Why Value Beats Costs: Simple Maths

Today I’m going to step through why a focus on costs is a dumb thing for IT to do. Or any business, for that matter.

In my consulting work, in conversations at trade shows, and just generally, IT management have a frustrating tendency to focus on costs. “Doing more with less” is so common a phrase it’s become cliché.

Vendor presentations usually stress the cost-saving aspect of whatever it is they’re doing. They know their audience responds to this idea more than others, and it’s an easy sell to say “we’ll save you X floor tiles if you rip out your old gear and put this in instead.”

There are loads of assumptions built into that statement, not least that the new gear is a perfect substitute for the old stuff (i.e.: a commodity) which it isn’t. One way to tell is by the margin: commodities don’t have gross margins above 30%. Think flour, not disk arrays.

I’ll go into that in more detail another time. Today, let’s use some simple maths to explain why a focus exclusively on costs is stupid.

Spreadsheets For Fun And Profit

Let’s take a fictional business that makes $100 in revenue, and has costs of $50, leaving it with a healthy $50 net profit.

There are two ways to make more money: reduce costs, or increase revenue. Duh.

So let’s do what 98%1 of managers spend all their time doing: cut costs. Let’s go wild and cut them by 10%!

Now our costs are $45, revenue is still $100, and our net profit is now $55. Woo! We’ve just increase net profit by 10%! The same amount we cut costs by. Bravo! Bonuses for all!

For the sake of completeness, let’s go wild and crazy and look at increasing revenues. Let’s go insane and raise them by the same 10%, but keep costs the same.

Now revenues are $110, and costs are still $50, so net profit is $60. Not too shabby. But hang on, that’s a whopping 20% increase in net profit! Huh? What’s going on? Here’s a table showing the results:

Baseline Change Costs Change Revenue
-10% 10%
Revenue: 100 100 110
Costs: 50 45 50
Net Profit: 50 55 60
change in profit: 5 10
10.00% 20.00%

This simple maths is telling us that it’s harder to get an increase in net profit by cutting costs than it is by increasing revenues. In fact, we had to work twice as hard to get the same result. That’s because revenue is a bigger number, so 10% is a bigger amount. Obvious, right?

Why Focus On Costs?

Why does everyone focus on costs if it’s so obviously the hard way? I contend that it’s mostly due to the availability bias: managers feel they understand their costs better than their revenues. And largely, that’s true, though it shouldn’t be.

Costs are easier to measure because they’re more obvious. With costs you just add up your supplier invoices in a spreadsheet, et voilà! It’s possible to measure value as well, but most people don’t have the foggiest idea how. With value, you have to understand what customers actually want and put a price on it. That sounds hard, so let’s just throw up our hands and not bother, yeah? Now costs are more available when managers think about what they can effect, while revenue is mysterious and difficult. Human nature being what it is, managers go for the obvious and seemingly easier option: a focus on costs.

What’s not obvious is that reducing costs isn’t as easy as it appears. Not all costs are equal: customers care more about some things than others, because that’s where the value comes from. Cut the wrong costs, and your quality will suffer, or timeliness, or lead times, or something else that customers value. You end up reducing your costs, but you also reduce your revenue, and as we’ve seen, that has much more impact on your net profit than reducing costs do. So you can cut costs and lose money.

Let’s cut both costs and revenue by the same percentage. Revenues are now $90, and costs $45, so we’re actually making 10% less money now. Whoops! In fact, if our cost cutting reduced revenues by a mere 5%, we would have been better off doing nothing.

  Baseline Change Costs Change Revenue
-10% -10%
Revenue: 100 100 90
Costs: 50 45 50
Net Profit: 50 55 40
change in profit: 5 -10
10.00% -20.00%

It’s even worse

But what if your costs aren’t exactly 50% of revenue? What if they’re a bigger proportion of revenue? Let’s look: let’s set costs to 80% of revenue. Now a cost reduction of 10% gives us 40% extra profit! But look again: increasing revenue by 10% gives us a 50% bump in net profit, so it’s still bigger, and by 10% from our baseline net profit.

Baseline Change Costs Change Revenue
-10% 10%
Revenue: 100 100 110
Costs: 80 72 80
Net Profit: 20 28 30
change in profit: 8 10
40.00% 50.00%

Let’s look at the alternate view: where costs are less than 50%. Maybe only 20%. A 10% cost reduction only gives us 2.5% additional net profit, but 10% extra revenue gives us an extra 12% net profit, also bigger by 10% from our baseline net profit.

Baseline Change Costs Change Revenue
-10% 10%
Revenue: 100 100 110
Costs: 20 18 20
Net Profit: 80 82 90
change in profit: 2 10
2.50% 12.50%

If you’re a low margin business (high costs as % of revenue) then cutting costs can make a big impact on the bottom line. Not as much as growing revenues the same percentage (without changing costs), but still a lot. The trick is knowing which is harder for you: cutting costs that customers don’t care about, or growing revenues?

But if you’re a high margin business, cost cutting at the expense of growing revenue is insane.

Know Thyself

It’s important to have a good grasp of both sides of this equation: costs and willingness to pay. For an IT organisation, that means understanding your customer and the value you provide to them, in quantifiable dollar terms. It is possible.

And then you need to understand the relationship between them. Without that clear understanding, you can’t know what impact cutting certain costs will have. If you cut costs the wrong way, and reduce your value, you piss off your customers who will replace you as soon as something better comes along. Shadow IT, BYOD, outsourcing, these are all symptoms of cutting the wrong costs while totally ignoring value.

You also need to have an honest understanding of your own organisational capabilities, and of yours personally as a manager. How good is your customer service, really? Are your staff happy and motivated, and love their jobs? No, seriously. Do you really have any idea how to do process improvement?

Get real about your level of understanding and get help. Most IT organisations have a poor understanding of their cost structure, let alone what value they provide or what their customers want.

There are known ways to figure it out, and I’ll attempt to shed some light on them in future posts.

1 This statistic, like 47% of all statistics, is made up.

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