Only a third of firms drive returns greater than the cost of capital, according to a Gartner, Inc. analysis of cost structure models. For those organizations built around factors such as unique competitive differentiators they drove a 6% greater return on return on invested capital (ROIC) over 3 years when compared to those with cost models focused on external factors such as competitive trends.
“Most companies have cost models that respond to factors external to the organization,” said Jason Boldt, research vice president for the Gartner Finance practice. “This might take the form of chasing the same ‘hot’ markets as competitors or overcommitting to well-known trends such as digital business or artificial intelligence.”
Yet CFOs who model their costs around the differentiating factors unique to their organizations secure on average a greater excess ROIC versus those who focus on extrinsic factors. They also exhibit more resilience in the face of unexpected events, such as the COVID-19 economic crisis.
“Even before the COVID-19 downturn, less than a third of public companies we studied were earning returns above the cost of capital,” said Boldt. “Our research shows that CFOs are often blown off course by external targets that prioritize growth over profitability. Their targets, because they are externally focused, are routinely disrupted by changes to the macro picture.”
As part of the analysis, Gartner studied the performance of 1,142 public companies over an eight-year period and complemented this quantitative analysis with in-depth interviews of large enterprise CFOs. The analysis revealed that the factors that influence the CFO in determining how they structure and prioritize costs can have a meaningful impact on value creation and excess economic return.
FOLLOWING COMPETITORS LEADS CFOS ASTRAY
The pressure to model growth, and therefore cost management strategies, around matching competitors leads to chasing after crowded markets, pursuing dubious trends and deals that boost short-term growth at the expense of long-term value. Among the public companies Gartner studied for long-term performance, revenues have improved by 25%, yet reinvestment efficiency and profitability both declined over the same period.
“The story of the last decade has been one of mostly unprofitable growth,” said Boldt. “In many industries, competition for organic growth has intensified, leading many organizations to secure growth through M&A. This boosts short-term growth but adds significant invested capital to balance sheets that the majority of companies have failed to translate into excess returns on capital,” said Boldt. “It’s clear from our research that CFOs who follow the herd and chase popular trends suffer when it comes to the most important long-term metrics.”
DIFFERENTIATED COST STRUCTURES DRIVE VALUE
CFOs seeking to move towards a differentiating cost structure will face three risks. First, when the business gets word that CFOs are protecting costs associated with differentiation, everything becomes differentiating to protect business unit’s budgets. Second, budget holders will potentially ask for increased resources to achieve differentiation. Finally, business leaders may struggle to make appropriate tradeoffs.
To overcome these barriers, Boldt recommends the following approaches:
• Cross-Functional, Not Finance vs. Business – The complexity and interrelatedness of costs that drive points of differentiation are critical to protect and require ongoing assessment from business owners to ensure these costs are protected. Resourcing the most complex costs with both business owners and finance leaders ensures cost optimization targets do not inadvertently cut areas of differentiation.
• Pressure-Test Constraints, Not Budget Inputs – To better understand both the lower and upper bounds of useful funding for a project, finance and business leaders can test both the absolute lowest budget before a project breaks and the maximum funding a project receives before returns diminish. Conducting such an exercise can reveal when a project can start on a “lean” basis and also illuminate opportunities for additional investments.
• Test-and-Learn, Not “All-In” – CFOs should avoid going all-in on differentiating investments until they have sufficient evidence for how specific costs create a point of differentiation and the market outcomes that prove it, such as customer willingness-to-pay.