Thursday, June 14, 2007

Cutting Your Way to Prosperity? (part 3)

Once there was a farmer who thought he had come up with the secret formula for living the good life. When he was young, this farmer had noticed how so many other farmers were struggling to make ends meet. Not wanting to live that way, this young farmer’s goal was to live well by farming differently.

Therefore, the young farmer spent time investigating what other farmer’s were doing, to find out why they were having trouble making ends meet. After a thorough analysis, he came to his conclusion: Farmer’s do not live well, because they foolishly waste their money. He saw many ways in which farmers were wasting their money:

1) They would let portions of their land lay fallow each year rather than plant something they could make money off of.

2) They put all kinds of money into fertilization and irrigation. Why spend all that money on something Mother Nature supplies for free? (rainwater and fertile soil)

3) They would waste money buying expensive seeds when they could just get seeds for free off of part of the prior year’s crop.

So the young farmer put his plan into action. He planted his entire land every year. He would use “free” seeds from what was produced in last year’s crop. He cut way back on irrigation and fertilization, relying on the “free” resources of Mother Nature.

At first, this plan seemed to work quite well. The money he saved on irrigation, fertilization, and seeds was used to live the good life—a nice home, nice car, luxury lifestyle. He was proud that he had “beaten the system” and could live well on the farm. Over time, however, the plan seemed less successful—every year the fields supplied less and less produce. Eventually, it got so bad that eventually the farmer had to declare bankruptcy.

The farmer in the story failed because he had a tragic flaw in his logic. He assumed that the farmland would continue to produce at peak performance forever without replenishing the soil. Yes, Mother Nature may have gotten him started out with good soil, but if you do not replenish the soil through fertilizer, irrigation, and letting it lay fallow, it will eventually become depleted—unable to produce crops. Weak crops do not produce the kinds of seeds which create healthy crops the following year—and are nowhere near as effective as specially grown hybrid seeds.

The farmer’s success was an illusion. What he thought was high profits from current operations was actually stealing the profits from future crops by failing to reinvest in the soil. These were not extra profits—they were the costs of doing business which he was refusing to pay. By not paying the price of reinvestment into the soil, he was destroying his own future.

Does it sound silly that a farmer would not be smart enough to take care of his soil? Well, I’ve seen otherwise smart business people destroy their future by not reinvesting in their businesses. Yes, it is wise to not be extravagant in your business spending. Keeping costs low can be a good thing, especially during the tough times. But a continual effort to starve a business of investment, even during the good times, can cause a business to have the same fate as this farmer.

This is the third and final blog in a series on the pitfalls of cost-cutting. In the first blog, “part 1”, we looked at how some cuts are really not cuts at all, but are rather just shifting of costs from one location in the company to another. In “part 2” we looked at the problems that can occur when cost-cutting is done without being connected to strategy. In this third blog, we will look at what happens when extreme cost-cutting becomes the norm, even in good times.

Extreme cost-cutting means not reinvesting into the future cash flow streams of the company and instead taking the money out as today’s extra profits. It may make you look like a genius today, but in the long run it depletes the business of what it needs to produce future profits. Businesses are like soil, they need to be replenished.

The temptation to take the money out rather than reinvest seems greater today, with top executives spending ever less time in their position. If the leaders only expect to be hold the position for a couple of years, why worry so much about the long term? In the world of marketing, the average CMO lasts less than two years in a job. Often times, as in the recent case at Macy’s, the rapid change in CMOs is a result of a conflict between near-term sales promotion and long-term brand building. The CMOs trying to invest in the long-term strength of the brand are losing favor to leaders trying to take the profits out now.

There are three main reasons why reinvestment is crucial to long-term success:

1) Things Wear Out
2) Customers are Fickle
3) Technology Improves

These are discussed below.

1) Things Wear Out
Cutting back on repairs and maintenance may work for a short period of time, but eventually, lack of repairs and maintenance will cause thinks to break down. There is an old Fram auto parts advertising campaign where a mechanic would say “Pay me now or pay me later.” The implication was that you could spend a few dollars now on a Fram oil filter or put it off until your engine breaks down and then pay hundreds and hundreds of dollars on engine repair.

This principle may seem obvious for equipment and machinery. However, other things can also wear out if money is not put into them. For example, in retailing, shopping centers and entire neighborhoods can wear out and become tired. It may become necessary to spend the money to move a store a few miles to a more vibrant neighborhood, even though the store itself may still be in relatively good condition.

Strategies themselves can wear out overtime and become less relevant in a changing environment. With the current movement to green environmentalism, an old formerly successful strategy viewed now as environmentally wasteful could severely damage a company. It is better to invest time and money in strategic thinking on a continual basis to stay in front of these changes, rather than waiting until it is too late to efficiently react.

2) Customers Are Fickle
Even if everything in your business is in fine working order, it does not mean that there is no need to reinvest. Customers are fickle. Loyalty is weak. Just being in fine working order may not be enough if competition is investing in the latest and the newest gizmos and gadgets. Shiny new things from the competition can catch the eye of your consumers and make you look dull and drab by comparison, even if there is nothing inherently wrong or broken in your process.

The goal is not to be serviceable. The goal is to be superior (in some way versus competition). Superiority is a relative term. Today’s exciting superiority can fall behind competition if they invest at a faster rate than you do.

3) Technology Improves
Even if your investment is in fine working order, that does not ensure top performance. For example, you may have the absolute best computer operating system available in the 1980s (which is when you purchased it) and you may have kept it in fine working order all these years. However, there have been so many technological advances since the 1980s that you would be woefully uncompetitive in the marketplace versus significantly more efficient competitors who are using the power of more up-to-date computer technology.

It could even be more subtle than this. In retailing, one could have perfectly serviceable cash registers which do a good job of scanning the price tag and letting the customer pay you. However, modern cash registers (which are now called Point of Sale computer terminals), can do so much more—capture customer data, process credit cards faster, allow more sophisticated pricing programs, suggest add-on selling opportunities, handle customer loyalty programs, and so on. By not investing in the new terminals, one is missing out on opportunities and falling behind those that do make those investments.

Continual aggressive cost cutting may be seen by some as being efficient, but it does not necessarily mean that you are effective. By not reinvesting in your business on a regular basis, you can deplete it of its ability to produce revenue in the future.

The biggest problem with chronic underinvestment is that by the time one can see the problem, it is often too late to fix it. The soil of the business is too depleted. Too much time and money would be needed to bring it back to life. And you don’t have the money, because you took it out in extra profits. And without new income coming in, you do not have the time to wait until the soil is brought back to life.

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