Thursday, 18 December 2008

In a downturn, manage your revenues, not your costs

Here's a hypothesis:

In prosperous times, companies often fall victim to not being able to resist the many opportunities for growth that present themselves to them. In isolation, many initiatives with respect to new products, new markets or new customers look good but when pursued in combination they have a negative effect and hamper growth. Yet, wealthy firms find all these options difficult to resist precisely because in isolation they look so good. They have the funds to spare and therefore they are inclined to do too much of a good thing.

Andrew Grove, former CEO of Intel, understood this well. Their best-selling product – microprocessors – had endowed them with much cash to spare. However, he resisted temptations to spend it on other initiatives and entering adjacent businesses, telling his people “this is all a distraction; focus on job 1 [microprocessors]”. It made them one of the most successful companies ever.

In a down-turn, companies should look different

However, companies in distress – such as in a downturn – often do the reverse. In academic research, we call this the “threat-rigidity” effect. They focus on their core business, shedding all other things, doing more of what they did before, and which they consider their strongest points, while trying to reduce their cost base to weather the storm, till it all blows over and they can come out of hibernation.

By itself, minimising one’s cost base is never a bad idea (also in prosperous times!) but these companies forget one thing: You have to not only manage your costs; you also need to manage your revenues. And, what’s more, the composition of a revenue base in lean times will have to look different from its composition when times are good. Where in happy times firms are often seduced to spread out too much, while they would be better off focusing on job 1, in meagre times firms are often inclined to focus too much, when diversifying one’s revenue base makes more sense.

Accessing different pockets of revenue

So why does spreading one’s revenue base in meagre times make more sense? It is, among others, because no job will be big enough to sustain the whole firm. What keeps firms afloat is accessing a variety of smaller pockets of revenues. Hence, rather than focus on job 1, hoping it will be enough to sustain the firm, the company’s effort should be aimed at identifying and creating additional sources of revenue. In the downturn, none of these additional sources will be big enough by itself. Moreover, many of these sources would not be attractive in prosperous times, because the firm would not be able to make them grow. However, this is not a time of growth, but of survival.

A diversified revenue base will also reduce dependency and with it risk. In a downturn, the probability of individual sources drying up is large, so a firm can’t afford to be focused on just one or a few of them.

But will searching for additional sources of revenue not be costly? If will not be costless but, by definition, it should not be expensive. Paradoxically, firms should not be focused on winning any big accounts, major new products or customers; they should aim for many smaller ones. They are relatively cheap to access and often the firm will already have knowledge about them; they shunned them in the past considering them too small to advance at the time.

Concurrently, this strategy of exploring multiple smaller pockets of revenue will equip firms well for the economic dawn, which will inevitably come. Their diverse revenue base has laid the foundation for new sources of growth. The firm will be able to quickly benefit from the upheaval in the economy. Many of the smaller pockets of revenue will stay small – and the firm would do well to shed quite a few of them – but the newly formed strategic landscape will be conducive to different sources of revenue than before. Although you can’t tell beforehand which ones it will be, some of the small pockets of revenue will be the new stars on the firm’s firmament.

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