Who Gets Paid Less When Companies Cut Costs?

Tuesday, February 16, 2016

The key to long-term profitability is to maximize the spread between revenue and costs. The larger the difference, the larger the profit.

I usually suggest focusing on increasing revenue, because revenue has no limit. It's not impossible for firms to earn ten, one hundred, or even one thousand times more income than in the previous time period. Costs, on the other hand, are bounded at the bottom end. It's quite difficult to ever reduce costs by more than 100%.

There's another reason why I don't suggest focusing on decreasing costs. It often leads to a long-term weakening of the firm. Nevertheless, many managers love to cut costs in the name of efficiency.

Today we'll take a look at some traits of parties who are most likely to be hurt in the midst of cost cutting efforts. Please understand, I merely seek to identify traits of those who are likely to be adversely affected. I make no claims that these traits should be used by decision makers.

• Sellers with very few buyers. It goes without saying that when a supplier only sells to a single seller, he gives up much of his pricing power. The quality of the product supplied is irrelevant. Suppliers with very specialized skills or tooling may produce very valuable, high quality products, yet still find themselves with minimal bargaining power. If a person is hired as a Vietnamese to Navajo translator, he won't have many career prospects, no matter his level of skill.
• Sellers with high fixed costs but low variable costs. The lower the cost of producing additional items, the more the suppliers can be squeezed. Traditional economic theories state that producers will always sell items as long as the actual costs of production are covered. The fixed costs (like factories or licenses) are completely irrelevant and sunk. Note: In many cases, it may be easier to negotiate for increased quantities (at a decreased unit cost) than a reduction in price.
• Sellers with cash flow issues. Many parties have minimal assets. Some have significant assets, but minimal cash on hand. A portion of these firms will happily negotiate lower prices in exchange for earlier payments. Employees can be dealt with in a similar manner. An employee who has just purchased an expensive house will often accept reduced payments in exchange for a guarantee of continued payments.
• Suppliers providing a value that is not easily measured or well understood. Security and infrastructure teams are often prime targets for cuts because they are seen as expenses, not as profit centers.
• Sellers without a sophisticated understanding of their own worth. Companies with a strong engineering culture (rather than a strong sales culture) are likely to accept cuts. The members of The Three Stooges are hardly the only people who undervalued the own worth. Firms that describe their products in terms of features rather than benefits will likely fall into this category.
• Suppliers that managers don't like. They may not have taught this in economics textbooks, but many managers will act against the best interests of the company. They call this the principal-agent problem, and it happens quite frequently.

Of course, there's one place that should never be cut: pricing. Even a small nudge in the right direction can have outsized returns on your balance sheet. You can contact me for a consultation, or buy a copy of the best book on software pricing.