"How do you create a successful small business?" the opening line of the joke goes.

"Start with a successful big business", is the answer.

The joke is funny because the answer is unexpected, Unfortunately, for organisations caught in the cult of cost cutting, it is no joke.

Cost cutting becomes a cult when it becomes the major means by which top performers are judged and, thereby, promoted. The "tough" image becomes the key to career advancement. Profit, return on capital employed, market share and sales become secondary. Their numerate values become the reason why the organisation has to undergo yet another round of cost cutting.

The unintended end game of a cost cutting cult is a reduction in the size of the organisation by reducing costs to a point where it is unrecognisable from its origin. It is smaller by far, usually geographically, has much less money invested in research and development and people development. As a result, the company has a severely diminished capacity to grow.

The culture of a cost cutting cult is one of high energy introspection with little time spent looking outwards or beyond the next twelve months. Any project which increases costs whether those costs are productive or not is demonised. So are the people who put them forward. It is a culture of low risk and little gain.

A cost cutting cult usually begins with flawed analysis. For example, analysis of margins may show that, on average, margins are declining.

A good analysis of a solution to falling margins would look at all costs in detail and attribute them to productive costs which earn a short term benefit, e.g. cost of sales or long term benefit, e.g. R&D. It would look at the potential to increase volumes and average prices which may indeed increase costs.

Hence. potential solutions to falling margins would include a mix of:

1. Cutting costs - fixed and variable
2. Increasing volumes - by increased market share or new allied products
3. Increasing average prices - by increasing discrete product prices or changing the product mix to higher priced/higher margin products

A poor analysis which, for example, looks only at margins and fixed costs without dissecting marginal costs and prices across the product range and the supply/marketing chain is doomed to give less than half the picture. And yet, this kind of analysis, is, in my experience, prevalent in many organisations undergoing tough times.

The issue of prices and product mix is swept away with an important sounding statement about the "competitiveness of the market". It is intimated that we cannot possibly increase prices or volumes. Unfortunately, the data from such a statement nearly always comes from sales people rather than a rigorous understanding of what customers value and therefore, are willing to pay.

The only solution seems to be to cut costs.

In a cost cutting cult, costs are cut in five ways:

1. Across the board reduction in budgets by 10% to 20%
2. Elimination of a product range
3. Closure of the business in a geographical area
4. Elimination or outsourcing of a support service
5. Reduction in discretionary budgets such as marketing, research and development, training and travel

The results of the cost cutting, short term, are good. Costs are reduced. Margins in most cases are increased. However, companies whose language of success for sales is the margin usually find their hard won reduction in costs flow on to customers. New business is written with an eye on the margin, not the price and the reduction in costs is passed straight on to customers as a reduction in price to overcome the "competitiveness of the market".

"Spill and fill" become a norm. "Privileges" and "old" costly practices are stripped away from employees. Structures become flatter and flatter. Individual responsibilities become broader. Geographic control and control of processes becomes broader for leaders. Less time is available for thinking and customers get less attention across the spectrum.

The medium and long term results though are sobering. Only a few people are left who remember how to grow a business, the rest have left. The company is now so risk averse that its people do not take risks and growth is unlikely.

The cut in costs, because it is across the board and at best tactical, maintains a competitive advantage for twelve to eighteen months. Soon, the "competitive market" mantra returns for another round of cost cutting as margins are still not exceeding fixed costs.

A death spiral of cost cutting ensues until someone, perhaps at board level, decides it is time to look for growth opportunities.

Cost vigilance is important in any organisation. However, when cost cutting becomes a cult rather than a subsidiary of good supply chain, portfolio and marketing management and pricing, then you may be on your way to creating a successful small business from a once successful big business.

©2008 Change Factory