Leadership in Economics

Cost Leadership Is Rarely A Driver Of Superior Profitability

FLI Oscar Wilde 2

“Nowadays people know the price of everything and the value of nothing.” Oscar Wilde, The Picture of Dorian Gray

“The prevailing managerial bias towards cost efficiency is seriously harmful to corporate performance”, by Jules Goddard, London Business School

Overall cost leadership is not a viable strategy. This is the key discovery to have come out of the most extensive and thorough study of corporate performance ever conducted. Michael Raynor and Mumtaz Ahmed, both with Deloitte, examined the performance of more than 25,000 US companies over a 40-year period. Their aim was to identify companies with sustained levels of high returns on assets and to find an explanation in terms of the strategies pursued by these companies. The most provocative of their ground-breaking findings challenges Michael Porter’s assumption that overall cost leadership is one of three generically viable competitive strategies.

Of the 25,000 companies in Raynor and Ahmed’s sample, only a handful achieved strong and sustained success with this strategy. They conclude that: “Very rarely is cost leadership a driver of superior profitability… it could have turned out that price-based competition was systematically more profitable, or that cost leadership took precedence as a driver of superior performance – but it didn’t.”

When this finding is placed alongside Tim Ambler’s equally provocative finding in his book, Marketing and the Bottom Line, that, “on average, boards devote nine times more attention to spending and counting cash flow than to wondering where it comes from and how it could be increased”, the implication is clear: there is a perilous bias within many top management teams towards the invariably losing strategy of cost competitiveness.

Many years ago, Jim Collins showed that a focus on profit is self-damaging, the evidence being that companies whose goals are financial tend to underperform those whose purpose is more visionary. Perhaps, in a similar way, a focus on cost-cutting has the unforeseen consequence of cutting revenues and therefore margins at an even faster pace. What would appear at first glance to be a bold assault on waste and inefficiency turns out to be a careless and costly assault on earlier investments made by even bolder managers in the competitive differentiation of the enterprise.

Porter in a storm

At face value, Michael Porter’s concept of a cost leadership strategy would seem to make abundant intuitive sense. By achieving the lowest cost base in your industry, you can afford to set the lowest prices and capture the most price-sensitive customers. He suggests there are three principal routes to cost leadership:

Enjoying a higher asset turnover, by spreading fixed costs over larger sales volumes, thereby benefiting from greater economies of scale and learning curve advantages;

Securing lower operating costs, by economising wherever possible on the cost of inputs

Reducing variety and other sources of complexity, standardising business processes, outsourcing noncritical activities, paying low wages, offshoring manufacturing and assembly and generally institutionalising a culture of parsimony; Negotiating a low-cost supply chain, using bulk-buying, competitive bidding, hard bargaining, lean purchasing and vendor-managed inventory.

Raynor and Ahmed’s research casts all three of these assumptions in doubt. Specifically, the implications would seem to be that economies of scale are generally a mirage, perhaps because every doubling of scale creates more than a doubling of managers, systems and processes. This self-fuelling ratchet effect yields what Gary Hamel has aptly called “the management tax”.

A climate of excessive frugality focused relentlessly on the denominator of any calculation of returns (whether on assets, capital, equity or sales) ends up being an inwardly-focused culture that, in the words of Oscar Wilde, knows the cost of everything but the value of nothing.

Treating suppliers as a cost to be cut rather than a relationship to be nurtured may be counterproductive in the long run. Those who treat their suppliers in this way may find themselves being treated by their own customers in a similar fashion.

Beneath all of these assumptions lies a deeper misconception still – the idea that a policy of cost-cutting makes more commercial sense than one of purposeful and judicious cost-adding. The raw truth is that a cost incurred in doing business – any cost – is just as likely to be too low as too high. In fact, the systematic corporate bias towards cost-cutting, particularly in an economic recession, means that, on average, more costs end up being too low than too high, and that, therefore, a strategy of increasing costs – making bolder, less risk-averse investments in the cost base of the business – is more likely to be successful than one of cutting costs. In other words, the bias, particularly in British manufacturing companies, of managing the denominator in preference to the numerator stands in need of a strong counter-bias in favour of bolder investments and higher costs.

Take the case of Dyson. The genuinely newsworthy story underlying the extraordinary success of Dyson was not the offshoring of manufacturing to Malaysia but the on-shoring of prodigious engineering talent to his research and design hub in Malmesbury. We misread the brilliance of James Dyson, and the lessons he has to teach British business, if we choose to interpret his skill and originality as a cutter of costs rather than as a creator of premium products. His vacuum cleaners, hand-dryers and fans are some of the most profitable products in the world not because their production costs are low (they are decidedly not), but because their functionality in use justifies a market price roughly three times that of the competition. Dyson exemplifies Raynor and Ahmed’s three* key rules of success:
1) Better before cheaper
2) Revenues before costs
3) There are no other rules*

Raynor and Ahmed

Michael Raynor and Mumtaz Ahmed

Model behaviour

I have built a model to describe and explain the different biases of winners and losers. Firms in the same industry or strategic segment are positioned on a two-dimensional grid (Figure 1). The horizontal dimension plots firms in terms of their unit costs; the vertical dimension plots them in terms of their added value. Thus, firms above the horizontal axis are creating wealth; firms to the right of the vertical axis bear unit costs higher than the industry average.

Winners tend to sit in the upper right-hand box, creating shareholder value by judiciously investing in higher unit costs and delivering superior value to customers. This strategy takes entrepreneurial courage, since it relies upon market insights that are unique to the firm – what I call “uncommon sense”. Those firms that choose to take on this risk but exaggerate the quality of their insights end up in the lower right-hand box: the home of brave losers.

Figure 1: Distribution of firms in an industry by cost base and economic profitability

Figure 1: Distribution of firms in an industry by cost base and economic profitability

It is rare to find a firm in the upper left-hand box. This is the core discovery of Raynor and Ahmed. Most losers sit in the bottom left-hand box, perplexed that their quest for cost leadership through cost-cutting has only led to value destruction. This is the home of false economies: there are no short cuts to wealth creation.

Self-evidently, the cost base of any firm, whether winner or loser, will comprise some costs that are higher than the industry average and others that are lower. Each firm makes its judgment on each category of cost as to where it thinks the optimum lies. This is the skill of strategy. Overall, most of the costs of winners will be higher than most of the costs of losers (Figure 2).

The fatal bias fig2

Figure 2: How winners and losers differ in the composition of their cost base

The strategic plans of companies reveal their assumptions as to the origin and destination of their strategic journey (Figure 3). The majority of companies envisage their path towards greater economic profitability as a journey from a place of relative inefficiency, waste and profligacy to one of greater discipline, frugality and competitiveness (the Southeast to Northwest trajectory). This “drive for efficiency” will invariably contain such fashionable cost-cutting methods as out-sourcing, offshoring, service-sharing and re-engineering. It is the journey chosen by the majority of losers. They aim for El Dorado but, by the law of obliquity, they end up in the land of lost illusions.

The fatal bias fig3

Figure 3: How winners and loses differ in their strategic journeys

A minority of companies, by contrast, envisage their path to success very differently. They see their strategic journey as one of continuous discovery, moving from a place of “best practice” to one of “unique practice” – from conventionality,  convergence and commoditisation to daring, distinctiveness and differentiation (the Southwest to Northeast trajectory). This quest for “corporate individuation” is driven by the conviction that markets reward uniqueness. This strategy has its risks, but it is the preferred path of most winners.

Implications and remedies

What are the practical implications of the finding that long-run profitability is strongly associated with a higher than- average cost base? In other words, if managers and strategists are to break the habit of looking mainly to cost efficiencies for the creation of competitive advantage, what changes of mind-set and behaviour are implied?

Strategies as experiments

There needs to be a more concerted, more confident focus on opportunities for out-spending competitors, for investing earlier in entrepreneurial ideas, and for using experimentation more routinely. Only an irrational objection to the cost of experimental risk (its hit-or-miss nature) can explain the reluctance of companies to conduct frequent, small-scale experiments in the search for viable strategic ideas. Is it not surprising that the tried-and-tested methodology of clinical trials, all too familiar to pharmaceutical companies in the testing of drugs, is not in routine use by companies for the testing of strategic ideas?

Plans as conjectures

All too often, the process of strategic planning descends into a self-defeating duel between the requirements of the executive board and the commitments of the individual business unit. Management teams, under varying degrees of duress, find themselves signing up to a host of targets and timelines. This has the inevitable effect of placing the focus on costs as the easiest way of securing the required margins and profits.

When plans become promises to be met rather than propositions to be tested, the default position tends to be a cost-cutting strategy. To combat this, perhaps firms should consider a one-year moratorium on any plans containing numbers. Instead, they could require plans to be built entirely out of ideas. In other words, the purpose of planning could (and perhaps should) be shifted from accountability to exploration and discovery.

Management accounts as explanations

It is symptomatic of the bias towards cost management in the pursuit of profit that the standard profit-and-loss statement devotes a single line to revenues and a long list of lines to costs. Imagine reversing this order of priority by breaking down revenues into multiple lines according to the source of sales and, conversely, aggregating all costs into a single line. Might this not have the desirable effect of shifting strategic attention from the cost of sales to the growth of sales? The way in which management accounts are constructed betrays a belief that costs are a tiresome burden to be subtracted after the revenues have been earned rather than the generative source of those revenues. Indeed, the names given to different categories of cost serve only to accentuate this illusion. Perhaps the cost of inventory should be relabelled as the “cost of product availability”, the cost of debt as the “cost of accelerating investments in new products”, the cost of training as the “cost of capability”, the cost of bad debt as the “cost of trust in customers”, and so on.

The economy as a scapegoat

When the economy falters, or when competitive pressures build, or when sales revenues dip, the cost consciousness of companies typically strengthens and managers instinctively default to ‘play-safe’ strategies. Instead of “battening down the hatches”, why not use the challenging conditions as an incentive to “break out of the box” of conventional thinking – to be bold when others are choosing to be more circumspect? When everyone else is cutting back, perhaps that is the opportune moment to invest in attracting the customers of competitors.

Volatility as hype

Preferring caution to courage under conditions of change is closely related to the belief that the world is becoming more volatile, more complex, and more unpredictable. In Beyond the Hype, Robert Eccles and Nitin Nohria affectionately teased Peter Drucker for routinely prophesying that the succeeding decade was destined to be a singularly significant moment in history, a potential game changer, a once-in-a-lifetime discontinuity, the dawn of a new age, and so on. These portentous pronouncements, which are adopted by so many self-respecting commentators, are threadbare. We like to feel that we are on the cusp of change – that our generation is living through particularly auspicious times – but the evidence for this is thin. If anything, the great achievement of the generations since World War II has been to make the world less eventful, more predictable and less threatening. But by using these alarmist prognostications, we give ourselves permission to be especially conservative and risk-averse in our policies and actions. In other words, over many years, we have used the volatility of the external world as an excuse to be internally cautious, particularly with respect to costs. Tis caution ultimately negates any volatility that there ever was: if everyone plays safe year after year, the argument for turbulence refutes itself.

Redefining waste and inefficiency

Wasted opportunities are a far more significant source of economic inefficiency than wasted resources. The opportunities we regularly forego that in retrospect we will wish we had had the courage and foresight to grasp are the real source of waste, regret and failure, not the investments that, in the nature of entrepreneurship, fail to come good. The strategic imagination is better employed attending to the former notion of waste, than fretting about the latter.

Final word: changing the frame

The way in which executive teams frame their forward thinking makes a critical difference to the quality of the strategic ideas that emerge. If ‘cost-competitiveness’ or ‘labour-productivity’, or ‘competitive benchmarking’ or ‘operational excellence’ or ‘affordability’ is a defining feature of the frame, then the thinking is unlikely to yield profitable solutions.

All too often, the overriding problem to which a company’s plans are expected to find solutions, particularly in ‘difficult’ times, concerns the identification and removal of waste and inefficiency in the organisation. The kinds of questions that frequently form the implicit frame of reference when strategies are being formulated take the following form: What cost savings can be made without our customers noticing? Which investment opportunities can be postponed or cancelled without upsetting our shareholders? What boosts to our short-term earnings can be created without damaging long-term value? What pressure can be placed on our suppliers without losing their trust? What targets do we need to meet to keep the City happy?

Now imagine framing the challenge in a different way, with a different set of questions: If we were required to carry a 20 per cent premium price on our products and services, how would we change our thinking? If we had to double our margins without cutting our costs, what strategy would we pursue? If there were no recriminations for making mistakes in the bold pursuit of greater success, what investments would we choose? If we were forced to double our cost base over the next five years, what changes would we make?

Simply by shifting the frame, we would get to different strategies, priorities and solutions. These more strategically astute questions play to our optimism, our imagination, and our responsibility. They get the creative juices flowing. And by countering the lazy option to cut costs, they are more likely, all other things being equal, to lead to enhanced performance.

by Jules Goddard, Research Associate of the Management Lab (MLab) at London Business School
Article originally titled: “The fatal bias”
*Small adaptations by The 7R Future Leadership Institute

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