Cost-Cutting Era Is Over, in Business and Government: Conor Sen

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(Bloomberg Opinion) — Whether it’s teacher salaries, physical retail stores or packaged goods companies, strategies based around cost-cutting are backfiring left and right. Last week, Kraft Heinz became the latest example, as its shares plunged following weak earnings and guidance.

Cost-cutting is an inevitable fact for most organizations, and it was a common theme in the U.S. over the past 15 years or so. A good starting point for this era might be the merger of Sears and Kmart in late 2004. At the time they were two cash-rich, profitable retailers that had grown stagnant compared with big box stores like Target and Walmart and the emerging e-commerce industry. The thinking was that by combining the struggling rivals, “inefficiencies” could be wrung out of the firms, freeing up cash to invest in growth or return capital to shareholders.

Later on, other retailers used the same kind of thinking in the face of e-commerce threats to cut back on in-store investments in favor of stock buybacks and dividends. There’s a certain logic to this thinking: If physical retail spending will be flat at best, with most consumption growth from e-commerce, then why invest in stores? Why not just return capital to shareholders instead?

Packaged goods companies adopted the philosophy too. With consumer staples like beer and ketchup you had mature markets and slow growth, but reliable demand for long-established brands. If you can’t get people to consume ever-larger quantities of beer and ketchup, the obvious way to grow profits is to keep searching for ways of cutting costs. 3G Capital evangelized the most radical version of this philosophy, called zero-based budgeting. Here, rather than looking to cut a certain amount of costs out of a firm, they started at the other end, assuming a starting budget of zero and forcing every cost to be rationalized. This allowed them to cut costs faster and more deeply than had been done before, resulting in huge short-term gains in profitability.

Cost-cutting religion spread to the public sector at the state and local level in the aftermath of the great recession, with government employees like teachers taking the brunt of it. Unlike the federal government, states and cities can’t print their own money and have to balance their budgets. Reduced economic activity led to weaker tax receipts, which led to painful spending cuts and salary freezes for public sector workers. When the unemployment rate was high, government employees were probably thankful just to keep their jobs and would tolerate going without pay raises for a while.

That works – for a while. Now we’re seeing the pain points of a strategy that may have made sense for organizations from the mid-2000s through the mid-2010s, but doesn’t fit the conditions of the late 2010s. Years of under-investment in firms have taken their toll on retailers and packaged goods firms as competitors and challengers who have made those investments have come out ahead. Walmart and Target have made investments that Sears and Kmart did not. The former will survive, and the latter will not.

Changing food tastes exposed a flaw in the cost-cutting strategy 3G Capital used to manage Kraft Heinz, as a lack of investment in their brands has led consumers to migrate to competing products. Freezing pay and hiring in the public sector can stabilize budgets temporarily, but eventually that leads to labor shortages and an inability to hire as labor markets tighten.

Rising costs are a part of the story as well. While overall inflation and inflation expectations remain around 2 percent, cost growth for freight and transportation, certain raw commodities, and low prerequisite service labor has been rising faster than inflation overall. For retailers and packaged goods firms, rising costs and falling demand are devastating for profits. For public sector employers when the cost of hiring people is rising faster than tax revenues, that means either raising taxes to find the money to hire or accepting gaps in service.

For a decade, organizations operated in an environment where cost-cutting was a sensible or necessary strategy. But the environment has changed, and now the choice may be to invest or die.

Conor Sen is a Bloomberg Opinion columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

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