Most companies don’t earn returns that exceed their cost of capital over the long term, even in “normal” times not disrupted by a global pandemic. Now, as organizations reset business strategy post-COVID-19, CFOs may be shocked to learn that trusted approaches to prioritizing investment and resource allocation are unlikely to drive long-term value.
CFOs commonly prioritize funding initiatives based on business cases they can comfortably measure. Those business cases are often tied to initiatives meant to help the organization become more adaptive to its competition (and other external factors). But the current environment is too high-change to adapt effectively. As a result, business leaders — enabled by CFOs — chase fleeting opportunities that fail to deliver value systematically over time
If you do what your competitors are doing, you won’t earn excess profits. And yet companies fall into this trap over and over
CFOs who instead invest in and protect costs associated with differentiation increase the odds that their organization realizes value from investments by over 42% — which translates into a full 6 points of excess return over a three-year period.
“The differentiation approach isn’t what CFOs are used to, especially now,” says Jason Boldt, Senior Director, Gartner. “They’re encouraged by everyone — from outside media to internal peers — to be more adaptive and responsive to the external environment. They become obsessed with copying competitors and investing in the same activities.”
Business case doesn’t equal value
The external view is familiar and comfortable for CFOs and business leaders. When a business leader makes the case for launching new products and services, or moving into new geographies to secure top-line growth, CFOs can easily check the box on financial-return metrics.
But just because business leaders are advocating for an investment, and competitors are doing the same, that doesn’t necessarily mean it’s worthwhile. Such strategies could create value for the company, but not always.
CFOs may lack the domain knowledge to argue — or to understand the organization’s points of differentiation
“We found that even if you become the most responsive company to your external environment, it has no impact on your ability to create value as an organization over the long term,” says Boldt. “That makes economic sense; after all, if you do what your competitors are doing, you won’t earn excess profits.”
And yet companies fall into this trap over and over again. Post-pandemic, for example, it will be especially tempting to expand footprints or business activities by acquiring assets devalued during the crisis. But seemingly inexpensive M&A doesn’t ensure long-term value.
“Everyone’s talking about deal fervor right now, but huge competition for every acquisition will just drive up bidding — and that extrinsic focus could actually destroy value over the next three to five years,” says Boldt.
Read more: 3 Hallmarks of Standout CFOs
Understanding competitive differentiation
Focusing resource allocation on differentiation can be challenging, though, especially as it may mean pushing back on business leaders who want to undertake growth investments for which they seem to have a decent business case.
CFOs may lack the domain knowledge to argue — or to understand the organization’s points of differentiation — even when they understand the value proposition of the business.
That knowledge is key, however, to the way CFOs approach their role as resource brokers. For example, the discerning CFO of a luxury hotel would seek to understand what aspects of the brand drive higher willingness to pay, and align investment and the asset base around those factors. Cutting such spend would choke the business model.
Some differentiators lie in intangibles such as the brand example above, or capabilities such as unique intellectual property and knowledge beyond what is needed to simply expand an existing product or service. But differentiators are also prevalent in tangible assets, such as patents and technology, or large fixed assets that create barriers to entry in a geographic or product market.
Skeptical CFOs can use some common high-level metrics to substantiate points of differentiation. Examples include:
- Ratio of market share to defined constraints, i.e., the higher the better
- Elasticity of pricing — especially the ability to charge higher prices than competitors or to sustain lower prices more profitably than competitors
- Customer acquisition costs, i.e., below that of competitors
- Cost of production, i.e., sustainably lower than competitors
A new toolkit for evaluating resources and costs
To make sure that resources flow to areas of unique differentiation, develop guardrails that steer business leaders to invest in and protect sources of differentiation.
Be open to new ways of guardrailing and pressure-testing resource allocation, rather than falling back on old constraints around cost and revenue assumptions. Two key steps are:
- Unravel complex interdependencies between costs. It’s hard to know whether a cost supports a point of differentiation, so make sure strategic cost categories that are directly tied to points of differentiation have a business owner who identifies, protects and advocates for resources.
- Surface productive spending limits. It’s hard to know how much cost to invest in a point of differentiation, and under- or overinvesting harms reinvestment efficiency and profits, so set limits rather than absolutes on spending.