Analogy #184: Don’t Cut Down All the Trees

THE STORY
Did you ever wonder what it would be like if countries were colored like they are on maps? When you look at a map, one country may be colored brown. Immediately on the other the side of the border, the next country on the map is colored green. Wouldn’t it be something to see such a border in reality, where everything is brown on one side and green on the other?

Well, the island of Hispaniola is something like that. The island of Hispaniola is in the Caribbean Sea, located southeast of Cuba. The western half of the island is the nation of Haiti. The eastern half of the island is the Dominican Republic.

You would think that because the island is so small, and since both are surrounded by the same body of water, that the climates in both countries would be nearly identical. They are not. Haiti is like a dry, barren desert. It is brown. The Dominican Republic is a lush, tropical area which gets plenty of rain. It is green. It’s almost like those multi-colored maps, brown on one side of the border, green on the other.

Why are the climates so different? It has to do with trees. In a desperate search for fuel, the Haitians have cut down nearly every tree on their half of the island. By contrast, the people of the Dominican Republic did not cut down all of their trees.

It is an interesting quirk of nature that if you want a lot of rain, you need a lot of trees. The trees interact with the atmosphere in such a way to promote the growth of rain clouds. Without the trees, the clouds do not form. With virtually no trees in Haiti, there is virtually no rain in Haiti. Because the Dominican Republic still has lots of trees, they get a downpour nearly every day.

When Haiti had lots of trees, their climate was like that of the Dominican Republic. But those days are long gone and now they suffer from a shortage of water.

This is a tough problem for Haiti to fix. It would take generations to re-grow a large forest. In the meantime, there is still a desperate shortage of fuel, so the temptation to cut down the trees for fuel would be great. Finally, Haiti does not have the monetary resources necessary to pull off such a project. With all of the immediate problems that they have, it is hard to commit to something with a payback so far into the future.

THE ANALOGY
At first, it is hard to see the connection between trees and rain. It is not necessarily intuitive. Therefore, when the trees are being cut down for fuel, people do not make the connection between this act and its consequences to the climate. They seem like separate, unrelated issues. However, whether we see it or not, the two are interrelated. And the consequences are quite dire. By the time people figured it out, it was too late to do much on a near-term basis.

Business models also have many interrelated parts. Sometimes it is difficult to see how the pieces all interrelate. Therefore, we think we can do certain things in one area of the business without it impacting the rest of the business. Unfortunately, just like losing those trees lead to losing water, disruptions in one part of the business model could cause a financial drought for the entire company that would take generations to repair.

THE PRINCIPLE
The principle here is about managing the interrelated pieces of complex business models. In many ways, you have to manage all of the pieces together, like a delicate ecosystem. Piecemeal approaches that only look at one isolated decision at a time can end up destroying that delicate business ecosystem.

For example, outside investor activists often do not have the same level of intimate knowledge that insiders do about the interdependencies of the business model. Therefore, they come bursting in with all sorts of ideas to break up the company and sell off pieces (or some other such restructuring).

Many times, these can be good ideas. A fresh perspective can be useful. However, other times, these suggestions may be the equivalent of telling Haiti to cut down all of its trees. Without realizing it, these innocent looking breakups end up selling off a key resource that makes the whole business ecosystem work. Without it, profits for the whole business dry up, because they sold of f what helps create the rain.

Recently, an executive of Southwest Airlines was talking to financial analysts/reporters. An analyst mentioned the fact that Southwest has some great long-term pricing contracts on jet fuel at favorable rates. Those contracts are extremely valuable in today’s environment. It was suggested that Southwest could make a bundle of money by selling those contracts.

But Southwest knows that those fuel contracts are their trees. They help create the low-cost structure upon which the entire business model is dependent. The executive correctly responded to the analyst that yes, they could make a lot of money on such a deal, but immediately after that, they would be out of business as an airline. Without the fuel contracts, Southwest’s entire business model would be in an irreversible drought.

Similarly, analysts and activist investors over the years have suggested that fast food chains divest of the restaurants they own. The idea is that they could fetch a lot of money from spinning the restaurants out to the franchisees. In addition, it would help them better focus on the franchisor side of the business.

The fast food companies contended that although the relationship may not be so obvious, owning a few of the restaurants does indeed improve the overall business model. By owning a few restaurants, they better understand the problems of the franchisees. It helps keep them closer to the ultimate customer. And it provides easy ways to experiment. As a result, they make the companies better franchisors, who can better serve the needs of franchisees and customers. Hence, without this so-called “fringe” business, the core business would suffer. They are like trees…an integral part of the entire business model.

If you have to cut down some trees, have plans to replace them. In the retail business, I have seen what happens when you keep taking money out of the business and don’t put any back in. Stores start to look run-down. The shopping centers deteriorate and become less desirable places to shop. Eventually customers give up on the run-down stores and shop the shiny new competitors.

Some have argued that Eddie Lampert is going down that path with Sears. By under-investing, in Sears, it is like cutting down all the trees and not planting any replacements. The stores become barren wastelands, as the customers depart for greener pastures. More on this topic can be seen in the blog “Don’t Eat Your Seed Corn.”

SUMMARY
Before you start to break up a portfolio, or restructure the business, or pull back resources from a particular area, first check how those pieces inter-relate with the rest of the business model. Although it might not be obvious on first glance, they may play a vital indirect role in the prosperity of the core business.

Losing those pieces may have dire long-term consequences. Just as it could take generations for Haiti to replace its trees, it could take your firm a long time to replace a vital resource once it is lost.

FINAL THOUGHTS
The water shortage in Haiti due to a lack of trees has gotten so bad that salt water is seeping into the freshwater supply, ruining what little water there is. Vacuums tend to get filled. And if you’ve taken away the elements that create success, the vacuum may be filled with things that hurt you.

Cutting Your Way to Prosperity? (part 1)

THE STORY
A long time ago, I was in charge of creating the advertising media budget for a retail company. I turned in what I thought was a reasonable budget.

A couple of weeks after I turned in my budget, I got a call from the budget department. They said that when the budgets of all the departments were rolled up, the expenses were too high. They asked me if it would be okay for them to cut the advertising budget by 25%.

I said, “Before I answer that, let me ask you a question. If the advertising budget is cut by 25%, are you planning on cutting sales by any amount?”

They replied, “No, the sales budget would stay the same.”

In response, I said, “Well in that case, why don’t you make advertising $0? Obviously, you do not think that advertising has any impact on sales, so I suppose we shouldn’t do any advertising at all.”

THE ANALOGY
One of the hardest times to execute a strategy is when times get tough, such as in an economic downturn. To get through the tough times, there is often a need to cut expenses deeper than normal. There can be many problems if the cutting is done improperly. This is the first of a series of blogs on some of the pitfalls to avoid when cutting costs.

The first pitfall to avoid is in ignoring the interconnectivity of cost reduction decisions. If you cut costs in one area, it can make that area look good. However, due to interconnectivity, the impact of that reduction impacts other parts of the business. It may cause damage to other parts of your business which are worse than the benefits gained in the inital cuts, causing you to actually lose ground in your quest for profitability.

You may end up congratulating someone for their cuts, even though it is ruining the profit structure elsewhere. Take, for example, the story above. One could look like a hero for cutting advertising by 25%. It might cause the people in the advertising department to get a big bonus. However, if the reduction in advertising causes sales to drop too far, then you have rewarded people for destroying value.

In most cases, it is illogical to believe that one can just cut 25% of advertising and expect it to not impact sales at all. The overriding purpose for practically all advertising is to influence people to buy more from you. Advertising and sales are interconnected. To budget a huge drop in advertising without any drop in sales is to either admit that you are incompetent in your advertising or admit that your sales budget is an unrealistic lie.

THE PRINCIPLE
The principle of interconnectivity needs to be considered when implementing cost reduction programs. There are three main areas where interconnectivity can hurt you:

1) Vertical Connections
2) Horizontal Connections
3) Customer Connections

These are discussed more fully below:

1) Vertical Connections
An income statement has many lines on it. If you focus on just one line on the income statement, you can achieve huge cuts on that particular line. However, it may just serve to move those costs up or down the income statement to a different line. The lines on an income statement are interconnected.

For example, let’s say one is focused on cutting a department’s payroll expenses. There are many ways to achieve this. For example, one can outsource work which used to be done internally to an outside third party. The payroll line goes down, but the outside services line goes up. It may even go up faster than payroll goes down.

Another way to reduce payroll is to increase the use of temporary services. The work didn’t go away…it just went to a different line item. If the focus is on cutting headcount, it may result in increased overtime for the remaining workers.

If the focus is on cutting capital investments, there may be an increase in repairs and maintenance in order to keep the old capital running. Or if the repairs and maintenance are cut too far, as appears to have been the case at some BP refineries, you may end up with serious disasters of entire businesses going out of commission for a long period of time. That raises costs on all sorts of other lines.

The moral of the story: When looking at a department’s cost cutting efforts, do not focus too narrowly. Look at the impacts that a cut on one line could do the increasing a different line on that department’s income statement. Cuts on one line rarely fall 100% to the bottom line. Some of it leaks back to other lines. Capture the leakage in your estimates.

2) Horizontal Connections
Vertical connections tend to be easier to address, because the income statement can be contained within a single department. For example, if you tell the legal department to reduce their total costs, then they do not gain much when shifting internal legal personnel costs to outside legal counsel. Since they have responsibility for both lines, they do not shift their total expense much in shifting the burden from one line on their income statement to the other. Hence, there is not much incentive for making the shift.

The more difficult problem is when the connectivity is horizontal—between departments. If one can improve their department’s expenses by pushing costs to another department, it can make that department manager look good, because his or her area has permanently reduced their costs. Even though the total company expenses did not go down, the department that shift costs to another department can get undeservingly rewarded.

Let’s look at how this might play out in a retail company. The merchants might be able to lower their cost on the good they buy by requiring less of the vendors. They could ask the vendor to stop doing certain tasks in return for a lower price. Those tasks could include:

A) No longer having the vendor put price tags on the goods.
B) No longer having the vendor sort the goods by store before shipping them.
C) Shipping the goods all at once, rather than holding onto the inventory and shipping it in more manageable quantities.

While this takes costs off the merchandiser’s books, it adds a ton of costs to the retailer’s distribution center, because now they have to do what the vendor used to do. They have to do the sorting and the tagging. At the same time, the warehouse gets clogged with extra goods, making processing at the distribution center less efficient.

Now the distribution center may want to escape some of this problem by shifting the burden to the stores. They could send the goods to the stores untagged. They could clog the stores with more inventory than they need. So now, someone at the stores has to do more work than before.

Moral of the story: Don’t just accept a department giving a commitment that they will reduce their costs. Ask them how they are cutting their costs, so that you can determine if their method of cutting is just shifting the burden to another department.

3) Customer Connections
Some cuts in cost are noticeable to the potential customers. If your cost cuts make your firm less desirable to customers, they could end up going somewhere else. It does little good to cut costs if it results in alienating customers and eliminating sales. Long after the tough times are over, customers will remember how you treated them in the tough times and may not come back when the times are good.

Using a retail example again, one can cut labor in the stores in a way that:

1) Makes the store visually less desirable, because there is less cleaning and straightening up.
2) Make the checkout lines longer due to fewer people operating the cash registers.
3) Create more out-of-stocks, because there are fewer people restocking shelves.

These outcomes can cause customers to no longer want to shop your store. The drop in sales could be greater than the drop in costs.

Moral of the story: Don’t forget the customer perspective when cutting costs. Do the reductions in expenses exceed their impact on reducing sales?

SUMMARY
Just because one has a “successful” cost cutting plan put in place does not necessarily mean that total costs really went down all that much or that profitability of the entire company is better off. To really have success in tough times, one needs to check the interconnectivity of cost cutting actions, to make sure that costs were not merely shifted up and down a department’s income statement, or shifted to another department, or caused customers to stop patronizing your business.

FINAL THOUGHTS
I am not trying to imply that cost cutting is bad or unnecessary. Cost cutting is often necessary and good. We just cannot go around blindly believing that all cuts are good cuts. The next blog will address some of these issues around deciding what are good cuts.