CHAPTER NINE

CUT COSTS AND GROW STRONGER

If you are like most executives, you have spent a lot of time thinking about costs. The pressure to reduce expenses—whether this pressure is driven by your cash flow, your shareholders, your uncertainty, or your investment needs—is always present. Frugality, productivity, and efficiency—the need to do more with less—are on every business agenda and have been scrutinized more intensely than ever since the economic crisis of 2008–2009.

But cost-cutting is typically practiced in a way that makes companies weaker and more limited, and most businesspeople assume that this is a necessary part of the exercise. We reject—and you should emphatically reject—this idea. If managed correctly, cost reduction should lead to better performance, making the company stronger by eliminating wasted expense. If you focus on strengthening your way to play and capabilities system, cutting costs can be a catalyst for exactly the change you need.

Costs and strategy are inseparable because every investment, whether good or bad, matters. Unnecessary cost is your enemy—and not just because it consumes profit. It is your enemy because it fuels incoherence. It reinforces multiple activities that prevent you from focusing on your capabilities system and way to play.

In a relatively coherent company, the following conditions hold true:

• No strategy exercise is complete without a strong look at costs.

• No cost project is complete without a look at strategy.

• No cost or strategy project is complete without a clear look at its impact on the company’s capabilities system.

• All cost-cutting is seen as the way to free up the investments you need most.

Finally, your approach to cost control is a key indicator of how coherent your company is (or is not). If you haven’t freed up resources to invest in the capabilities you need most, then you haven’t gone far enough on the journey to coherence. That’s because you’re never just cutting costs; you’re deciding that some things are more strategically relevant than others.

Cost-Cutting and Its Discontents

Why do conventional approaches to cutting costs leave companies weaker? The answer has to do with ingrained incoherence. Without a clear way to play or a capabilities system to guide priorities, leaders focus mechanically and programmatically on reducing the pain of cost-cutting. For this reason, they cut across the board, instituting, say, a 10 percent workforce reduction to be shared by all departments. They make cuts based on ad hoc, sometimes even capricious, criteria. They benchmark the cost levels of competitors, without comparing their own strategic priorities—which means, in effect, that the leaders base their decisions on the mistakes of other companies or on their competitors’ strategies. Or they relegate the problem to special initiatives: a yearly cost analysis or a biannual audit of SG&A (selling, general, and administrative) expenses. The recommendations are overlaid on top of everyday operations and seen, in effect, as a constraint that the organization must endure.

The result of all this? The cutbacks generate a great deal of pain in the short term. Then when good times roll again, companies revert to their old habits as if nothing was learned. After all, the old forms of incoherence—the overinvestment for the sake of matching competitors, the desire to be excellent in all things, the proliferation of growth activities, the continual focus on putting out fires—have never gone away. Marketing gets its budget replaced (at least in part), R&D and manufacturing get theirs, M&A proposals are considered again, and so on down the line. Worse yet, while the budgets of some functions and divisions may not return to normal, these groups continue to be asked to deliver the same level of service and complexity. So they struggle even more in the new, post-recovery environment.

Sometimes this leads to a second round of haphazard, ad hoc layoffs and cost reductions—and then to a third and fourth. Cutbacks that come in waves produce further problems. In one January 2009 survey of U.S. corporate executives, 72 percent said they expected to make across-the-board cuts. They knew that doing this would hurt their top-line revenue streams, but they felt they had no choice.¹

Ultimately, the leaders of these companies find themselves in the same position that three high-ranking executives we know found themselves in. Each of them came to us in late 2009 or early 2010 with the same complaint: “We can’t figure it out. We took out all these costs eighteen months ago, and now they’re back.”

The Conversation About Costs

To take expenses out of your system and keep them out, you need to change your conversation about costs to a more productive one. Part of your existing conversation is probably about blame. In many companies, because functions contain most of the “cost centers” of the enterprise, functional leaders tend to be held responsible—implicitly or explicitly—for creating bloated cost structures. Is this fair? Occasionally. But more often than not, functional leaders are guilty of nothing more than responding to the incoherent strategy of the moment.

Let’s say that the head of information technology at one company has been given a long list of projects to fulfill: virtualization, customer-relationship management, cloud computing, and service-oriented architecture, each for a different part of the business. The operations chief must accommodate twelve new product lines. The R&D leader is figuring out which investments to fund, without a clear mandate to guide the choice. Even the CFO is spending in an ad hoc fashion, exploring a series of unrelated acquisitions.

In this company, no one considers which functional endeavors are most essential to the company’s advantage. No one, especially none of the functional leaders, is given the right to say no to any requests. But when the costs are all added up, these leaders will be at least partly blamed for it.

Another part of the existing conversation has to do with control. When cutbacks take place without an obvious and clear strategy, you as a business unit leader or line manager feel as if someone from above has taken the autonomy away from your business. Decisions made from outside can seem arbitrary; they inevitably force you to renege on some promises or kill some projects that are already showing potential.

If you expect to promote coherence in your company, you need to change these conversations up front. Convert them into the kind of conversation you should have had all along: about the value of your endeavors. “A Process for Cutting Costs” shows an exercise that can accomplish this.

The Opportunity of a Crisis

Some of the most significant and successful moves toward coherence occur when management realizes, “If we don’t turn ourselves around, we may not survive.” These urgent situations provide an impetus to make critical strategic changes, including the reinvention of the company’s way to play and capabilities system. In other words, a crisis can provide a chance to reorient your company to a new business environment—if you seize the opportunity.

In the early 1990s, this type of challenge faced the automobile battery division of Johnson Controls, Inc. (JCI). (The car-seat division of the same company was featured in chapter 3.) The retailer Sears, Roebuck and Co., which represented 20 percent of JCI’s business in motor vehicle batteries, suddenly pulled its contract. The reasons had nothing to do with JCI’s products or service, but the company nonetheless faced huge overcapacity and steep losses, almost overnight. JCI’s top executives reacted by looking at their business with fresh eyes.

To make the new approach work, JCI built up its prowess in lean manufacturing, six sigma, and operational flexibility. In the past, production had been organized to get the highest performance out of every individual assembly line, with many plants devoted to particular models. Now JCI’s executives looked at operations as a single network, reconfiguring production flows as needed to serve customers more flexibly. They treated the cost of shipping batteries—which had been a primary factor in their previous configurations—as just one of the many variables to consider, and they explicitly redesigned the flow to reduce complexity. This reduced the costs they had to manage. They also identified other cuts in areas where their capabilities were not differentiated, such as accounting, human resources, and information technology. Altogether, they cut about $150 million annually, which at the time represented about 35 percent of their expenses. They understood that they might make some mistakes in implementing those cuts, but they knew that they had to act decisively and fix any errors later.

By the fourth quarter of 1995, despite the loss of revenues, profits had began to rise again.²

In later years, when executives looked back on this crisis, they thought of it as a moment of transformation for Johnson Controls and an example to emulate. By engaging in a high-level strategic analysis and then converting their conclusions into action, they had turned their company around. Other observers agreed; for example, an analyst’s report from that time on “hot stocks” recommended investing in JCI, because the “repositioning and restructuring of the [battery] business . . . looks like a modern business miracle.”³

In the long run, this shift laid a foundation for still-stronger logistics, global marketing, and innovation capabilities. Today, JCI sells automobile batteries internationally under such brand names as LTH (Mexico), Varta (Europe and China), and Optima. It has been a leader in developing IT-enhanced warehousing and logistics capabilities for reducing costs and increasing market intelligence for auto component retailers. JCI has also become a leading battery design innovator. Selling increasingly to auto manufacturers, it has developed new technologies for microhybrid (diesel-electric) vehicles, which require battery chemistries that can handle frequent stops and starts. The company is perhaps unique in producing both traditional (lead-acid) batteries and new lithium-ion batteries for electric and hybrid vehicles. In short, a challenge that could have led to retrenchment and incoherence became, instead, the beginning of a twenty-year-long transformation to a customer-focused, innovative company that is unusually well prepared, compared to the rest of their industry, for whatever powertrain technologies become dominant in the next few years.

Another example of adapting to turbulent change by embracing coherence took place with the R.J. Reynolds Tobacco Company in the early 2000s—as a response to a complete shift in the industry structure over a few years. R.J. Reynolds had spent the previous thirty years as, essentially, an experience provider: cigarettes, before their negative health effects became publicized, were primarily marketed for the smoking experience and the statement they projected about the individual. (Camel smokers were fun-loving; Marlboro smokers were rugged; Dunhill’s smokers were high-class.) The margins on a cigarette pack were high enough that an individual smoker’s brand loyalty was worth a great deal for a tobacco company, and tobacco companies spent generously on marketing to win that loyalty. In the 1950s and 1960s, they had done this through mass-market brand advertising. Then after 1971, when they were forbidden from advertising on television in the United States, they built up a new capabilities system, aimed at winning the “war in the store” for customers. This included sophisticated promotions: using coupons, premiums (gifts for buying a small number of cartons), and in-store displays to persuade smokers to try their brand. At one point, competition through premiums was so intense that R.J. Reynolds became the largest purchaser of T-shirts in the United States. Another capability was embedded in its elaborate sales force: securing shelf space, maintaining the racks, and moving premiums and promotions into and out of particular sales outlets whenever the competition heated up. The cigarette companies paid for all this by raising prices when they needed to.

Then came the U.S. government’s 1998 Tobacco Master Settlement Agreement, ratified by the four largest U.S. tobacco companies (R.J. Reynolds, Philip Morris, Brown & Williamson, and Lorillard) and the attorneys general of forty-six states. The agreement required the cigarette companies to pay out about $206 billion to the states over twenty-five years, in return for settling the case. Since only the major cigarette makers had to pay these damages at first (the agreement was later expanded to others), the opportunity rapidly arose for new, low-cost tobacco manufacturers to enter the market with so-called value brands. This forced cigarette prices lower, cutting back the major cigarette companies’ top lines at the moment that the first payments to the states hit their bottom lines, in a declining market, with fewer and fewer new smokers every year.

Whatever your view of the tobacco industry, there is no denying the impact of a declining market on tobacco companies—or the imperative it gave them to find a new approach to their business. To start with, the executives at R.J. Reynolds realized that their old capabilities system—geared to support and promote the market-share-gaining brand Camel and the profitable but shrinking brands Winston and Salem—was no longer sustainable. Nor would cutting costs, in itself, solve the problem unless they could change the way they went to market and the tools they used. They needed a fundamentally new way to play with a fully new capabilities system.

Simply to survive, they initiated a major short-term cost-cutting program, including laying off a large portion of the workforce. But RJR’s leaders did not make cuts across the board or try to compete as a value player. Instead, they focused on becoming an experience provider in a narrower domain. They continued to support Camel aggressively, while dramatically cutting back support for RJR’s other brands, Winston and Salem. And they looked at the value that R.J. Reynolds could gain by changing its merchandising capabilities.

In particular, they moved rapidly away from full-scale, in-store marketing to a new “sharp-pencil” (targeted) marketing capability. There would be no more T-shirts and ball caps (and sourcing them would no longer be a critical capability). The arrival of an R.J. Reynolds salesperson at a retail shop would no longer mean a check for the shopkeeper with the notation “promotional support” on it. R.J. Reynolds would cut down its sales force, negotiate space more strictly, “buy” shelf space with promotions (featuring selected retail stores) instead of with cash, and build its relationships with those key store owners.

It was a strategic leap—and a huge risk. R.J. Reynolds was betting that it could re-create a new, slimmed-down sales force that could change the nature of the conversation at the point of sale. Executives deliberated over the likely response: would retailers still welcome their reps? How would the company build brand loyalty now?

In the end, it worked; R.J. Reynolds gained $1 billion in cost reductions. The company’s bottom line improved, which gave it the controlling position in its merger with Brown and Williamson a short time later. As the benefits of its strategy became increasingly evident, R.J. Reynolds stock rose threefold over a twenty-two-month period, putting it in the top fifteen Fortune 500 companies, measured by returns.⁴

In the case of both JCI and R.J. Reynolds, the key to the change was not cutting costs in itself. Through the creative energy released in the crisis, company leaders decided on a way to play and a capabilities system—and therefore ensured that some costs would be worthwhile, while others could be jettisoned.

If you find yourself in a similar situation, you will need to bring the same creative energy to bear, perhaps to make a change of similar magnitude. To the extent that developing coherence is difficult in your company, a crisis can at least force you to take a big leap forward.

Frugality for the Long Run

Having cut what isn’t essential, how do you ensure that it stays cut? Expense creep is a sign that incoherence is returning to your company—or perhaps that it never went away. Your best response, even in good times and even when there’s less pressure, is to continue evaluating your costs in light of your way to play.

That’s what JCI did. For many years after its Sears-induced crisis, its executives were still holding monthly get-togethers to talk about what might be changing in their business. Those sessions allowed them to conduct ongoing cost assessments and make the needed adjustments—without unexpected layoffs or draconian measures, but also without returning to their old losses.

One valuable lesson from both the JCI and RJR examples—indeed, from every case we know—is a statement we made at the beginning of this chapter. Costs and strategy are inseparable. Every investment, whether good or bad, counts. On one hand, only by assessing costs regularly and consistently can you develop an ingrained awareness of your capabilities system and its relationship to other expenses. On the other, only by being clear about your way to play and capabilities system can you ensure a long-term, sustainable, good cost position. Without that clarity, you will always be tempted to overinvest in the wrong places.

In the final part of the book, we’ll look more closely at the processes needed to develop a capabilities-driven strategy. Chapter 10, in particular, walks through the steps from start to finish. We hope we’ve shown that linking costs with coherence is not only a smart thing to do. It’s the only way you’ll realize your aspirations.