Why cost cutting succeeds as a tactic but fails as a strategy
Companies embrace cost-cutting and, at first, it delivers as expected. But after that, it is a case of diminishing returns.
When a private equity firm acquires a new company in its investment portfolio, cost cutting is one of the first things undertaken. The same often happens when a new CFO joins a company. As a short-term tactic, this is a wise decision that can yield significant fruit but as a long-term strategy cost cutting can fail with disastrous results.
Case in point: The Kraft Heinz collapse. In July 2015, 3G Capital, a private equity firm merged Kraft and Heinz. As mentioned by David Aaker in his LinkedIn article, 3G’s cost-cutting strategy could be called “Gut, squeeze, repeat” and it failed with a predictable outcome. When 3G merged Kraft and Heinz in July 2015 the stock was trading just under $80 but as of May 30, 2019, it had fallen to around $28, about one-third of its initial value.
Why did this happen to Kraft Heinz, and why does it continue to happen to other companies? Dividing cost cutting into 3 rounds provides a perspective to answer that question.
The first round of cost-cutting harvests the “low hanging fruit” and is well worth doing. With relatively little effort a company can reap significant financial rewards from their cost-cutting efforts. You can see this reflected in the above Kraft Heinz stock chart as the price rose gently to peak at about $96 on February 17, 2017. The first round is often so successful that it encourages a second round of cost-cutting.
In round 2 of cost-cutting, there is no more low hanging fruit because it was harvested in round 1. It takes a lot more work to make cost savings materialize, and the results are smaller. The work required to harvest those cost savings increases, and the return from that work decreases. The fruits of the work in Round 2 are much smaller than in Round 1.
In the 3rd round of cost-cutting, you are left only with the difficult stuff. This is where the cost of the work to make the costs savings materialize exceeds the realizable value of those cost savings. It is also the point at which the effects of unwise cost-cutting starts to damage the business. Once you reach this point the returns trend negative and there is no reason to proceed. Unfortunately, management at companies like 3G and Kraft Heinz fail to realize this.
As David Aaker said, Kraft Heinz made short-term financial gains at the expense of long-term business health and performance. After all, a cost-cutting strategy eventually runs out of costs to cut and ends up damaging the business. Viewed from the perspective of three rounds explains why cost-cutting succeeds as a short-term tactic but fails miserably as a long-term strategy.
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