leaders should view each expense line as a valuable investment in the business—and recognize how the decision to increase, decrease, or maintain it will shape the company’s future—whether they are faced with an urgent need or not.
Danaher, a multinational conglomerate headquartered in Washington, DC, is a successful company that views costs as investments. Some are good, while others are bad. Danaher doesn’t try to cut costs; instead, it tries to weed out bad investments while keeping the good ones—every day, through booms and busts.
One key component of its strategy is to apply what it calls the Danaher Business System to the steady stream of companies it acquires. The system repeatedly applies lessons learned from Danaher’s diverse portfolio of businesses to improve operational efficiency. “Most managers have the mindset that if you apply a tool once, you’re done,” recalls George Koenigsaecker, president of Danaher’s tool group in the 1980s, who implemented the first version of the system. Koenigsaecker, now an investor and lean manufacturing expert, claims that a single application of a process improvement can result in a 40% increase in productivity. “However, to get the 400% gain, you must use it at least ten times,” he adds. “You must study the process over and over.” At Danaher, the drive for efficiency is unwavering, and cultural reminders abound. In meetings, for example, executives frequently question whether the meeting really needs to last as long as it has been scheduled. The motto is “waste nothing.”
Many businesses, on the other hand, take a one-time approach to cost cutting and do so only when it is the only obvious option for meeting profit targets. Unfortunately, in their haste to eliminate things that appear to be frivolous, they frequently sacrifice some of their most important investments.
Such danger has recently increased. According to a PwC survey conducted in November 2022, 42% of senior executives said that cost cutting would be a priority in 2023, a prediction that has been confirmed by the waves of layoffs that have made headlines during the first half of the year. When cost-cutting programs are rushed, as many of the current ones have been, there is little (if any) debate about the strategic intent behind spending. Typically, leaders assign targets across the board, leaving functional groups and line managers to quickly determine what (or who) must be eliminated. As a result, organizations become weaker, more imbalanced, and, in some cases, desperate and without direction.
We conducted a study of the 1,500 largest global public companies based on 2021 revenue to learn more about how companies have successfully managed costs while achieving growth. (This research was assisted by our colleague Harsha Kasturirangan, a director at Strategy&.) Among that group, we identified 201 companies (or 13% of the sample) that implemented what we call a cost transformation: achieving EBITDA above the industry median while experiencing revenue growth below the industry median from 2015 to 2018. This distinguished companies that increased their margins through cost reduction from those that increased them through top-line growth. Then we examined the financial results of those 201 companies over a three-year period ending in 2021. 125 (62%) of those companies delivered below-market revenue growth and profitability. Their revenue remained relatively flat, declining by 0.6% on average, while their EBITDA fell by 8.3%. Despite earlier margin improvements, their efforts were ultimately unsuccessful because they had jeopardized their future results.
One way to gain a fresh perspective is to imagine a new competitor entering your market without the burden of all your previous decisions. How would it fare in competition?
The good news is that 76 of those 201 companies (including Danaher) saw higher revenue growth and profit margins over the next three years. Their revenues increased by 16.8% on average, and their EBITDA increased by 6.8%. These firms came from a variety of industries, including technology, industrials, pharmaceuticals, and financial services, with no single industry accounting for more than 11 firms. They were also geographically dispersed, with headquarters in 19 countries across North and South America, Europe, Asia, and Australia.
These 76 businesses had clearly set themselves up for future success. The question was, “What did they get right that others didn’t?”
Developing a Cost-Effective, Growth-Oriented Organization
To be successful with cost transformation, you must start with a blank sheet and disregard sunk costs. This is the mindset that underpins zero-based budgeting, as well as Peter Drucker’s famous question, “Would you enter this business if you weren’t already in it?”” Applying this lens to every project, line item, and role enables leaders to look at the cost structure strategically, which is critical because there may be no more strategic topic than where you spend your money.”
However, simply challenging each line item isn’t enough in our analysis—and doing so may feel like a disjointed and never-ending effort. We believe you should also take five crucial steps.
Link costs to outcomes.
Consider every dollar spent as an investment in the value you provide to your customers and the specific cross-functional capabilities required to deliver that value. Costs should no longer be trapped within organizational silos that are protected and thus disconnected from growth. Budgets must be thoroughly discussed and prioritized with the leadership team in order to focus on what truly supports your strategic goals and the capabilities that will assist you in achieving them.
IKEA is a great example. For many years, the company has been guided by a simple principle that makes this promise to customers: “We do our part.” You play your part. “We save money together.” After opening his first retail store in 1958, the company’s founder, Ingvar Kamprad (the I and K of IKEA), pushed employees to pursue any cost-cutting opportunity that didn’t compromise the quality of the merchandise, the customer experience, or the efficiency of operations—a practice that continues to this day. IKEA’s designers, for example, are constantly working to reduce the materials and size of packaging so that the company can fit more pieces into a container, save money, and offer lower prices. That kind of alignment between strategy and execution is uncommon in product design. Many companies design products by people who are not in charge of managing expenses. However, IKEA links its design to all customer outcomes, including cost. When you visit the company, you will notice that it is cost conscious. Executives, for example, almost always take guests—even VIPs—to IKEA cafeterias rather than fancy restaurants to avoid any expense that might be passed on to customers.
Companies frequently take their operations for granted and make incremental changes rather than taking a bold, holistic look at which businesses, product lines, SKUs, or operations should be part of their future. Most people also undervalue the cost of complexity, focusing only on direct costs rather than system costs. One way to gain a fresh perspective is to imagine a new competitor entering your market without the burden of all your previous decisions. How would it fare in competition? What kinds of products, activities, solutions, and services would be developed? How would it simplify the customer offering to maximize value?
The Dutch company Philips had a long history in lighting and personal electronics, but in the mid-2010s it decided to focus on health care and divest, spin off, or sell everything else. Philips recognized that in order to succeed, it needed to concentrate management’s attention solely on health care. With this massive simplification came new investments in the capabilities that would support a much bolder health-care strategy, resulting in major innovations in health products and services.
Digitally reimagine value chains in sprints.
Yes, automation has great potential—but only when it is tied to large, drawn-out technology programs. Companies can reap the benefits of digitization by rethinking entire processes from start to finish, but they will gain far more in the short term by layering automation on top of—or in place of—existing tools. To manage such efforts, some businesses establish “digital factories,” which are responsible for the rapid and continuous rollout of automation throughout the organization. By following a pre-determined playbook, these “factories” significantly streamline the process. They also enable businesses to assess all automation investments holistically. While you may wonder how you could afford one during this time of intense cost-cutting focus, we have seen that they can not only pay for themselves but also generate enough savings to fund other cost-cutting and growth initiatives.
When executives at one of our clients, a global food and beverage company, embarked on a multi-year enterprise resource planning (ERP) modernization program, they quickly realized that the cost savings required were so significant that the company couldn’t wait that long to realize them. They formed a digital factory team, assembling experts in automation design, development, adoption, and maintenance, and charged them with reimagining manual, costly, and time-consuming processes (such as the procurement-to-accounts-payable cycle and HR practices from hiring to retirement). The team’s solutions captured savings within the current ERP platform while reshaping processes in preparation for the new system’s improved automation and insights.
Rethink the work that you and your ecosystem do.
Developing powerful new capabilities isn’t cheap; it requires a lot of technology, data, and people. Smart businesses recognize what must be truly differentiated—and then consider who can best deliver it. Your ecosystem of partners most likely has much greater scale in some areas than you do. Outsourcing non-differentiating capabilities or even elements of your most important capabilities can allow you to direct your resources where they are most needed.
What a business must do today is far more complicated than it was even a decade ago. The traditional marketer, for example, was a generalist who could handle a wide range of tasks. However, marketing now necessitates specialized knowledge in a variety of areas, including social media, ethnographic research, data science, and content curation. Having all of that knowledge on staff is not only costly, but it necessitates a talent model that allows for career paths and skill development in a variety of areas. Outside agencies can provide an easier path to scale with such capabilities, as well as a more dynamic career path for specialized talent.
Apple realized in the early 2000s that manufacturing was neither core to its strategy nor a historical strength. As a result, it rapidly outsourced nearly all component and finished product manufacturing to its ecosystem partners. This allowed the company to pursue even more material and design innovation, as well as further integrate data and devices across its various offerings, thereby strengthening its overall product differentiation.
Create a long-term, cost-effective management system.
Smart businesses do not view cost cutting as a one-time reaction to a slowing economy; rather, they believe it is the primary responsibility of managers to be constantly vigilant about costs. But that is an unusual attitude. Too many businesses downsize during times of economic stress, only to increase selling, general, and administrative expenses the following year—without seeming to understand this pattern.
Budgets are a true indicator of how your company views costs. If you tend to adjust them incrementally through function-by-function agendas, you’re probably not managing them actively or strategically. However, if your budgets are zero-based and allocated and evaluated across functions, focusing on the most critical and differentiated capabilities, you are developing a cost-management culture and process.
In 2019, HP took the correct approach. Despite a strong global economy at the time, the iconic provider of computer and printer products and services had begun to face headwinds from increased competition and commoditization. In response, it embarked on a cost-cutting initiative that resulted in a radically simplified product portfolio, the elimination of an entire organizational layer to get closer to customers, and the centralization of R&D. In addition, as it transitioned to a hybrid work model, HP reduced its real estate footprint by creating more efficient digital workspaces. It also created a new digital backbone: an ERP system that enabled the deployment of additional tools and capabilities. These deliberate moves saved more than $1.3 billion in annual costs. These savings allowed HP to make significant investments in R&D and acquisitions, positioning the company to weather significant volatility in its industry.
HP is now aiming to save an additional $1.4 billion per year by reducing complexity and costs in its mature businesses and simplifying its operating model. A significant portion of that money will be reinvested in the company’s Future Ready initiatives, which aim to drive growth through innovation. HP’s chief financial officer, Marie Myers, notes that these changes frequently necessitate “difficult choices,” but she believes they will enable the company to continue providing cutting-edge offerings to its customers.
Enterprise cost transformations are difficult to implement. They necessitate significant changes in technology, operating models, working methods, and other aspects of a company’s DNA. That kind of change has always been difficult to implement, but constant firefighting and increased performance pressure have made it even more difficult in the last decade.
Companies should do the following to link costs to their strategy and avoid hastily made cyclical cuts that leave them weaker:
Adjust the top.
Delegating a strategic transformation is impossible. The board, the CEO, and the executive team must all be committed to taking the necessary steps to achieve the articulated goals. The more revolutionary the change, the more likely it is that those in power under the status quo will oppose it. Some members of the current management team may lack the necessary skills, mindset, and determination to carry out the program. As a result, one of the first steps in any transformation should be to facilitate those executives’ swift and discrete alignment—or departure.
Accelerators can help you build confidence.
Early victories build momentum, focus the organization, and persuade employees that change is possible. Initiatives to capture them should close performance gaps in a few critical areas, reduce costs, and free up funds to fuel longer-term initiatives. If they demonstrate a positive impact on profit and cash flow from the start, the transformation will be self-funding. Other immediate opportunities include eliminating unnecessary roles, applying digital automation to time-consuming tasks, and spending less on outside contractors.
Aim for a two-year trip.
Investors and analysts are becoming increasingly skeptical of transformation efforts that last more than 24 months, especially since those that promise the most benefits in the long run frequently fall short. Organizations become fatigued when they are subjected to repeated and invasive changes over a long period of time.
Executives must demonstrate that they are “proud to be frugal” in order to dispel the widespread belief that cost cutting is something that the top tells the middle to do to the bottom.
As a result, it is critical for a cost transformation effort to produce results in the short, medium, and long term. Consider it to have three chapters. Launch initiatives to reduce costs without relying on technology, freeing up funds to invest in what truly matters. Chapter Two: Launch more complex initiatives involving the movement of work across geographical boundaries or the automation of large swaths of processes through the use of ERP or advanced digital technologies. Chapter Three: Make sure you’ve established a continuous cost-cutting process and are investing in new products, platforms, and capabilities that will give you a competitive advantage.
Create a dedicated change infrastructure.
Running a business while revamping it is a juggling act. The company will require a chief transformation officer who will focus on aligning strategy and costs in all economic environments—and hold executives accountable for both “performing” and “transforming,” recognizing the importance of doing both. A transformation office that structures workstreams, appoints project sponsors and leads, defines accountability, and drives results should support this new or improved C-level executive. That office must earn trust by being authoritative and self-sufficient. It should function as a single source of truth, providing verifiable data. It should also step in when impediments must be overcome, major course corrections must be made, or disparate workstreams must be synchronized.
Early on, recruit middle managers and front-line employees.
Midlevel managers are well positioned to contribute because they bridge the gap between the front line and senior leadership. Give them a say in the process so they feel invested. Allow them to provide feedback, concerns, and suggestions. Give them incentives to generate genuine innovation, and maybe even share the profits with them. Frontline employees, on the other hand, are best suited to determining where expenses can be cut and processes can be streamlined without sacrificing quality or client satisfaction. Our work with clients has shown that frontline opinion leaders can generate far more broad-based support for cost-cutting efforts than any corporate-sponsored effort.
Put your culture to good use.
Continuous change becomes sustainable when your culture facilitates rather than hinders transformation. The key is to concentrate on a few critical behaviors that some people already exhibit on a regular basis and that, if everyone adopted them, would result in tangible business improvements. Changing behaviors is difficult, and changing more than a few at a time is impossible, but focusing all employees on a few helps ease them into a new way of thinking.
All employees at one global food company were asked to adopt three behaviors: speaking up when they saw evidence of waste anywhere and offering solutions to fix it; using self-service for their business needs whenever possible; and encouraging their teams to bring any backup materials to operating reviews and stick to the agenda. Even when no one was looking, these behaviors promoted cost consciousness and encouraged employees to spend the company’s money as if it were their own.
Create mechanisms to maintain a cost-conscious mindset.
There is always a need to reallocate resources to your strategic capabilities and fastest-growing businesses. More transparency should be created in financial systems around “good” costs—those associated with differentiating capabilities—and “bad” costs, which are required to keep the lights on and the business open. Give budget owners detailed information about cost drivers and assist them in developing a deeper understanding of decision economics.
One of our clients, for example, created a simple slide to demonstrate how one dollar of savings flowed through the system and resulted in improved company performance. This allowed managers to see firsthand how cutting unnecessary costs translated into company results that benefited them personally. An annual review of all costs—and prices—at IKEA is part of the company’s stated goal of saving customers money and ensuring constant attention to cost management.
In addition to traditional P&L targets, leaders should hold individual functional and business unit owners accountable for achieving a step change in certain cost pools (such as SG&A, transportation, indirect spending, and cost of goods sold). Executives must set an example of cost-conscious behavior. They must actively demonstrate that they are “proud to be frugal” in order to dispel the widespread belief that cost cutting is something that the top tells the middle to do to the bottom.
…In today’s economy, cost management is at the forefront of boardrooms and leadership teams. Executives must make a decision when dealing with this issue. They can cut costs the traditional way and risk weakening their organizations, or they can do the difficult work of rethinking the very basics of their business: identifying the bold outcomes that will differentiate the organization, simplifying every part of their operations, creating savings through automation, leveraging their ecosystem to take on activities they shouldn’t be owning, and building cost management into everything they do.
You’ll know you’ve made progress when costs aren’t just a negative topic for a select few, your budget truly reflects strategic decisions, and your entire company understands how valuable every investment is. You won’t just have discovered a better way to manage costs at that point; you’ll have discovered a way to transform your company and shape your future.