Published: 20 January 2021
Analyst(s): Finance Research Team
Declining profitability and rising capital costs have destroyed value across the past decade. This research will help executive leaders learn how leading organizations are optimizing costs — by investing and cutting — to realize long-term value.
This research has been adapted from, which helps CFOs optimize costs that enable their firms to realize long-term value.
Gartner research into what drives profitable growth shows leading organizations — those that outpace their industries in revenue growth and margin expansion over a decade-long period — derive advantages from objectively different cost structures than their closest competitors. In particular, they consistently exhibit:
Lower cost of goods sold (COGS)
Higher operating leverage from sales, general and administrative (SG&A) costs
Denser geographic operating and customer footprints
More concentrated growth investments
Fewer products and services as stock keeping units (SKUs)
Over the past decade, the percentage of large global organizations earning returns above their costs of capital declined from 38% to 31%. Creating long-term value is a balance between three factors:
Growth — How much top-line growth an organization can capture in its addressable markets
Profitability — How much top-line growth is converted into operating profits
Reinvestment efficiency — How much reinvestment is required to generate top-line growth
The problem is difficult to solve not only because executive leaders have to balance growth, profitability and reinvestment efficiency but also because their cross-functional peers must align around these goals with interdependent activities, resources and objectives.
Another key challenge is that executive leaders focus on adapting the cost structure to extrinsic factors. Gartner’s research shows that this has zero impact on an organization’s ability to realize long-term value. Moving from the bottom decile of effectiveness — a mediocre and inconsistent ability — to top decile, superior adaptiveness drove a 0% improvement in value realization. In other words, adaptiveness to extrinsic factors is a baseline requirement, not a pathway to performance.
This is puzzling, as adaptiveness has seemingly become a hallmark of good management. The reality is that while adaptive cost structures lead to more responsiveness and flexibility in decision making, they also lead to herd behavior and scope creep.
Today’s operating environment is high-change; unexpected geopolitical and social events, disruptive technologies and the speed of competition make it difficult to keep up. Allocating investment and costs based on these factors increases organizations’ fragility; this fragility is costly, and unexpected events force these organizations to take drastic action to keep their organizations operating.
An alternative approach to investing costs and managing profitability, followed by progressive organizations, is to differentiate the cost structure — intentional changes in which costs are and how much cost is invested in the cost structure — based on a set of intrinsic factors:
Organizations create or acquire assets that form the foundation to pursue growth opportunities. These “assets” may or may not show up on a balance sheet, but they are the foundation from which executive leaders launch and capture growth opportunities. In some businesses, this may be fixed manufacturing resources that enable scale and continuous improvement, or control over a physical resource or service location. For digital companies, this may be extremely high fixed costs to create a two-sided network and near-zero marginal transaction costs of revenue.
Organizations invest to create differentiating capabilities, enabling them to develop value propositions for customers that endure through time. The evidence of a differentiating capability is straightforward: A competitor would struggle or fail to create the capability if they tried. Two differentiating capabilities that do not pass this test are people and technology. While people are critical, they are always up for hire to competitors and other organizations. Mechanisms to retain talent are critical for high-performing organizations, but they are not an enduring source of differentiation. Likewise, licensed technology that is unprotected by patents is equally available to competitors. Organizations differ in how effectively they utilize technologies, but again, this is not an enduring point of competitive differentiation. People and technology enhance and enable differentiating capabilities but are rarely the point of differentiation in isolation.
Realizing value depends on a high degree of internal alignment on which costs create value. At high-performing organizations, both midlevel and senior managers are aligned on which costs they need to protect to capture opportunities and realize value. This becomes especially important in highly matrixed and distributed organizations with many interdependent budgets and processes, where misalignment can inadvertently undermine competitive strategies or create entirely new strategies by default. Executive leaders who achieve a high degree of internal management alignment can more effectively structure costs around internal points of differentiation, avoiding harmful resource trade-offs.
Gartner’s research that involved moving from the bottom decile of performance to the top decile resulted in a 42% increase in long-term value realization. A cost structure rooted in differentiated intrinsic factors enables executive leaders to drive long-term profitable growth at returns above the cost of capital. The economic payoff is high — over six percentage points of excess return compared to competitive peers’.
In a high-change environment, structuring costs around intrinsic factors of differentiation increases resilience to unexpected events. Rather than a vicious loop of reactive decisions, a differentiated cost structure becomes a platform from which to leverage any operating environment.
In some cases, unexpected events can completely undermine a point of differentiation. While this situation is rare, executive leaders must ensure their direct reports fully understand if and how the organization can invest to protect and reestablish differentiation. Without starting from the point of differentiation, executive leaders will inadvertently reinforce herd behavior in both investing and managing profitability.
A differentiated cost structure has three types of costs (see Figure 1):
Executive leaders who seek to create differentiated cost structures face three barriers:
It’s hard to know whether a given cost creates or enables a point of differentiation. Modern organizations are complex, matrixed entities with substantial interdependencies. Executive leaders who drive cost categorization risk inadvertently harming a point of differentiation through changes to the cost structure.
It’s hard to know how much cost should be invested in a point of differentiation. The risk of getting this question wrong is that overinvesting harms the efficiency of reinvestment and decreases returns, while underinvesting in a point of differentiation makes it easier for competitors to replicate and eliminate the advantage.
It’s hard to know when to accelerate, reduce or eliminate investment. In the long run, all points of differentiation evolve or are eliminated by market forces. The risk of getting this question wrong is prematurely abandoning or unprofitably entrenching in lines of business, products or services, or parts of the industry value chain.
To overcome these challenges, executive leaders should:
To build and protect points of differentiation, executive leaders must adapt their cost optimization approach to recognize which costs are commoditizing, enabling and differentiating, and disproportionately invest in the latter.
Economic headwinds force organizations to focus on cost reduction and present an opportunity to differentiate performance from peers. This research helps executive leaders avoid common cost optimization errors as they take critical actions to improve their organization’s financial health and grow.
In response to the economic uncertainty unleashed by COVID-19, executive leaders are rethinking budgets for the rest of 2020. This research provides options to adjust budgets for short-term resource allocation decisions.
The Business Value Model is a set of common business outcomes across traditional and emerging business models. Executive leaders can use the corresponding catalog of leading indicators, connecting dependencies to desired business outcomes for planning and reporting, to guide investment decisions.
Executive leaders should optimize risk, value and cost in a business context through the lens of key stakeholders’ needs. Doing so will strengthen business cases, funding requests, committee reviews and board reporting to support the achievement of business outcomes.
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