CAREFUL WHERE YOU CUT
Computing the long-term cost of slashing marketing and R&D.
By Don Durfee

A few years ago, Steve Player, a Texas-based management consultant, met with the CEO of a US corporation. The executive had mandated company-wide cost cuts of 20% – even though his officers had been paring expenses for years. Player dutifully compiled a list of cost reductions that wouldn’t hobble operations. But the CEO demanded more. Exasperated, the consultant had another suggestion: cut costs by 100% – starting with the CEO’s salary.

“But I add value!” protested the CEO.

“Value?” responded Player. “I thought cost reduction was your only goal. If you want to discuss value, we need to start over.”

For CFOs, the story illustrates a problem most understand intuitively: as an accounting matter, almost any reduction in costs can yield a short-term jump in profits. But get greedy and you can easily inflict long-term harm.

A new study helps quantify the damage. Researchers Natalie Mizik of Columbia University and Robert Jacobson of the University of Washington, analyzed 30 years’ worth of financial data for over 2,000 public US companies. They looked at companies that had done secondary equity offerings and put them into two groups: one group that made deep reductions in SG&A just prior to their offering with the aim of boosting share prices, and another group that didn’t. The researchers then compared their market performance.

As the chart on this page shows, those that made the cuts did indeed see a quick lift in their share price. But as the years went on, the long-term cost of this short-term gain became apparent. Four years after the equity offering, the cost cutters or “myopic firms” saw abnormal stock returns (the difference between actual and expected return) of minus 22.3%. Those that hadn’t cut expenses posted returns of 10.47%.

Mizik and Jacobson, both marketing professors, also argue that most tempting cut to make – to the marketing budget – can be one of the most damaging. In an earlier study, they showed that when marketing achieves brand differentiation and relevance, it has a strong, positive effect on share price. “Firms can cut costs or ‘discretionary’ spending to artificially inflate earnings,” says Mizik. But, according to research, such cuts are even more likely to yield an underperforming stock than managers using accounting tricks to puff up earnings.

It’s not as if most executives aren’t aware that slash-and-burn management can be bad for future growth. The real problem is that incentives are geared around short-term goals, whether annual profit targets or a successful share offering. And until those incentives change, many will continue to pursue a strategy that Steve Player compares with the worst weight-loss plan around: amputating limbs as a way of shedding pounds.