In the middle of the 2008 recession I spoke to the leadership team of a large company and asked them how many of their units were facing budget cuts?
So they all laughed nervously and raised their hands. I then asked how many of them had seen their budgets increase? And they laughed again and this time no one raised their hands.
I then asked them if this situation was good or bad? They did not understand my question and responded with a puzzled look. I said, let me explain.
If you are not increasing your spending in any domain at this time then it means you are not sowing the seeds for future expansion. You are not going after anything. Instead, what you are doing is falling into the trap most businesses fall into when the going gets tough, which is to simply play defence and cut back across the board with the intention that we must live to fight another day. All this is in the face of evidence that perhaps the best time to leap frog competition is when markets are down and not up. And yet, we back away precisely at the time when we should not be doing so. The point I was trying to make was that the thought that they should be going after markets or attacking competition, just hadn’t crossed their minds.
Then I took a step further and asked them, who is in charge of budget cuts at this time? And everyone pointed to the finance function. I said if finance is responsible for the allocation of scarce resources, a question to ponder is what do they know about customers and markets and what customers want or don’t want? Furthermore, the preferred approach for budget cuts was the proverbial cheese slicer approach where each unit was impacted equally. In doing so, they were now allocating their limited resources with limited knowledge of customers or markets.
If we look at this example very objectively, there is something terribly wrong here. The company was not attacking their market in an environment where everyone else was not doing so either. And the person/division of the company that was cutting back had no idea what the customers wanted.
I think the realisation here is that in a low growth and turbulent environment most companies go into pure defence, where the entire focus is on how do we survive and wait to fight another day. The only thing the companies can think about is cutting back on costs. But does this really work?
I along with my Nitin Nohria (of the Harvard Business School) and Franz Wohlgezogen (of the Kellog School of Management) wrote a piece titled Roaring Out of Recession for the Harvard Business Review, which was published in 2010.
In this piece we looked at corporate performance during the past three global recessions: the 1980 crisis (which lasted from 1980 to 1982), the 1990 slowdown (1990 to 1991), and the 2000 bust (2000 to 2002). We looked at 4,700 public companies and studied their performance in three periods: the three years before a recession, the three years after, and the recession years themselves.
And the results were rather interesting, which went against conventional wisdom. Companies that focus on cutting costs and cut costs faster than competition don’t necessarily flourish when the recession gets over. In fact, we found that only 21% of such companies did better than competition when times got better.
An excellent example of this is Sony, which announced a cost reduction target of $2.6 billion in December 2008. The company planned to close several factories, fire employees and delay investments into newer technologies, as a part of the plan.
This strategy was similar to the one followed by the company during the 2000 downturn, when the company cut its workforce by 11%, its R&D expenditures by 12%, and its capital expenditures by 23%, over a two year period. This helped the company increase its profit margins briefly, but sales tumbled.
While Sony managed to boost its profits briefly, it has struggled to retain momentum since then. It has tried developing new products like electronic book readers, but these markets have been taken over by swifter rivals like Amazon.
The trouble with concentrating totally on cost cutting during a recessionary or a low growth environment is that managers approach every decision from a lens of minimising costs. The other thing that happens is that those responsible for resource allocation decisions frequently have no idea of either the customers or the various markets the company operates in, and prefer to make across the board cost cuts. This leads to the company paying no attention to initiatives which might lead to future growth.
Also, it is worth remembering that there is a collective paradox here: when everyone is playing defence, what should you be doing?
But pure offence does not work either. Being overly aggressive during a recession, and ignoring early warning signs like customers clamouring for lower prices, is not viable either. In fact, we found in our research that such firms stand only a 26% chance of becoming leaders after the downturn has ended.
An excellent example of a company that became a victim of being too aggressive in a recession is Hewlett-Packard. At the height of the recession that followed the dotcom bust in 2000, the company under the leadership of Carly Fiorina, drew up an ambitious change agenda. As Fiorina put it “In blackjack, you double down when you have an increasing probability of winning. We’re going to double down.”
Among other things, the company bought Compaq for $25 billion, spent $200 million on corporate branding and also went about spending $1 billion on expanding the availability of information technology in developing countries. These initiatives strained the organisation and spread its resources too thin. After the recession ended, and growth returned, the company couldn’t match the profitability levels of its competitors like IBM or Dell.
So pure offence does not work and neither does pure defence. What works is being able to selectively blend both. The key is how do you learn to play defence and offence at the same time. What you do is you say that I am going to cut back more than I need to do in some areas and I am going to expand in some areas. The trick is to learn how to spend more by spending less.
What I am proposing is a zero budget answer. In order to spend more you have to spend less. Before you can spend more you have to figure out what are the things that you are doing that do not add any value to the customer. And you will be amazed how many inefficiencies actually pop up. Taking a disciplined approach to resource allocation that is informed by a deep understanding of what customers value or not become the key to success. Cost cutting has to be done in a disciplined methodical way because its remarkable how many things organisations do that are not value adding to customers. So that is the starting point.
But politically it is very challenging to do this in an organisation. Are you going to tell three people that I am cutting back your budget and then tell one person that I am increasing your budget? Instead many organizations prefer an egalitarian way, where we want to share the pain equally. Everybody gets to cut back on their budgets equally.
A deeper issue that holds back organizations from leveraging such opportunities is their inability to truly engage with their customers and markets. Something that should be the foundation of every business of being customer centric doesn’t materialize very easily. And the problem isn’t usually the lack of market knowledge. Its usually embedded in the organization itself. The devil here is inside and not outside the organization! Most large organisations are built around production and distribution. You organise around product to make sure that you are intensely focused on developing and selling outstanding products. You organise around geography to be able to effectively distribute those products. And you add into this mix your functional organization that is created to be efficient and build deep expertise within key functions. But somewhere in this whole equation the customer gets lost. The bureaucratic morass here impedes are abilty to operate in concert to take on difficult markets.
Very few companies master the skill of playing offence and defence and doing so in a way that is centreed around their customers. In our research we found that only 9% of all companies came out of a recession stronger than before. These chosen few outperformed industry rivals by at least 10% in terms of sales and profits.
These select few companies re-examined almost every aspect of their business model. They looked at how they have configured supply chains and structured/reduced their operating costs on a permanent basis. This ensured that when demand came back again, their profits grew faster than their competitors. Also, money that was saved in one area was invested in another area.
A good example of this is Staples, an American office supply chain store , and how it withstood the 2000 recession. It closed down many underperforming facilities but at the same time increased its work force by 10%, in order to support the high product categories and services it introduced. The company also contained its operating costs and came out of the recession much stronger and more profitable.
The sales of the company more than doubled from $7.1 billion in 1997 to $14.6 billion in 2003. In comparison, the sales of Office Depot, another office supply company, went up by about 50% from $8.7 billion to $13.4 billion, during the same period. In fact, Staples was 30% more profitable than Office Depot in the period of three years that followed the recession.
To conclude, I would say you never want to waste a good recession. But the only way you don’t waste a good recession is if you realise that you need to use this to leapfrog everybody else. Getting ahead of competition during an up market is much harder. If you are wasting a recession you are wasting an opportunity.
Ranjay Gulati is the Jaime and Josefina Chua Tiampo Professor, the Unit Head of the Organizational Behavior Unit, and the Chair of the Advanced Management Program at Harvard Business School. He is also the author of Reorganize for Resilience: Putting Customers at the Center of Your Organization (Harvard Business Press, 2009)
The column originally appeared in the Business Today edition dated January 19, 2014
(As told to Vivek Kaul)