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  • ⚖️ Strategic Finance Part III: Increase value or reduce cost?

⚖️ Strategic Finance Part III: Increase value or reduce cost?

Strategic unit economics in the real world

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Working

“Delivering”

“Your business is complacent. Frankly, you are complacent.”

I wasn’t Derek’s biggest fan. So I was glad to be on bad-cop duty for this business review.

He was suave and arrogant. More style than substance. Not my cup of tea at all. But he was President of an important division. So I needed to get through to him.

Derek bit back with a smile: “Does it matter if we are delivering numbers?”

“Yes, it does. Your OEE (Overall Equipment Effectiveness) is down 5 points year on year. Labor costs are out of control. You are burning cash on marketing spend, and you can’t prove it’s driving an uplift.”

“And yet we are still delivering our budget, what’s the problem?”

“You are only hitting your budget because you’ve jacked your prices up to compensate for your terrible operating performance.”

“So what? There are many ways to deliver a budget.” He wasn’t even denying this was his approach.

“It just means your budget was too soft. You are damaging the long-term health of the business and our customers are paying for it.”

“You mean MY customers.”

Wow… just when I thought it was impossible for me to dislike this guy anymore.

Egos aside, the real question was this: how on earth could this business stand so many unjustified price increases, seemingly without any impact on demand?

None of our other business units could have done the same.

The answer was clear: it was the brand. This business had a fantastic brand. A crown jewel with real dominance in its category.

I knew the brand was strong, but it was amazing to me that it could command so much pricing power in the market. I guess this was the first time it had been truly tested.

And if we could deliver this performance without operating the business unit properly, imagine how it would go when we shaped up.

Eventually, I convinced the CEO of this, and Derek was fired (although it took longer than it should have).

With a serious operator running the brand, it went on to even greater heights.

And I learned a killer brand is so potent, it can hide a host of shortcomings.

Deep Dive

This is the third part of a 4-part series on strategy from the CFO seat.

Increase value or decrease costs?

Two weeks ago we defined the role of the CFO in business strategy.

Last week we laid down some theoretical foundations with classic strategy models.

This week, we start to connect strategy to financials. Think of it as a cousin to the recent series on unit economics.

A great strategy should unlock superior returns. So this week we’ll get into what that means, and how it should affect investment decisions. Specifically, how do you decide where to make strategic investments? How do you cut through the noise to figure out what merits the checkbook and what doesn’t?

Let’s work a simple, single-product example:

There are three parameters which define the financial impact of a strategy:

  1. Unit cost of the product

  2. Price of the product

  3. Value to the customer of a product

In order for a business to maintain its market share, there must be some equilibrium of these three things.

The price charged needs to be lower than the value provided, otherwise customers would stop buying. And the price needs to be far enough above cost to survive (and reinvest). Caveat: Unless you have an equity provider willing to fund the gap between price and cost until equilibrium is found in the future - i.e. VC backed.

A simple visual for this equilibrium:

Strategic Equilibrium

Note: this isn’t to scale. It’s the relative positions that are important, not the absolutes. For this example see cost as total cost per unit (COGS, expenses, depreciation, finance costs, etc.)

So the job of the strategic leader is to disrupt that equilibrium. And find a way to build an unfair advantage into that equation - and earn superior returns.

The Role of Price

Sales price is not a source of strategic advantage, on its own. Let me explain:

If you increase price without increasing customer value, you are capturing some of that value once offered to customers into your margin. If that ‘value to customers’ narrows vs. competition in the long run, this will hurt market share.

This was my misgiving with Derek in the opening anecdote. He was free-riding on the back of the work of his predecessors - who’d built a great brand with a strong market position. And making his successors’ job harder in the process. Left unchecked, this will be a slow death.

Likewise, if you reduce price without reducing costs, you are increasing value to customers. But at the expense of returns (vs competition), so that value does not exist in any sustainable way. This will kill your cashflow.

And if you are lucky enough to survive the immediate threat that brings, you will still suffer a slow death.

You won’t be able to invest, and your cost of capital will rise. All of this will further erode your competitive position over time.

Moving Price

So, yes, price is an important short-term weapon in competing. But building a real sustainable advantage can only come in one of two ways:

  1. Move the cost line down

  2. Move the value line up

Or ideally both.

Put another way… the goal of good strategic management is to increase the distance between the value offered to customers and the cost price to the business.

Then pricing becomes a question of how much value is captured in the returns of the business vs. how much is passed on to customers.

Let’s dig further in. Starting with pushing the cost line down.

Moving the cost line down

Durable cost advantages are forged through economies of scale - the fixed cost dilution benefit. We talked a lot about this in the unit economics series).

That dilution comes not only from the businesses' own fixed costs but throughout the entire value chain. Maintaining cost leadership is a real skill. It requires a deep understanding of supply chains and profit pools.

SpaceX’s pursuit of cost leadership against complacent incumbents has been interesting to watch. They have re-invented the aerospace supply chain.

A supplier’s inefficiency becomes the customers’ raw material input cost:

Supply chain

For every component of their rockets, SpaceX are relentless in the search for shorter supply chains and cheaper ways of operating.

We’ll run a series in 2025 diving deeper into how to compete on cost.

For now, we’ll focus on what you do with a cost advantage you have.

If a business has a cost advantage (i.e. a lower unit cost vs competition for an equivalent product product) but keeps the price the same, that business will earn superior returns.

Cost advantage

If you have shareholders looking for a quick buck, this is a good way to keep them happy. This will give you access to cheaper capital, and better reinvestment opportunities (likely further reducing cost).

But over the long term to really capitalize on that cost advantage, you need to pass those savings onto customers in the form of lower prices.

That will give more value to customers, which will grow market share. And increase $ profit and total customer value created overall:

Passing on cost savings

More volume dilutes fixed costs further. Which means cost prices come down even further. So sales prices can come down … which leads to more volume, and so on. Creating a flywheel effect that is nearly impossible to disrupt.

For example, Costco buys so much chicken meat, they were able to vertically integrate into owning and operating their own chicken supply chain. From farm to shelf, removing several margins along the way.

These strategies survive on having the lowest gross margin requirement possible. If business A can thrive on a gross margin so low it would kill its competitor, THAT is a strategic advantage. B is dead.

Great cost leadership models wear low gross margins as a badge of honor. Costco operates on a gross margin of around 14%.

Finance Functions’ Role in Moving the Cost Line Down

At the heart of cost leadership strategies is a ton of number crunching.

They are essentially giant math problems. “If we invest $xxm into automation capex, we can reduce our cost by $yy per unit. If we reinvest that in price, we expect to grow demand to zz units.”

So finance has a huge role to play in executing cost leadership strategies.

A CFO in a business looking to lead on costs will need to ensure their finance function is set up for precision in planning & reporting on costs: 

  • Zero based budgeting

  • Bill of materials (BOM)

  • Actual performance vs. BOM

  • Supplier Financial Reviews

  • Variance analysis

  • Operating efficiencies

  • Yields

  • Inventory losses

  • Etc etc

Anywhere cost can leak becomes a target. Finance has to identify the leaks and ways to plug them. Then hold the mirror up to the business so it focuses on the right areas - using reporting and storytelling.

Being a cost leader is hard and relentless. A full team effort. A culture. And you have to be prepared to invest.

Ultimately the only way to create durable cost advantages is to convert opex into capex.

Moving the Value Line Up

Let’s move away from cost leadership strategies. And toward how we can increase the value provided to customers (for the same cost price).

Value can come in many forms. It can be tangible: improved product features, longer product life, shorter lead times, better customer service, etc.

Or it can be emotional: status (Rolex), peace of mind (home security system), saving the planet (electric vehicles).

These things are nearly impossible to put a $ value on. So it can be difficult for finance teams to comprehend investments here.

It’s easy to default to measuring them the only way we know how; how much more can we charge our customers for this extra value?

Makes sense, it's tangible. But that approach can miss the point.

If all we do is move the price line up, we capture better short-term returns, but we are still offering customers the same level of value. Customers are getting more, but they are paying more for it.

Let’s think through the alternative, whereby we leave the price line where it is. Now we are offering more value for customers vs. our competitors but for the same price (and cost per unit). 

This increases our capacity to grow market share. And ultimately is the secret to long-term growth in equity value.

Increasing Value

This is a theoretical point, of course. The real magic happens when you grow the value delivered so far that you can increase your gross margins. And still, deliver an excess of value for customers.

This is how luxury brands work. Hermes can charge $30k for a Birkin bag because of the story they have built with their customers for the past two centuries.

Finance Functions’ Role in Moving the Value Line Up

Building a competitive advantage through moving the value line up requires investment. And often these investments have non-tangible benefits.

Therein lies the challenge for the CFO.

Which strategic investments do you support when payback can’t be easily measured?

This is 90% art and 10% science. So there are no hard and fast rules.

But some guiding principles you can follow:

  1. You must understand where the ‘magic’ is in your business. What drives the business's competitive advantage? Cost down or value up? Where does it come from? Operations, product development, technology, brand, etc.?

  2. Make sure you don’t starve the source of the magic. Protect the budget that fuels it in your strategic plans and budgets. Manufacturers need capex. A pharma company can’t survive without R&D. CPG can’t thrive without brand investment.

  3. Build great relationships with the rest of the C-Suite. Help them understand that $1 to their function is $1 taken from someone else. Be open about these trade-offs.

  4. Align closely with the CEO. What do they see as most important? Test them with trade-offs: “If you had to give that $10m to the brand team or the product team, which would it be?” Even if you can afford both, conversations around trade-offs with the C-Suite build understanding and alignment on priorities.

  5. Assess projects on financial payback, if possible. Beware free-riders. If something can be quantified into the financials, it should be.

  6. Build non-financial leading KPIs into investment appraisals. If a project can’t be measured on its contribution to the financials, make sure it can be measured on another key balance scorecard measure.

  7. Use the long range plan to set parameters for investment and to align the CEO, C-Suite, board, and business.

Most of the biggest shareholder value creation events in history started with hard-to-justify investments in non-tangible payback areas. It needed a CFO with a strong stomach to increase the R&D budgets in Apple back in 1997, when the business was on its knees.

But imagine if they hadn’t …

Next week, we will laser in on how to embed strategy into the FP&A cycle and bring this all to life.

Bottom
Bottom Line SCFO

  1. Long term competitive advantage comes from having lower costs, offering more value to customers, or both.

  2. Cost led strategies are math problems. Finance finds a natural home here.

  3. Strategic investments without clear financial returns need much more nuanced thinking. Prepare to embrace the gray. It’s where the real value is built.

Office

Keven from Washington, DC asked:

How can I (entrepreneur/consultant/employee) convince organizations that a Fractional CFO can help organizations achieve their goals and mission? Essentially, CFOs maintain systems and processes and identify threats to those systems. There appear to be many positives for organizations to move to a Fractional CFO posture, but there also seems to be some resistance (RTO) to the concept.

Thanks for the question, Keven.

Small businesses don’t have the budget (time or cash) to invest in things without a clear and direct benefit or payback.

So to sell fractional CFO services to small businesses, you need to make clear how it improves the life of the owner. You should see this in two ways:

  • They make more money

  • They have more time (to either spend with their family or make more money)

If you can’t demonstrate you can directly deliver more time or money to the owner, you are making it too hard to get a clear ‘yes.’ And anything other than a clear ‘yes’ is a clear ‘no.’

The way you described a fractional CFO in your question will be too abstract, or frankly, discretionary for most business owners.

Businesses make money by making and selling things. So you need to work out how your offer can demonstrate a transformation that is attractive to the owner.

Not in an abstract way, but in a way that directly benefits their wallet or their watch.

Something like this could work: “By improving your inventory controls, I can help you reduce waste by 3%, which is worth $50k per year to your business.”

Or “You are spending 20 hours a month in back and forth with your bookkeeper over the accounts and reporting. I can take all of that from you, and within 3 months reduce those 20 hours to 1 hour. Those are 19 hours per month you can spend selling more, or at home with your family.’

It’s about framing. Good luck.

If you would like to submit a question, please fill out this form.

Footnotes

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And Finally

Next week we’ll bring this all together in our strategy finale.

If you enjoyed today’s content, don’t forget to check out this week’s sponsor Vic.ai.

Stay crispy,

The Secret CFO

Disclaimer: I am not your accountant, investment advisor, tax advisor, lawyer, CFO, director, or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. And certainly is not investment advice. Running the finances for a company is serious business, and you should take the proper advice you need.

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