When times get tough, revenues have a way of disappearing. Expenses, however, tend to stick around without deliberate and often painful action. The mantra is to “cut costs” or “drive costs out of the system” (these are not the same thing). During this cost-cutting process, the distinction is often made between a profit center and a cost center. A better distinction should be between an investment and a cost.
Before we begin, we should define these terms:
- A profit center is an organization unit to which we can assign both costs and revenues. “Assign” is the operative word here, because no unit can generate revenues on its own.
- A cost center is an organization to which it is impossible or very difficult to assign revenue. All cost centers contribute in some way to either the production of revenue or reduction of expense, or at least that was the intent. Both cost centers and profit centers can become obsolete.
- An expense is a use of cash in exchange for some good or service. This is slightly different than the accounting definition of expense, but the difference is only in the timing by which the expense is recognized. In the long run, all such exchanges of cash for goods and services end up as expenses, either directly, as cost of good sold (COGS), or as depreciation.
- A cost is an expense for which the primary purpose is to continue operations under the current revenue and cost structures.
- An investment is an expense for which the primary purpose is to change the future revenue or cost structure of the enterprise.
- Capital expense (CapEx) is an expense, usually but not always an investment, that first appears on the balance sheet as an asset and is allocated to future revenue in the form of depreciation. Purchasing computing hardware or renewing software licenses to support current operations are capital expenses that are also costs.
- Operational expense (OpEx) is an expense that is recorded directly on the income statement in the year in which it is incurred. Some operational expenses are really investments, including the salaries of the strategy people and possibly many of your business and technical architects, although it often depends on how they spend their time.
A good activity-based cost (ABC) model can help categorize an expense as an investment or cost, and as CapEx or OpEx. This categorization uses a two-by-two matrix. The category into which a particular expense is assigned does not have any implications on its value. Investments are not inherently better than costs as businesses make a lot of questionable investments. This categorization is simply a way to allocate the expenses (and thus the activities) of a company so we can better manage them.
Cost Cutting vs. Cost Structure Change
When revenue drops, there is tremendous pressure to reduce the expenses proportionately to maintain the current level of profitability. We run into problems not when we try to do this, but in the way we usually go about it.
There are two ways to reduce the level of expense relative to a given level of revenue: Cut costs, or change the cost structure of the company. Cutting costs, using the definitions above, entails reducing expenses incurred to support continuing operations. This has the effect of either reducing capacity or reducing and potentially eliminating a capability. These are not necessarily bad outcomes as too much capacity can be a real issue. Sometimes, too, capabilities are no longer required and should be eliminated. Either way, there are only two outcomes to cutting costs. Problems arise with either or both of these outcomes are unintended consequences of an action taken to shore up financial performance elsewhere.
The other option is to change the cost structure of the company. This involves making investments in order to change the level of expense relative to a given level of revenue. Most of the time, the target is to reduce the level of expenses required to produce a given level of revenue, thereby increasing the productivity of the company. Sometimes, the target is to create a new capability or increase or decrease the scale of an existing capability.
The important point to note here is that changing the cost structure always requires first making an investment, that is, spending more money now to reduce expenses later. This is true of changing the revenue structure, too.
There are many situations in which it is necessary to change the cost structure rather than just managing costs directly. One case has already been discussed, when cutting costs will reduce capacity or capability below a minimum level and there just isn’t room to cut further. Another case is when proposed or actual increases in business activity overwhelm current operations and changes need to be made to simply support the volume.
Systems designers know this problem well. A solution architect will take a very different approach to a solution in which the transaction volume is several million transactions per day than when it is a few thousand transactions per day, even when both solutions solve the same business problem. The higher volume solution will necessarily be more complex and will likely cost more, maybe much more, but the simple, lower cost solution simply would fail under the higher level of activity.
So it is with processes and capabilities. An order fulfillment system, including the order routing logic and the facilities in which the orders are picked, packed, and shipped, will be much more complex and costly for a high volume business. Amazon has invested billions in its fulfillment capabilities, and can now effectively compete with most in-house fulfillment capabilities at most companies. Large volumes create problems that simply do not exist at lower volumes, and these problems add complexity and cost to any solution.
Likewise, significantly lower levels of revenue, if they are more permanent than cyclic, may require changes to the cost structure. If business volume was in the many millions of transaction per day and now numbers in the thousands, the systems and processes in place to support the higher volume will cost too much to support and need to be simplified.
What Does this All Mean?
When revenue drops, or the business anticipates large increases in revenue, the question must always be asked whether the cost structure needs to be changed or whether we can just reduce the capacity of the current cost structure. If the incorrect choice is made, the future of the company can be put at risk.
When revenue declines, management often opts to cut costs in order to affect near-term financial results. This is often the wrong decision, but that depends on whether the reduction is temporary (cyclic) or permanent. The time frame used to distinguish these two is fluid, largely because the future is hard to predict. If the revenue decline is temporary, the company can reduce capacity, a temporary measure, or reduce capability, a more permanent measure, by simply cutting costs. The decision needs to be deliberate, however, since you don’t want to accidentally cut future capability that you are going to need again.
If management decides the cost structure needs to change, it almost impossible to affect near-term financial results in a way that most investors would like. Making an investment means that you have to spend money now in order to not spend more of it later. If it works out the other way, you made a bad investment.
Managing Costs and Investments
Costs and investments have to be managed differently, since they have different affects on the business. The performance of a cost portfolio is measured differently than that of an investment portfolio (here, portfolio is simply a collection of costs or investments that are managed as a group). An operational cost portfolio is measured in terms of efficiency and productivity. Costs can be adjusted locally to affect these measures, but not by much, usually only a few percentage points in either direction. The main goal in managing costs is to get the most output for each unit of input, or maximizing the productivity of the money spent. Efficiency provides another way to look at the problem, and states the goal as to spend the least amount of money to get a given level of output (input required to produce each unit of output).
Investments are measured in terms of their total return and risk profile. The return on investment is the future cost savings, revenue generated, or both, less the cost of the initial investment and the cost of capital. Risk is the subject of another paper. Efficiency and productivity are not measures of investment performance. Rather, you make an investment in order to achieve major improvements in either operational measure. Effectiveness is the primary goal of investment management, or making the right set of investments. Since the measures are different, managing investments is necessarily a different game.
Not All Costs are Operational and Not All Investments are Capital
By now, you should realize that not all costs are operational expense and not all investments are capital expense. The split between OpEx and CapEx is based entirely on which financial statement is immediately affected and that is determined by the relationship between the money spent and future activity. The split between cost and investment is based entirely on whether the money is spent to operate the current cost structure or to modify that cost structure.
Enterprise architecture thought leaders, especially folks like Chris Potts, have advocated managing investment versus costs, not capital versus operational expense. The difference is in the management focus. Managing costs requires focusing on the current revenue and cost structure and wringing a few percentage points out of it. Managing investments requires focusing on the cost structure required to support a given level of revenue and then maximizing the return given a level of risk to create that cost structure. This almost always requires moving from the current cost structure to a new cost structure following a roadmap of incremental investments.
Note: The image accompanying this article was created by a friend and colleague, Bina Reed.