The death Spiral of cost cutting
Imagine a flight from Brussels to Nice in November appears to be “losing money” because it isn’t filling every seat. If the airline cancels that flight, they might save on fuel and labor costs (baggage handling, admin..). However, they still have to pay the pilot’s salary, the lease on the Boeing 777, and the gate fees. The leadership pulls out the big question mark. Do we still need to keep running this flight?
Similarly, in a manufacturing company, a product line is showing a loss. If we cut the underperforming department, will our overall profit improve?
Before making any cost cutting decision to a product, service, department or customer, we must first analyze cost behavior.
Let’s look at a simple example: Aramis, Athos and Porthos are 3 customers. Should we drop the lose making customer – Porthos?
Dropping “Porthos” (the loss-maker) didn’t fix the problem; it worsened the profits of the remaining departments. The thing is that equipment, rent, and admin expenses are usually fixed costs. If you drop “Porthos”, those expenses do notdisappear; it simply gets reallocated to Aramis and Athos, weighing them down.
This leads to the “death spiral” of cost cutting:
In decision-making, we only care about relevant costs – those that could be really avoidable depending on our decision. In this example, equipment depreciation, rent of warehouse and general admin are not relevant for decision-making, they are sunk costs, as the money is already spent. Whether you keep Porthos or not, that equipment is sitting there losing value.
Last but not the least, don’t forget opportunity costs – what are your alternatives?
Don’t just cut costs – understand them. Otherwise, you might find yourself in the “death spiral” of cost cutting.