Look at a handful of corporate earnings releases in a down economy, and you're bound to see the phrase “cost cutting.” Cost cutting is a set of actions a company takes to lower expenses. Usually, the goals of cost cutting are to improve profitability and conserve cash.
How companies cut costs
Companies can approach cost cutting in various ways. Much like you might try to lower your household spending, a company may address its highest spending categories first. For example, companies with high labor costs may lay off employees, eliminate shifts, or reduce salaries. Other strategies include:
- Renegotiating supply chain contracts
- Changing internal policies, e.g., pausing business travel
- Downsizing facilities
- Closing or selling unprofitable units or divisions
- Pausing costly growth initiatives
Why companies cut costs
Different circumstances can prompt companies to initiate cost-cutting efforts. The economy, however, is a common culprit.
Economies expand and contract in cycles. When the economy is expanding, businesses will often experience higher demand for their products and services. In response to higher demand, the business increases its capacity -- and its costs.
Later, when the economy contracts, demand can moderate and revenues can drop. At lower revenues, the same business model may lose some cost advantages. As a result, the company would produce smaller profits on every $1 of sales.
The ratio of profits to sales is called the profit margin. Shareholders and prospective investors watch profit margins carefully. When a company's margin is low compared to its competitors, the business is generally less profitable but also less appealing as an investment.
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What do to when companies you own cut costs
When a company you're invested in announces a cost-reduction plan, pay attention to the details. You can usually find the highlights in earnings releases. These highlights should include the reason for cutting costs and the areas of the business the plan will affect.
For a deeper understanding, you can also listen to the earnings call. Analysts are likely to question the nuances of any cost-cutting plan. Those questions and the answers can provide a ton of insight. Ideally, you'll want to find out if the company is working toward a stated goal, such as a specific profit margin, and its timeline.
You'll also want to know how the new cost focus will affect shareholder programs and growth initiatives. Companies that need to conserve cash, for example, may cut back on things such as:
- Share repurchases
- Shareholder dividends
- New product launches
- Geographic expansion
- Acquisitions
- Capital spending
When a company reduces investment in these programs, it usually changes the outlook for shareholder returns. If that change is negative and likely to be long term, you may need to rethink your position in that stock.
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