Reducing Costs Does Not Always Increase Profits

To be blunt, taking measures at cost reduction is often a naive way of trying to increase profits. It’s not that there’s no place for it, but it’s typically first-level thinking that fails to see the big picture.

It’s like rent control in government: on the surface, it looks like controlling what rental properties can charge will keep prices down. But ultimately what it does is decrease the incentive for people to rent property, thus creating a housing shortage. This has been the well documented outcome in cities like New York and others, all over the world (see Thomas Sowell’s Basic Economics: A Common Sense Guide to the Economy for a great treatment of this).

The reason is that cost reduction measures often cut into the very things that produce the revenue for a company — including intangibles such as employee morale. (Yes, employee morale translates into revenue because it results in employees going the extra mile, treating customers better and more proactively, generating ideas that can enhance productivity and performance, and is even a more effective way to reduce costs because it reduces turnover.)

Here’s what Jeff Pfeffer has to say on this in What Were They Thinking?: Unconventional Wisdom About Management:

In case you haven’t noticed, in spite of the many rounds of wage cuts, the major airlines have continued to lose market share to the discount carriers such as JetBlue and Southwest and have continued to bleed money. . . . That’s because the solution management seized on — cutting workers’ pay — actually doesn’t do very much to make organizations more profitable and competitive or even, in some cases, to reduce costs.

Instead, cutting employee wages often worsens company problems. Hourly rates of pay simply don’t do nearly as much as most people seem to believe to determine a company’s — or even a country’s — competitive advantage. That’s because wage rates are not the same thing as labor costs, labor costs don’t equal total costs, and — in many instances — while it is n ice to be low cost, low costs and profits aren’t perfectly correlated either. . . .

The competitive success of airlines such as Southwest, Alaska, and JetBlue depends on lots of things besides wage rates. For a start, it’s nice to be able to offer customers a product or service offering they actually want to buy. . . .

Virgin Atlantic Airways has consistently pursued a strategy of offering more amenities and better service for both its business-class and economy fares, and has generated a profit when other airlines have struggled. After further upgrading its business-class seats and service in 2004, the carrier reported a 26 percent increase in business-class traffic for the fiscal year ending in February 2005. . . .

In the automobile industry as well, profits depend on more than just costs. Profits are also affected by brand image and product design and quality, all of which affect how much people are willing to pay for a car.

There is much more to being profitable (or, for a non-profit, having the funding they need) than cutting costs and being efficient. Often, the things that are most efficient — such as making sure employees feel that they are valued and respected and treated well — appear inefficient at first. But that’s just a short-term perspective. In the long-term, these “inefficient” things are actually more efficient, because they are the best prevention of the truly large and inefficient costs of high turnover and low quality.