Cutting costs so often leads to cutting corners

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Today’s managers are victims of the tyranny of the quarterly earnings report. And that is why yesterday’s cost-savings are so often today’s corporate crisis.

I remember an illuminating conversation with a senior executive of a recently privatised water company. I was puzzled that so many companies seemed to be able to issue peremptory edicts to their managers to reduce costs, or headcount, and see these edicts fulfilled. Could it really be that there was so much inefficiency and, to get rid of it, little more was necessary than to tell people to sort it out?

The person I was talking to explained that water supply was largely automatic. Rain fell, and flowed downhill, the water went through treatment works and along supply pipes, all untouched by human hand. Most people were at the company to stop things going wrong, or to fix them when they did.

The system could always operate with fewer people. In fact, if you sacked the whole workforce, except for the billing staff, profits would soar and everything would be fine – for a bit. Over time, however, problems would first accumulate, then emerge. My informant predicted that his company, in common with its rivals, would engage in successive rounds of efficiency savings, and be congratulated by analysts and regulators. Eventually, he predicted, there would be a big problem – or several. Then politicians would compete in the vigour of their denunciations. Money would be thrown at the problems. He hoped he would have retired before this.

His prediction was right, but he got the industry wrong. A series of publicised accidents on Britain’s railways led to a panic overreaction by the privatised track operator, Railtrack. The company collapsed and public money has flooded the rail system since. As oil from BP’s well continues to flood the Gulf of Mexico, I am again reminded of that old conversation.

What is the right amount to spend on preventive maintenance as opposed to responding urgently after the event? The water company executive did not think there was an objective answer. It was, he said, a matter of managerial judgment: sometimes you erred too far in one direction, sometimes the other. When the business he worked for was a nationalised industry, the main aim was to do nothing to incur public criticism. In a private company, the imperative was to cut costs a little faster than your competitors.

So has BP just been unlucky? Or do the disasters that have occurred in its US business over the past five years – the Texaco City explosion, the Prudhoe Bay leaks, the Gulf of Mexico oil spill – result from an emphasis on cutting costs that led to cutting corners? I don’t really know – and nor does the US Congress, or President Barack Obama, or even the company itself.

At moments like this, it is not just easy, but obligatory, to say that safety and the environment must be overriding priorities. But this is just a reassuring platitude. If safety and the environment always did come first, economic activity would be paralysed. Managers have to strike a balance between expenditure and efficiency and between the cost of anticipation and that of repair. Sometimes they will get this wrong – as they probably did at BP. Even if they get it right, accidents will happen occasionally and commentators, with the benefit of hindsight, will hang them out to dry.

Safety is not the only area in which managers are required to balance incompatible and incommensurable factors. Any business whose long-run viability depends on its reputation faces a similar dilemma – the damage to BP’s reputation may well exceed the direct cost of the Gulf of Mexico spill. Has a bank, or a retailer, sacrificed the trust of its customers for short-term profitability? Have pharmaceutical companies neglected their pipeline of new drugs in favour of cost-cutting and marketing? Only time will tell, and perhaps we won’t know even then. As the Greek philosopher Solon put it: “We don’t consider any man successful until he has died well.” But ancient philosophers were subject only to the verdict of posterity. Today’s managers are victims of the tyranny of the quarterly earnings report. And that is why yesterday’s cost-savings are so often today’s corporate crisis.

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