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Don’t destroy company value by cutting costs

While increasing profit margins can relieve short-term cash flow difficulties and appease shareholders, it's not necessarily the way to grow a healthy organisation. An article published by McKinsey, by authors Tim Koller and Jack McGinn, outlines how some cost-cutting strategies aimed at short-term gains can have detrimental effects to the bottomline in the long run. If cost-cutting means taking services or quality away from customers, that could damage customer loyalty, the brand and the company's growth in the long term. The McKinsey authors note that underinvesting in product development and marketing, or increasing prices indiscriminately, can be counter-productive strategies and are often not the answer to cash-flow problems.

Better margins don't mean better performance

A study by McKinsey of 615 of the largest non-financial companies, from 2001 to 2013, looked at how many companies were able to sustain margin improvements for three or more consecutive years (the answer – around two-thirds). McKinsey notes that “the longer companies increased their profit margins, the more likely they were to fall behind their peers in terms of total revenue share (TRS) once their margin growth stalled.”

The following chart shows that improving margins for four years made subsequent performance even worse, not better:

Three considerations before cost-cutting

The authors also note that the company's starting position in terms of profit margins also needs to be taken into account: companies starting from very low margins may have more leeway to increase over a longer period. Generally, the authors write that the following rules should be considered before resorting to cutting costs or raising prices to increase revenue:

  • cut costs only when it doesn’t affect customers negatively – an alternative is to look for efficiencies in production processes or the use of technology to reduce admin;
  • be careful that the cuts won't affect your company’s ability to market and sell its products or to meet changing customer needs;
  • managers should conduct a thorough review of their industry-, product-, and transaction-level strategies before raising prices, and consider other routes to increase revenues, such as discounts. The authors write: “Cutting overhead too far can also be detrimental if it leaves managers without the information and analytics they need to understand a company’s performance in light of industry and competitive dynamics.”

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