You can’t cut costs without cutting service


Successive cost cutting rounds may just be a way of funding the present at the expense of the future.

Could industry really be so inefficient? That question puzzled me a decade ago. Chief executives with one eye on the bottom line and the other on their share options could tell their subordinates to cut costs. And in almost every line of business these subordinates could do it.

A conversation with a friend who worked in the water industry supplied the answer. He explained that most of the people who worked in his company were there to stop things going wrong, or to fix them once they had gone wrong. There was no scientific way of judging whether there was too much inspection or too little.

In his business, planning followed a regulatory cycle. The regulator would require cost savings at each review and the company would then find a bit more, to keep the stock market happy. And this was always possible. If you fired all the operating employees, costs would plummet but the water would keep flowing.

That could not go on for ever, of course. There would inevitably be an incident: customers would be poisoned, or there would be extended disruption of supply. People would point to things that could have been done but had not been. And then, in panic, money would be thrown at the industry to ensure there was no repetition – but it would not be well spent.

We described the scenario accurately, we just got the industry wrong. It did not happen in the British water industry – although it still might. It happened instead on Britain’s railways. And now it has happened in the American electricity industry.

We all want pure water and reliable electricity but you can always make the water even purer and the electricity more reliable if you spend a bit more. A balance has to be struck and finding that balance demands fine, and debatable, judgment. Public sector managers made cautious assessments. Private sector executives were more inclined to be optimistic. No one can say, with confidence, who was right and who was wrong. But British rail commuters and New York electricity consumers may be forgiven for judging that their suppliers made mistakes.

The consequences of utilities failing are obvious and unacceptable. But they only exemplify what has happened across large sectors of British and US industry in the past decade. We now recognise the dishonest ways in which companies such as Enron and WorldCom inflated their current earnings at the expense of their assets. What are emerging more slowly are the honest ways in which other companies inflated their current earnings at the expense of their assets.

This was possible because modern business depends on intangible factors that, for good reasons, are not measured on the balance sheet. Security of supply is one. But the loyalty of employees, the trust of customers and the quality of service are also assets that require investment and depreciate if not well maintained.

Reducing these investments enhances earnings. Media companies could focus on producing clones of already successful works – and it would be a few years before their bored audiences turned away. Financial institutions could replace their customer service staff by sales people and call centres. And drug companies could reduce costs and obtain synergies through mergers – and today find their pipelines of new drugs narrower than they have ever been.

When revenues slowed, it was possible to restore earnings with another round of cost reductions. “Disappointing results mean more job cuts” has been a staple FT headline for a decade. These companies are engaged in a process of internal liquidation. Eventually they will have cut out everything that made people want to do business with them.

In media, pharmaceuticals and finance, businesses that have funded the present at the expense of the future will continue to decline and others will take their place. But there is no similar market solution for infrastructure utilities. Determining the right balance between supply security and costs will always be a matter of expert regulatory judgment and political negotiation. The illusion of the past two decades was that it could ever be otherwise.

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