We recently heard a CFO bragging about his ability to improve the profitability of companies:

“I have worked with three businesses, and in each of them I have managed to increase profits while revenue is falling.”

We’ve seen this mindset in a number of incarnations, typically from finance people (it’s tough for us finance guys to admit that) who work for a private equity firm or a portfolio company. They are asked to come in for a short period of time, generally two to three years, to “fix” the company.

The problem is that these saviors often end up destroying the company while attempting to fix it.  The reason: You can’t cut your way to growth, and while cost-cutting may create a short-term win by improving EBITDA or net income, it’s not sustainable in the long term.

There are three things you need to consider when looking at cost cuts as a way to increase value:

1.  What costs and investments are required to maintain the existing or projected revenue base?

In most businesses there are opportunities to cut fat, but in many cases cost reductions cut to the muscle or even the bone. Which costs in the business are critical to achieving this year’s revenue targets? Which investments, when cut, will have a negative (rather than neutral) effect on this year’s revenue? Cutting sales resources or marketing investment may very well lead to a decrease in revenue. It doesn’t help the cause if cost cutting leads to an equal or greater percentage decrease in revenue.

2.  Which costs or investments will impact revenues in future years – positively or negatively?

Even if costs don’t eat into this year’s revenue base, they may have a significant impact on future years. The CFO we quoted above was quite proud of himself for increasing profits during his tenure. But it’s fairly easy to increase profits this year by cutting investment, while ignoring the fact that the cuts will inhibit or prohibit the business from creating revenue in future years. Essentially, you end up moving profits from year to year rather than creating real value over the entire time horizon.

3.  Will your cost cutting necessitate further cuts in the future, creating a snowball effect?

When cost reductions cut to the bone and beyond, the inevitable result is a snowballing sequence of profit declines. The lack of critical sales, marketing, R&D, and other investments will likely reduce revenues, which leads to additional cuts. As the pace of revenue declines increase, profits will eventually evaporate and the business will not have the ability to recover.

There are definitely “bad” costs in every business and it’s helpful to trim the fat on a regular basis. But, when cutting costs becomes the primary goal, it’s extremely difficult to grow the business.

What are your experiences with cutting costs in your business? Share your thoughts with us at karlandbill@avondalestrategicpartners.com.