BUSINESS

IDEAS AT WORK

THE REALITY
OF COSTS
If you think that cost cutting
is the surest way to business
success, Jules Goddard wants to
challenge every assumption you
hold. Costs are an outcome of a
sound strategy, he argues, never
the goal of a strategy. Here, he
offers a new perspective on what
counts when it comes to costs.
A ‘cost strategy’ is a contradiction
in terms. If it is a strategy, defined
as a unique way of adding value,
then costs are simply a measure
of the monetary effort required to
execute it. If cost is the focus of
attention, then strategic thinking is
superfluous. All that is required is the
determination to cut costs.
Costs, then, are not the basis of 01
a strategy, but the result of putting 01 Ford’s UK Dagenham
it in play. If, when executed, the production line, 1967
02 Ford’s UK Dagenham
strategy proves to be uncompetitive, production line, 1950
it is invariably the strategy that is 03 Henry Ford, Founder of the
Ford Motor Company
flawed, not that the costs are too
high. The most prevalent source of
corporate failure is management’s
conviction that their costs are out of
line rather than that their strategy is
misconceived. The majority of firms
that are destroying wealth are doing
so by focusing their attention on
reducing their cost base rather than
reinventing their strategy. 02

On strategy and cost

All genuine strategies, by definition,
entail differentiation; but cost cannot
be differentiated. Costs are different
because strategies are different.
Thus, the choice of strategy precedes
the estimate of costs. Questions
about performance concern not
the magnitude of the cost but the
strength of the strategy.
Costs are the inputs required to
achieve an output. The choice of
output is the task of strategy. Since
outputs (in order to be competitive)
must be unique, it makes no sense
to compare the costs of competitors.
For example, comparing the costs of
Porsche with Ferrari, or even Volvo,
is meaningless. The only competitive
comparison worth making is between
the strategies of these companies. The
only cost comparison worth making
is between each company’s cost base
and the market’s perceived value of
the offering to which it gives rise. In
other words, costs should be compared
with prices, not with competitors.
It is the strategy of a company, not
its management, that essentially sets
the cost base of the business, that
establishes the terms of competition
and that defines the metrics of
performance, including efficiency.
Thus, cost pressures are, in
reality, strategic pressures in disguise.
When a company finds its margins
are falling, looking to the cost base
for a solution — such as finding
ways of slashing prices without
decimating margins — is invariably
mistaken. It is the business model
that is being questioned, usually for
being insufficiently distinct from
competitors. An effective strategy
makes operational efficiency a
second-order activity.
It is a paradox that aiming for x
is rarely the best way of achieving
x. This is an example of the oblique
principle, first formulated explicitly
by the economist John Kay when
03

40 BUSINESS STRATEGY REVIEW Q2 – 2010


arguing that financial targets tend
to be counterproductive. Profit in
business tends to be maximised when
management focuses its attention on
customers rather than shareholders.
As reported in Built to Last, Jim
Collins and Jerry Porras showed that
companies that made profit their
primary goal were less profitable,
on average, than those that chose
higher-order goals.
Costs are best managed
obliquely. Early in its history, the
Ford Motor Company managed its
costs supremely well by focusing
on something else. Henry Ford
is famous for the invention of
the assembly line, but this is to
misunderstand his genius or, at least,
to ignore his own explanation for his
success. Ford arrived at the idea of
mass production by first imagining
the possibility of mass marketing.
He started with a hypothetical price,
not a cost. He asked himself how
many cars he would sell if the price
were just $500. The answers so
excited him that he put his mind to
finding a way of ‘making the price’.
It was this ‘transitional object’ that
Costs are best managed
obliquely. Early in its
history, the Ford Motor
Company managed
its costs supremely
well by focusing on
something else.
led to the assembly line. As one
marketing expert, Ted Levitt, put
it, “Mass production was the result,
not the cause, of his low prices.”
Ford described his philosophy in the
following way:
“Our policy is to reduce the price,
extend the operations, and improve
the article. You will notice that the
reduction of price comes first. We
have never considered any costs as
fixed. Therefore we first reduce the
price to the point where we believe
more sales will result. Then we go
ahead and try to make the prices.
We do not bother about the costs.
The new price forces the costs down.”
In short, Ford did not set the price
on the basis of the cost; he set the cost
on the basis of the price. This was his
Q2 – 2010 BUSINESS STRATEGY REVIEW 41
IDEAS AT WORK The reality of costs
genius. He continued, “The low price
makes everybody dig for profits. We
make more discoveries concerning
manufacturing and selling under this
forced method than by any method
of leisurely investigation.”
Ford’s insight has still to be
fully appreciated and understood.
It is remarkable how many business
people to this day set prices on the
basis of their costs, rather than vice
versa. The moral of this illustration
is clear: as a business executive, you
incur a cost for no other reason than
to pursue a strategy; and it is the
strategy, not the cost, that determines
the competitiveness of your business.
On cost reduction
There is a common prejudice that
holds that business costs are more
likely to be too high than too low —
that taking costs out leads to higher
levels of competitiveness than putting
costs in. Perversely, executives
speak frequently of cost reduction
strategies but rather rarely about
cost enlargement strategies. This is
illogical. A level of cost is like a level
of service or a level of quality — the
aim is to find the right level, not the
minimum level.
Both in theory and in practice,
costs tend to be treated as a bad
thing. They are seen as being too
high; they need to be cut; they
are symptomatic of waste, excess,
profligacy and irresponsibility.
Consultants are expected to reduce
costs, not add to them. An incoming
chief executive will normally want
to rationalise costs, not justify them
or grow them. Competitiveness is
usually defined in terms of the cost
base — and the lower the better.
Predator companies will traditionally
want to make economies in their
newly acquired prey. It is a rare
acquirer who is looking to grow
the cost base.
Why is this? Why is there an
assumption that costs are biased on
the high side rather than the low side?
Is there any evidence, for example,
that cost-cutting strategies enrich
shareholders? Do investors employ
managers principally to strip out cost?
Tom Peters and Bob Waterman, as
far back as In Search of Excellence,
were wont to point out that cost
reduction strategies often came at a
steep price: higher quality or revenue
generation were often suppressed.
BUSINESS

At what point do (or should)

shareholders step in and say,
“Enough is enough; change the
strategy, not the costs”? In capital
markets, it is assumed with a high
degree of reliability that share prices
are unbiased estimates of the true
value of the business. In other
words, it is meant to be just as
difficult to buy a portfolio of shares
that underperform the market as
outperform the market. Why do we
see costs differently? Why don’t we
also assume that costs are an unbiased
estimate of the optimal investment
in human talent, working capital,
research and development, advertising
and sales, investor relations — and so

Competitiveness,
defined as the ability
to compete profitably,
is set by the firm’s
strategy, not by its
costs. There are
many companies
that boast the highest 01
costs in their industry 01 Dyson vacuum cleaners
going through rigorous
that are also the stress-testing
02 Sir James Dyson,
most competitive. inventor of the dual
cyclone, bagless
vacuum cleaner

on? Why do we tend to believe that

managers are sloppy in their decisions
on cost, systematically and wantonly
paying people too much, holding
excessive inventory, recruiting too
many, travelling too much, over-
training their staff and supporting
bloated research departments?
The misconception that costs
are biased on the high side owes a
lot to Michael Porter’s typology of
generic strategies. In this famous
and influential theory, Porter
distinguished between strategies of
cost leadership and strategies of
differentiation. Anyone who has
ever taught this theory to managers
will have been confronted on
every occasion by the immediate
challenge: “If these are different
and contrasting strategies, how
come almost every market-leading
company is characterised by both
simultaneously?” In other words, how
can one become a cost leader without
02

42 BUSINESS STRATEGY REVIEW Q2 – 2010


being different? Why, for example,
are the vast majority of global brand
leaders both strongly differentiated
and highly cost efficient? Indeed,
economies of scale mean just that:
cost is a function of scale, and scale
is a function of (relevant) difference.
The tiresome and obvious fact that
should have killed this theory at birth
— namely, that almost all successful
companies are both differentiated and
cost leading — would seem to have
been willfully ignored.
I can argue that any cost carried
by a business is just as likely to be
too low as too high. In other words,
we assume that cost levels in a
business are not biased one way or
another. In the case of inventory,
for example, as many materials,
parts and products will be under-
stocked as over-stocked. In the
case of quality, as many products
will be under-engineered as over-
engineered. In the case of marketing,
as many service levels will be set
too low as too high. In the case of
compensation, as many salaries will
be too stingy as too generous. It is
not, for example, self-evident that the
CEO is being paid too much — or
too little. The presumption that costs
are more likely to be on the high side
than the low side is simply sloppy
thinking. The management of cost is
never as easy or straightforward as
simply cutting it. It is as difficult to
cut costs profitably as to raise costs
profitably. Disinvestment is as skilful
as investment.
A rule for costs
If this line of reasoning is valid so
far, then certain corollary arguments
can also be made. The rule for
cost control should be: cut back
on those existing costs that are not
germane to the strategy and invest in
those costs that, if they were to exist,
would strengthen the strategy. The
benchmark of competitiveness should
be value, not the competition. For
example, the British manufacturer
James Dyson was right to outsource
manufacturing to Malaysia because
his strategy was in no way dependent
on domestic manufacturing — and it
reduced his cost base. But we should
not worry that, when the story of
Dyson’s global success is finally told,
it will certainly feature his design
philosophy, his entrepreneurial
resilience, his investments in R&D,
and his world-beating products. It
is unlikely to dwell on his decision
to offshore his manufacturing. Cost
cutting in the context of a game-
changing strategy is very different
from cost cutting as the only game
in town.
As a concept, cost leadership is
as meaningless as price leadership
or operational leadership or working
capital leadership. Cost leadership
makes sense only in the context
of a commodity market that,
by definition, is a set of trading
conditions characterised by an
absence of competitive strategy.
Every company is competing on
the same terms. Thus, the only
differentiating variable is the cost
base. The more that companies
are seduced into believing that cost
leadership is a viable strategy, the
more commoditised markets become,
the less their wealth-creating capacity
and the slower the growth of the
economy of which they are a part.
Does this rule apply in both good
and bad times? Yes. Recessions bring
out the worst in cost cutters. It is
irrational for costs to become more
important when economic conditions
Q2 – 2010 BUSINESS STRATEGY REVIEW 43
IDEAS AT WORK The reality of costs
are difficult. If costs are important,
their significance should not vary
at different stages of the business
cycle. Perhaps there is an implicit
assumption that costs have something
to do with affordability, and that
in a recession firms must cut back
on costs — not because they don’t
produce a return but because there
isn’t enough money to go round.
However, a cost is borne not because
it can be afforded but because it
leads to sufficient revenue to cover it.
Recession is a lame excuse for giving
up on strategy and choosing instead
the lazy option of cost reduction.
Another related question is
whether this rule should apply to the
‘back office’ that is often the first
cost area to be cut. The back office
invariably (and unfairly) bears the
brunt of every efficiency drive and
change initiative. Why should the
back office provide easier pickings for
cost savings than front-line services?
Cutting costs in the back office is
somehow regarded as less harmful,
contentious or provocative than
cutting front-line services. This is
illogical. It suggests that when these
costs were originally put in they
were massively biased towards the
back office and that therefore this
degree of slack can safely be cut out.
A December 2009 monograph on
public sector efficiency by the think
tank, Reform, reversed this logic by
showing that waste is more likely to
be a feature of front-line services
than of the back office.
The emphasis that top
management places on cost is
inversely proportional to the trust
they place in their middle managers
to make responsible decisions. When
dealing with costs, managers are
more often assumed to be profligate
than frugal — and generally to err
on the side of waste, extravagance,
irresponsibility and indiscipline —
hence the need for supervision.
Left to themselves, most managers
would become spendthrifts, with very
little concern for shareholder value,
particular when times are tough.
Indeed, the main role of senior
management is to rein in the natural
exuberance of middle managers.
The traditional model of
management has the unintended
consequence of making cost cutting
the default option. In the standard
version, top management sets the
BUSINESS
01
strategy and everyone else executes
it. Skilful execution is defined as the
minimum cost to deliver the strategy.
The only variable subject to middle
management discretion is operational
efficiency. It is no surprise that many
managers interpret this rule to mean
‘the lower the cost base the better’.
When pressures on margins increase,
better execution implies even lower
costs. ‘Managerialism’ has a built-in
bias to interpret competition in cost
terms rather than value terms.
On cost competitiveness
Competitiveness, defined as the ability
to compete profitably, is set by the
firm’s strategy, not by its costs. There
are many companies that boast the
highest costs in their industry that are
also the most competitive — such as
Porsche, Prada, Dyson and McKinsey.
Indeed, the most valuable brands in the
world typically combine the virtues of
high cost, high price, highly perceived
quality and high profitability. Low-cost
brands typically underperform their
higher-cost competitors.
The concept of competitiveness is
often misunderstood and misapplied.
If it is to be used at all, then it can
only be applied logically to corporate
strategies, business models or
44 BUSINESS STRATEGY REVIEW Q2 – 2010
what Michael Porter refers to as a
company’s ‘unique mix of activities’.
A cost or an expense cannot be
described as competitive any more
than can a revenue stream or a cash
flow. These are simply the visible
The true test of the
innovative capability
of a firm is that it never
needs to worry about,
let alone wrestle with,
the cost competitiveness
of its business model.
manifestations and inseparable
elements of a strategy. Divorced from
their strategic context, a particular
level of working capital, for example,
cannot meaningfully be called either
competitive or uncompetitive.
The popular managerial
expression ‘relative cost’ is equally
misleading. Comparing your
cost with a competitor’s cost
(a remarkably popular form of
benchmarking) can only be relevant
if both companies are competing with
identical strategies, in which case
01 The new Porsche
Panamera Turbo
02 Ikea: Furnishing the
world on a budget
02
the cost base is carrying the entire
burden of delivering profitability. But
if this is the case, the problem is not
the magnitude of the cost base but
the absence of strategy. The attention
of management should not be
focused on relative efficiency but on
the need for a differentiating strategy.
In short, reliance upon efficiency
usually betrays an absence of
strategy. The rhetoric of ‘operational
excellence’ is generally camouflage
for a dearth of strategic ideas.
The way that firms account
for their performance accentuates
and encourages the bias away
from strategic vitality and towards
operational efficiency. A good
indicator of the general bias that
steers managers to being more
concerned with levels of cost than
with the generation of revenue is
the extraordinary importance that
financial and management accounts
give to costs rather than revenues.
Revenues are normally limited to a
single line in the accounts, as though
fate or some exogenous force had
delivered this income to the company
and the only task for management
was to meet this demand with the
minimum level of cost. By contrast,
costs are typically disaggregated into

numerous lines, as though profitability
depended mainly on how successfully
these awkward and burdensome
penalties on the firm could be reduced.
The role of accounting should be
to understand better the source of
the cash flow. Failing that, it should
at least detect any backsliding to
cost management as a surrogate for
genuine strategy. A useful role for
the finance department could be to
provide lead indicators of any change
in the strategic health, competitiveness
or overall performance of the firm,
focusing particularly on those ‘default
settings’ whereby management resorts
to easy short-term gains that are
rationalised in terms of cutting out
waste but that tend to emanate from
managers who are short of ideas and
out of their depth.
A senior management team that
is unable to formulate a strategy
for making wealth-creating use of
the resources available to it has
every right to reduce the headcount,
provided it starts with its own heads.
Firing others simply on account
of being unable to find gainful
employment for them — which is
the job of senior management — is
all the evidence that shareholders
should require to invite these senior
managers to find work elsewhere.
IDEAS AT WORK The reality of costs
Author
Jules Goddard
jgoddard@dial.pipex.com
Goddard is a Research Associate
A new perspective in the Management Innovation
The art of management is to manage Lab (MLab) and a Fellow of
a business in such a way that the London Business School.
need for operational excellence, Resources
continuous improvement, cost
James Collins and Jerry Porras,
leadership, process redesign, Built to Last, Random House, 2005.
corporate renewal, cultural change
Editors of Harvard Business
and so on is redundant. Moreover, Review, ‘What business are you
the declared pursuit of these in? Classic advice from Theodore
objectives should count as a clear Levitt’, hbr.org/2006/10/what-
admission of managerial failure. business-are-you-in/ar/1
When executives reach for John Kay,
these remedies, you can be sure The Hare and the Tortoise:
that the business has been woefully An Informal Guide to Business
mismanaged and failure cannot be far Strategy, Erasmus Press, 2006.
away. You don’t manage costs, you www.reform.co.uk/Research/
design the business strategy and the tabid/56/Default.aspx.
strategy establishes the necessary cost Tom Peters and Robert Waterman,
base. Costs are an outcome of the In Search of Excellence,
Profile Business, 2004.
strategy, not the goal of the strategy.
Strategy is therefore the skill of Michael Porter,
Competitive Advantage:
staying one step ahead of the need to Creating and Sustaining Superior
be efficient. As soon as the firm starts Performance, Free Press, 1985.
to attract competitors and pressures
on cost start to be felt, a winning
strategy will already have been
invented to ensure that the business
is moving into a new, distinctive and
unassailable market position in which
its quasi-monopolistic power enables
the firm to be a price-maker, not a
price-taker or cost-cutter.
The true test of the innovative
capability of a firm is that it never
needs to worry about, let alone wrestle
with, the cost competitiveness of its
business model. Its creativity and
courage are of a quality that they
immunise the firm against ever having
to resort to such mundane and mind-
sapping activities as cost reduction,
business reorganisation, zero-based
budgeting or change management.
The job of accounting is to keep
the firm honest to this purpose.
Financial accounts should be
designed primarily to pick up signs
of commoditisation at the earliest
possible stage, before strategic
damage is done, by detecting
any backsliding to policies such
as downsizing, restructuring,
outsourcing or, indeed, any other
management fad that serves only to
damage the firm’s strategy.
Time spent on strategies of cost
efficiency is time stolen from the much
more important and wealth-creative
activity of innovation, differentiation
and entrepreneurship.
Q2 – 2010 BUSINESS STRATEGY REVIEW 45