CFOs should avoid peer pressure and build cost strategy around differentiating factors, not competitive trends, Gartner researchers said in a cost structure model analysis released Friday.
Only a third of firms drive returns greater than the cost of capital, Gartner found. Organizations built around factors such as unique competitive differentiators drove a 6% greater 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’ cost models 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 over-committing to well-known trends, such as digital business or artificial intelligence."
CFOs who model their costs around the factors unique to their organizations secure, on average, a greater excess ROIC, Gartner found. They also exhibit more resilience during unexpected events, like the current economic crisis.
Focusing on differentiation is "a way for the CFO to combine competitive strategy and functional strategy to sort out the economics of the business," Boldt told CFO Dive.
"Even before COVID-19, less than a third of public companies we studied were earning returns above the cost of capital," Boldt said. "Our research shows external targets prioritizing growth over profitability often blow CFOs off course. Their targets, because they are externally focused, are routinely disrupted by changes to the macro picture."
In its analysis, Gartner studied 1,142 public companies’ performance over an eight-year period and interviewed several large enterprise CFOs. The pressure to model growth and cost management strategies around matching competitors, they found, leads to "chasing after crowded markets, pursuing dubious trends and deals that boost short-term growth at the expense of long-term value," Gartner said. Among the public companies studied for long-term performance, revenues have improved by 25%, yet reinvestment efficiency and profitability both declined over the same period.
"The last decade has been mostly unprofitable growth," Boldt said. "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 the majority of companies have failed to translate into excess returns on capital. CFOs who follow the herd and chase popular trends suffer when it comes to the most important long-term metrics."
"The way organizations grow efficiently is through scale-enhancing investments," Boldt said. "So how do you get scale? How do organizations reach scale as they target concentration in their portfolios?"
The answer can be complicated; there are no across-the-board points of differentiation. "The true points of differentiation tend to be highly fixed, in terms of nature of cost," Boldt said. "Fixed cost is overhead and support functions; it’s whatever investment lets you create your service or product. They don’t necessarily guarantee revenue or profit."
One example is technology. "When you look at licensed tech, it’s rarely differentiating in and of itself, because it’s often available to everyone" Boldt said. "But tech could be connected to something differentiating." Another example: many executives name employees as their point of differentiation, Boldt added. "Your employees are always up for hire, and they themselves will rarely be the point of differentiation," he said. "It’s usually what they’re building, or working on, that’s the point."
Boldt says conglomerations are the enemy of scale. "The more industries you have, the less differentiation there is."
"A consistent theme is the idea of collaboration across the business; it’s unlikely any CFO will have all the answers for the problems we’ve laid out," Boldt added. "Knowledge of how an organization uses costs for services, from a proposition standpoint, is not a problem CFOs go in the corner room and figure out a solution for. You have to involve all sides of the business."
CFOs seeking a differentiating cost structure face three risks, Gartner said. Firstly, when the business learns CFOs are protecting differentiation-associated costs, everything becomes differentiating to protect the business unit’s budgets. Secondly, budget holders might 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 differentiation costs are critical to protect, and require ongoing assessment to ensure protection. Resourcing the most complex costs with both business owners and finance leaders ensures cost optimization targets don’t inadvertently cut areas of differentiation.
Pressure-test constraints, not budget inputs
To better understand both the lower and upper bounds of useful funding, 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 in differentiating projects.
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.
"CFOs who model costs on differentiators are much more likely to stay on track with their long-term plans, avoid hasty cost-cutting in response to a change in the macro picture and realize value through principled and focused reinvestments built around their differentiators," Boldt said.