Only a third of firms drive returns greater than the cost of capital, said Gartner recently when releasing the results of a study.
Organisations that drove a 6% greater return on invested capital (ROIC) over three years are those built around factors such as unique competitive differentiator rather than external factors like competitive trends, compared to those with cost models focused on external factors such as competitive trends, the research firm noted.
“Most companies have cost models that respond to factors external to the organization,” said Jason Boldt, research vice president for the Gartner Finance practice. “This might take the form of chasing the same ‘hot’ markets as competitors or overcommitting to well-known trends such as digital business or artificial intelligence.”
Yet CFOs who model their costs around the differentiating factors unique to their organisations secure on average a greater excess ROIC versus those who focus on extrinsic factors, Boldt pointed out.
They also exhibit more resilience in the face of unexpected events, such as the economic crisis resulting from the current pandemic , he added.
“Even before the pandemic-induced downturn, less than a third of public companies we studied were earning returns above the cost of capital,” said Boldt. “Our research shows that CFOs are often blown off course by external targets that prioritise growth over profitability. Their targets, because they are externally focused, are routinely disrupted by changes to the macro picture.”
As part of the analysis, Gartner said it studied the performance of 1,142 public companies over an eight-year period and complemented this quantitative analysis with in-depth interviews of large enterprise CFOs.
The analysis revealed that the factors that influence the CFO in determining how they structure and prioritise costs can have a meaningful impact on value creation and excess economic return, Boldt said.
Following competitors leads CFOs astray
The pressure to model growth, and therefore cost management strategies, around matching competitors leads to chasing after crowded markets, pursuing dubious trends and deals that boost short-term growth at the expense of long-term value, according to Gartner.
Among the public companies Gartner studied for long-term performance, revenues have improved by 25%, yet reinvestment efficiency and profitability both declined over the same period, Boldt observed.
“The story of the last decade has been one of mostly unprofitable growth,” he said. “In many industries, competition for organic growth has intensified, leading many organisations to secure growth through M&A. This boosts short-term growth but adds significant invested capital to balance sheets that the majority of companies have failed to translate into excess returns on capital. It’s clear from our research that CFOs who follow the herd and chase popular trends suffer when it comes to the most important long-term metrics.”
Differentiated cost structures drive value
CFOs seeking to move towards a differentiating cost structure will face three risks, according to Gartner.
First, when the business gets word that CFOs are protecting costs associated with differentiation, everything becomes differentiating to protect business unit’s budgets.
Second, budget holders will potentially ask for increased resources to achieve differentiation.
Finally, business leaders might struggle to make appropriate tradeoffs.
To overcome these barriers, Boldt recommends the following approaches:
Cross-functional, not finance vs business: The complexity and interrelatedness of costs that drive points of differentiation are critical to protect and require ongoing assessment from business owners to ensure these costs are protected. Resourcing the most complex costs with both business owners and finance leaders ensures cost optimisation targets do not inadvertently cut areas of differentiation.
Pressure-test constraints, not budget inputs: To better understand both the lower and upper bounds of useful funding for a project, finance and business leaders can test both the absolute lowest budget before a project breaks and the maximum funding a project receives before returns diminish. Conducting such an exercise can reveal when a project can start on a “lean” basis and also illuminate opportunities for additional investments in differentiating projects.
Test-and-learn, not “all-in”: CFOs should avoid going all-in on differentiating investments until they have sufficient evidence for how specific costs create a point of differentiation and the market outcomes that prove it, such as customer willingness-to-pay.
“CFOs who model costs on differentiators are much more likely to stay on track with their long-term plans, avoid hasty cost-cutting in response to a change in the macro picture and realise value through principled and focused reinvestments built around their differentiators,” Boldt advised.
