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Bending the Cost Curve

Posted by  Mike Huthwaite

When we think about creating value for our organizations, we often think about increasing Revenue. 

For growth stage firms this makes a lot of sense.  But what do you do when your organization or business unit is in the Maturity or the Decline phase?  Can you still create value?  How do you transform your business in a way that enables your organization to reinvest in more growth stage opportunities? 

We all know that intrinsic value is created when we can increase the Growth in Free Cash Flow over longer periods of time (simple Discounted Cash Flow logic).  But how do you do this when your business isn’t growing at double digit rates?

Creating value is not always about increasing revenue.  It can also be about decreasing costs.  More specifically, it’s about continuously decreasing costs over long periods of time.  This approach creates value that can then be reinvested into new business opportunities that are in either the Initiation or Growth Stages.  This is quite literally the fountain of youth strategy. 

But in order to implement a fountain of youth strategy, your organization not only needs to adopt the J-Curve approach to Strategy, they also need to master the art of bending the cost curve.

What Does it Mean to Bend the Cost Curve?
Bending the cost curve happens when the Marginal Benefit is greater than the Marginal Cost.  Over time, the rate of cost increases at a lower rate than the benefit received for the good.


 
Enterprise Software licenses are a perfect example of bending the cost curve, where adding additional users (the benefit) continues to increase even though the cost of the software remains fixed.  

Identifying the Right Benefits
In the example above I intentionally use the term benefit rather than volume.  That’s because bending the cost curve often requires users to shift from a particular product to a substitute.  For example, companies can bend the cost curve on travel if they shift more of their cost to web conferencing software.  In this case, the benefit is the same (more or less) yet the cost can be significantly less, thus bending the cost curve. 

Moving from Growth to Variable (strategic thinking)
On face value, cost cutting doesn’t sound very strategic, but if done right it can be extremely strategic.  When we talk about cutting costs, the easiest costs to focus on are SG&A or Overhead costs.  These are the costs that are typically forecasted based on Growth Rates (spend what you spent last year plus a bit more).  But over time, these costs begin to bloat and for mature companies, this amount can be considerable. 

Shifting your thinking from growth-based drivers to a percentage of Revenue can help slim down those costs (slowly working down the percentage over time).  Furthermore, it naturally shifts organizations to think more strategically and with more agility.  Under this thinking, it’s ok to spend more if you can generate even more revenue.  This approach is in line with more modern ZBB practices. 

Matrix Strategy
Trying to optimize the cost curve across numerous different costs can be difficult and often takes time to analyze.  In order to optimize the process, it helps to classify and monitor costs into one of 4 categories.  


 
It obvious that any costs that increase over time relative to the benefit received are bad costs.  These costs should be the first to go as the company is essentially getting ripped off.

The costs that often fly under the radar are the costs that bear a constant price but increase in overall spend because the consumption continues to increase.  I like to call this category Business as Usual.

These costs can be deceiving because overtime they really add up. 

Many subscription-based services fall into this category.  They start off seeming like a decent price, but years down the road they add up to a big amount of spend. In the long run, these types of costs typically do not bend the cost curve. 

The All You Can Eat category is the optimal category to land in.  These types of costs are quite literally optimizing value creation at the spend level. 

The last category is the Retreat category.  This category is typically reserved for costs that are eliminated over time and correspond to changing demand for those costs.  Fax machines are a good example of a cost in retreat.  For most organizations the level of spend on fax machines is low, but the benefit for those costs is also low, so over time they dry up. 

Building a Culture of Sustainability
The key to bending the cost curve is sustainability.  This is what creates an immense amount of value. 

But in order to sustain these cost curves, organizations need to change their spend culture.  They can’t leave it up to Procurement to negotiate the price only to consume excessively.  They need to build a culture around driving smarter spend behavior. 

This can often be as simple as booking flights in advance or sharing team presentations digitally rather than printing out copies just for the sake of providing a handout. 

Changing the culture within an organization is never easy and there often isn’t a single answer to the challenge.  However, building accountability and incentivizing employees to share in value creation is a great place to start. 

Building an analytically led organization, focused on bending the cost curve and reinvesting those savings into opportunities that are earlier on the product lifecycle are key steps to growing and sustaining shareholder value. 

No company will continue to grow forever.  In order to stick around you’ll need to one day start to bend the cost curve.  

 

Mike Huthwaite

Passionate advisor and thought leader in the area of Strategic Finance. A seasoned consultant with 20 years of experience, Mike has advised numerous mid-market and large multi-national organizations enhance their strategic planning capabilities.

Mike is an advocate for Cash Flow and Discounted Cash Flow (DCF) analytics. He is a regular speaker and blogger on the topics of uncertainty, Real Options (advanced scenario analysis) and various financial modeling technologies.