Published: 23 April 2020
Analyst(s): Finance Research Team
COVID-19 has introduced massive economic disruption. Despite this threat, CFOs may encounter internal resistance to change that makes it difficult to respond to these circumstances. Our research has identified strategies CFOs can use to respond to this inertia.
With millions of job losses in the U.S. alone, collapsing oil prices, rapid declines in corporate revenue and growing liquidity concerns, COVID-19 has introduced fears of an economic depression. CFOs are preparing for cash flows to stop in the second quarter and face high uncertainty about when a recovery will occur. Yet, many CFOs encounter senior decision makers who underappreciate the timing and materiality of these economic changes and behave as though conditions are not as stark as reality. This resistance arises from the mental momentum of business managers who are reluctant to cut costs out of fear it would dismantle teams and projects they have spent years putting together. Our research has identified strategies CFOs can use to respond to this inertia.
The mental momentum of business managers who want to stick with a previously winning formula is one of the biggest challenges CFOs face during the downturn caused by COVID-19.
One of the primary causes of this mental momentum is weak financial processes that do not frame the situation in an intuitive way, so management’s understanding of the business economics created by the COVID-19 downturn is limited.
CFOs need to ensure there is consistent messaging surrounding the economics of the COVID-19 pandemic and the company’s response, so finance, investors, the board and business management are all on the same page.
In response to the COVID-19 downturn, CFOs need to stay a step ahead of the business and determine which cost reductions to make and when to roll back austerity measures after the immediate crisis has passed.
To tackle the problem of mental momentum in the context of COVID-19, CFOs should:
Develop a general theory of value creation and a narrative approach to forecasting to constantly refresh management’s understanding of how COVID-19 has changed the company’s business economics.
Communicate the company’s changing business economics to investors and the board to ensure a shared understanding of the market impact of COVID-19.
Categorize business lines into those subject to cost reductions and those with growth potential, even during the COVID-19 downturn, to avoid undercutting productive business lines.
Assess risk tolerance and risk appetite to determine when it is time to return to normalcy and which austerity measures to keep in place once the crisis is over.
In this research, the term “recession” refers to (1) a macroeconomic recession that may or may not be localized by geography and industry in its effects or (2) a structural downturn in an industry that is caused by external factors management cannot control. In some ways, a macroeconomic recession can be easier for CFOs to handle than a structural downturn. In the latter case, CFOs often face the challenge of persuading management teams that the economic reality of the business has changed, even though the macroeconomic environment remains healthy. Currently, the COVID-19 downturn is following the former course, as it has shut down large parts of the economy across multiple geographies and industries.
The COVID-19 crisis has created an unprecedented drop in corporate earnings, with the most severe effects felt in the travel, entertainment and other consumer industries. For many companies, even those that experienced double-digit growth as recently as 4Q19, sales growth for 2020 is expected to be negative. In the face of this rapid decline in revenue, CFOs must convince management teams that financial strategies need to change for the business to survive — for everything from budgets and investment priorities to customer and supplier payments.
Even under these urgent circumstances, however, CFOs may face the problem of mental momentum. Management’s appreciation of the new economic and financial reality often lags behind that of the CFO and finance by weeks or months, depending on its experience with recessions and financial management. As a result, CFOs often have to invest time explaining how the rules for success during a downturn are different from during economic expansion. The responsibility of the CFO under these circumstances is to make sure everyone in the organization is on the same page in terms of the economics they are facing. CFOs need to interpret the economic situation, identify how the company should act differently and educate the business on what it needs to do, including when to move away from recessionary measures.
Prior to the beginning of an economic downturn, the best strategy for solving the mental momentum problem is to lay a proper foundation that does not allow the problem to exist in the first place. CFOs can prime business management to periodically rethink broader economic conditions by carefully choosing financial interventions with the business and using their authority sparingly during the growth phase of the business cycle.
Figure 1 models the CFO’s role in financial strategy based on the map used by Nielsen in 2010. Each node represents a potential point where the CFO can make a financial intervention to improve performance. To identify if intervention is necessary, CFOs track financial performance and its drivers, which show when value creation becomes suboptimal.
In periods of economic growth, CFOs’ interventions should be restrained. CFOs should focus on forecasting and performance oversight to lay the groundwork for effective performance management. During recessions, however, CFOs should make interventions on a tighter schedule, as management tries to rapidly triage emerging risks and develop appropriate responses. CFOs and finance should pressure-test management’s decisions about tactics like capacity reduction, cost cuts and recovery preparations.
With this in mind, the following structure describes the measures that effective CFOs should take before and during a COVID-19 downturn.
Sensing a downturn:
Arrive at a general theory of value creation.
Adopt a headwinds and tailwinds forecasting model.
Responding to a downturn:
Communicate changing business economics to investors and the board.
Take a feast/famine approach to cost cuts.
In the recovery, be highly discriminating about which austerity measures to end and which to leave in place.
Due to data constraints, there is typically no perfect way to develop a recession early warning system. In the last 20 years, the U.S. has endured only two official economic recessions: the bursting of the domestic technology equity bubble in 2001 and the global liquidity crisis in 2008. Because the causes and consequences of these events were completely different, they have not provided reliable predictive data. Even with the current economic disruptions caused by COVID-19, it remains to be seen how extensive a recession will occur.
Although recessions are unpredictable, there are strategies a CFO can use to identify weak performance trends and accelerate the company’s response during the COVID-19 downturn. First, CFOs should develop a general theory of value creation and monitor it to quickly assess performance anomalies. Secondly, CFOs should add a narrative layer onto their forecasting to spell out what is helping or hindering portfolio businesses from delivering on their plans.
A general theory of value creation is a powerful model for visualizing how resources are currently allocated and how that allocation might need to change in response to the new market reality created by COVID-19. One of the most significant challenges in financial strategy is converting and interpreting data formatted for accounting purposes into data formatted for strategy evaluation. This challenge could inhibit a company’s ability to respond to the COVID-19 downturn. However, if a general theory of value creation already exists and is refreshed weekly, monthly or quarterly, time can be saved when revenue dips. By illustrating these relationships, a general theory of value becomes a strong tool for countering mental momentum.
After establishing a general theory of value creation, the next step in addressing management inertia is to transfer this theory to the forecasting process and continually test it against market reality. Stanley Black & Decker has developed a particularly effective strategy for carrying out this activity, which allows the CFO to constantly challenge and reform the business’s understanding of economic reality.
CFOs have a lot of ground to cover in a short period of time when they face an economic downturn. The theory of value creation enables CFOs to determine why business performance is lagging, while the forecast model lets them communicate with the business about performance issues and why a course change is necessary more quickly than if they were relying on backward-looking financials. Together, these tools will help CFOs combat mental inertia in the face of the COVID-19 downturn.
A downturn forces CFOs to quickly adapt to a new economic reality, even as the timing of financial strategy decisions and actions is compressed. While the recent period of economic expansion lasted more than a decade, the financial crisis and recession of 2008 through 2009 spanned only 18 months. It is unknown how long the economic downturn caused by COVID-19 will be, but the situation so far has been changing rapidly. One of the best ways to adjust quickly to an economic downturn is for the CFO to ensure everyone understands the new market reality and responds appropriately. Communication and cost cutting are critical components of any response strategy.
During a recession, CFOs play a critical role in investor communication. They must ensure the investor relations team understands the impact of the company’s changing business economics and that key ideas from the company’s financial value framework are communicated through appropriate messaging. The general theory of value creation is essential during this time because it will help the CFO filter the information that needs to be shared internally and externally as economic conditions change. By using the theory of value creation to guide messaging, the CFO can vet whether it is necessary to disclose more information than normal. For example, during the 2008 financial crisis, investor relations teams were often pressured to provide additional information on financial institution exposure, details on project costs and information on cash conversion in standard investor updates. This information just added unnecessary noise.
Consideration of what information to disclose in investor messaging is critical during the COVID-19 pandemic. CFOs and investor relations teams may once again be pressured to release more information than they would in typical updates. Our research on discussing the impact of COVID-19 with the investment community suggests all companies should adhere to the following best practices (see “How to Discuss the Impacts of COVID-19 With the Investment Community”):
Partner with the marketing and public relations teams to guarantee that any message distributed is clear, unified and consistent.
Avoid trying to predict the future, because doing so offers little upside but exposes the company to significant risk.
Be frank and forthcoming about obstacles the company faces in this situation and acknowledge any challenges head-on.
Explain any mitigation steps the company has taken to reduce the risk and impact of COVID-19 to assure investors that key risks are actively being addressed.
Emphasize business fundamentals and point investors toward the company’s performance record to remind them of its long-term profitability and horizon beyond the pandemic.
Tailor any messaging to audience priorities, whether it’s buy-side analysts looking at the impact on EPS, sell-side analysts concerned about the effects of the crisis on the company’s business fundamentals or the media looking at the human impact of the company’s decisions.
In addition to communicating externally with the investment community, CFOs are also responsible for internal communications to ensure the board of directors understands the economic reality of the COVID-19 situation. During periods of crisis and instability, boards need updates on financial performance on a more frequent cadence. By focusing on the elements of business economics that matter and clearly communicating these to the board, CFOs can help board members understand performance dynamics and relay better advice to the company’s management teams. Board members may fulfill the same roles at other companies and be able to contribute insights from those industries. Alternatively, they may have experience from previous economic downturns that is relevant now. If the management team does not have similar experience, then the board may be an additional resource for addressing the company’s current problems. However, this is only effective if the CFO has done his or her part to ensure everyone in the organization shares the same understanding of the crisis.
Once management teams understand the new economic environment of a downturn, cost reduction becomes one of the most prevalent strategies to shore up financial health. Depending on how well the timing and severity of a downturn have been forecast, cost reductions can either be mild in nature or structural, which cuts into business capacity. In a recent poll of senior financial leaders, most respondents reported undertaking mild cost reductions so far in response to COVID-19 (see Figure 4). The most common cuts are canceling leadership events and off-sites (60% of respondents), freezing hiring (58%), canceling conference spend (58%) and freezing travel and entertainment (T&E) (51%). Some senior financial leaders have also begun making more structural changes, with 49% reporting they have delayed capex investments as a result of COVID-19. These cutting measures will intensify as companies realign budgets with dramatically weaker earnings forecasts for 2020 to 2021.
In some cases, the cost cuts enacted in response to COVID-19 are easy-to-identify opportunities. It’s easy to cut T&E when there is no travel occurring or to cancel conference spend in light of the rules on social distancing. However, other cuts are less obvious. For example, even though the growth of cloud services has meant that more cash is going toward technology operating costs, it is difficult to reduce these costs when most of the workforce is now working from home. CFOs need to develop two competencies to carry out effective cost management during the COVID-19 downturn:
Discovering where excess costs exist within the company.
Developing a framework to differentiate between revenue-driving costs and unproductive costs.
Finance teams with poor cost data will face greater challenges during an economic downturn. Our research shows many finance teams are currently overinvested in analytic support models and have underestimated the critical importance of financial data standards and access. Consequently, most CFOs have strong analytic talent in their FP&A teams but have not yet resolved the fundamental problem of financial data access. A lack of accurate data makes cost management more difficult because it is harder to aggregate costs at the business, product, service and geographic levels. It also complicates any efforts to define the relationships between cost categories and performance variables, like revenue, which are critical steps in cost management.
To determine the quality of current financial data and reporting structures, CFOs should answer the following questions:
How well can financial and nonfinancial managers access cost data?
How reliable is the data?
How timely is the data?
How easily can the data be manipulated to answer a variety of business questions?
How easily can the cost data be combined with noncost data to answer analytic questions, like which costs are strong leading predictors of sales growth?
Even after determining whether they have sufficient cost data to execute a cost management strategy, CFOs still need frameworks to identify where they can reduce expenditures. Two effective frameworks for use during an economic downturn are grading costs based on business value and work type.
Prior to the Great Recession in 2008, P&G deployed a simple and effective cost framework called ZOG, HOG, NOG. These acronyms stand for zero overhead growth (ZOG), half overhead growth (HOG) and negative overhead growth (NOG). P&G’s executive team applied this framework to each of its product lines to set up guidelines around the extent of cost management each product line required.
For brands categorized as ZOG, all hiring was frozen. This bucket included most P&G product lines. The HOG category included high-potential brands in emerging markets. For these brands, funding growth had to occur in line with revenue. NOG product lines were low performers, which needed to be divested or subjected to stringent cost cuts. ZOG and NOG brands feed HOG brands in an example of internal creative destruction under the auspices of the CFO evaluating operating budgets.
P&G’s framework is an invaluable tool because it facilitates smoother and faster internal and external communications about the actions taken during a downturn. At the same time, it combats internal resistance to cost cutting. A financial framework that attributes value creation to different types of businesses can be a critical tool in repositioning the company’s cost allocations during a downturn. In the unique context of the COVID-19 downturn, this framework can be particularly valuable if an enterprise’s product lines are not impacted equally.
Another approach to cost management is identifying cost reduction opportunities based on work type. Although these changes often take more time to implement, they can yield significant cost savings. Most corporate cost-efficiency initiatives try to capture cost savings by introducing structural changes in transactional and calendar-centered work. In these cases, rule-based work is moved into lower-cost shared services centers, outsourced or centralized. These centers introduce further cost savings by introducing robotic process automation. Two other work types contribute just as much to overhead costs but are often overlooked by management: ad hoc work and initiative-based work (see Figure 5).
To understand and size the costs of ad hoc and initiative-based work more effectively, CFOs can pursue two key cost strategies:
Develop service catalogs for high-expense areas. By cataloging services, CFOs and management can more easily identify which activities and departments are driving costs. They can then make cuts as necessary.
Customize budgeting models based on the nature of the work involved in the business or function. Although this approach can make budgeting more complex, a driver-based approach to budgeting will help capture how changing workloads impact costs.
Table 1 offers counterintuitive insights into how CFOs should consider moving into a recovery period as the COVID-19 crisis subsides. Not all cost reductions remain in place forever. For example, rather than simply raising overhead costs again, in line with revenue growth, CFOs should only raise those costs that are critical to sales growth, while capping others.
A critical responsibility of CFOs during an economic downturn is to stay a step ahead of the business. As the recovery phase of the COVID-19 downturn begins, this means keeping an eye on risk tolerance and risk appetite to determine when it is time to roll back austerity measures. In some areas, a quick return to normalcy can give a company an edge over any competitors that remain committed to a more conservative approach. In other areas, such as cost management, CFOs might want to lock in efficiency gains made during the downturn and only let costs back in strategically. As CFOs begin to lead the company out of the downturn, it is important to ensure management teams are on the same page about what cost-saving measures to reverse and which to keep in place.
CFOs can increase the likelihood of success during the current economic downturn caused by COVID-19 by responding to senior decision makers who underappreciate the severity of the current economic situation. CFOs can counter mental momentum by adopting certain financial management strategies. First, they need a general theory of value creation to generate their own understanding of value. Second, they should take a narrative approach to forecasting that captures emerging headwinds and tailwinds, so the value creation theory is constantly tested against economic reality and management teams are prompted to revise their plans.
Once a downturn has begun, the CFO needs to focus on communicating the company’s changing business economics to investors and the board to ensure everyone shares the same understanding of the market impact of COVID-19. As reducing costs becomes a necessary response, CFOs can focus on categorizing business lines into those that should experience significant cuts and others with room for growth.
When the recovery phase begins, CFOs should direct their attention toward intensive financial discipline and use what they have learned about customers, competitors and the business during the downturn to gauge risk tolerance and risk appetite for rolling back austerity measures. Not all austerity plans should be reversed. Some business areas will need to remain lean in the long term, even after the COVID-19 crisis has passed. However, other growth investments and overhead expenses will need to be introduced rapidly and aggressively to ensure the company has a competitive edge as the economy enters a period of growth again.
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