Here is an excerpt from an article written by Vinay Couto, Paul Leinwand, and Sundar Subramanian for Harvard Business Review and the HBR Blog Network. To read the complete article, check out the wealth of free resources, obtain subscription information, and receive HBR email alerts, please click here.

Credit:  Plasticbionic

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In times of economic uncertainty, many leaders turn to an old standby: cost cutting. When so much in the world feels beyond our control, costs are, to a large extent, controllable. But cutting costs with the singular goal of realizing short-term savings is myopic. Whether they’re faced with an urgent need or not, leaders should view each expense line as a precious investment in the business—and recognize how the decision to increase, decrease, or maintain it will shape the company’s future.

Danaher, a global diversified conglomerate based in Washington, DC, is a successful firm that sees costs as investments. Some are good, and some are bad. Danaher doesn’t work to reduce costs; instead it tries to weed out poor investments while keeping the good ones—day in and day out, during both booms and busts.

A key element of its approach involves applying something it calls the Danaher Business System to the steady stream of companies it buys. The system draws on lessons from Danaher’s broad portfolio of businesses—repeatedly—to make operations ever more efficient. “Most managers have a mindset that if you apply a tool once, you’re done,” recalls George Koenigsaecker, who implemented the first version of the system in the 1980s as the president of Danaher’s tool group. Koenigsaecker, now an investor and an expert on lean manufacturing, says a single application of a process improvement might yield a 40% gain in productivity. “But to get the 400% gain, you have to use it at least 10 different times,” he notes. “You must study the process over and over.” At Danaher the drive toward efficiency is relentless, and cultural reminders of it are everywhere. In meetings, for example, executives often ask if the meeting really needs to run as long as it has been scheduled for. The mantra is “Waste nothing.”

Many companies, in contrast, take a one-off approach to cost cutting and do it reactively when it’s the only obvious option for reaching profit targets. Unfortunately, in their hurry to eliminate things that seem discretionary, they often sacrifice some of their most important investments.

Such risk has been growing lately. In a PwC survey conducted in November 2022, 42% of senior executives said that cost cutting would be a priority in 2023—a prediction borne out by the waves of layoffs making headlines during the first half of the year. When cost-cutting programs are implemented in haste, as many of the current ones have been, there is little (if any) debate over the strategic intent behind spending. Typically, leaders dole out across-the-board targets, leaving functional groups and line managers to quickly figure out what (or who) must go. That winds up leaving organizations weaker, imbalanced, and in some cases desperate and without direction.

To learn more about how companies have successfully managed costs while still achieving growth, we did a study of the 1,500 largest global public companies, based on 2021 revenue. (Our colleague Harsha Kasturirangan, a director at Strategy&, helped us with this research.) Among that group we identified 201 companies (or 13% of the sample) that from 2015 to 2018 implemented what we call a cost transformation: achieving EBITDA above the industry median while experiencing revenue growth below the industry median. That separated companies that grew their margins through cost reduction from those that grew them through top-line improvements. Then we analyzed those 201 firms’ financial results in the three-year period ending in 2021. Of those companies, 125 (62%) delivered below-market revenue growth and profitability. Their revenue remained relatively flat, dipping 0.6%, on average, and their EBITDA dropped by 8.3%. Despite their earlier margin improvements, their efforts ultimately weren’t successful, because they’d undermined their future results.

The good news is that 76 of those 201 companies (which included Danaher) experienced higher revenue growth and profit margins in the following three-year period. On average, their revenues rose by 16.8% and their EBITDA by 6.8%. These companies represented a wide range of industries—including technology, industrials, pharmaceuticals, and financial services—with no single industry accounting for more than 11 companies. They were also widely distributed geographically, headquartered in 19 countries across North and South America, Europe, Asia, and Australia.

These 76 companies clearly had set themselves up for future success. The question was: What did they get right that the others got wrong?

Creating a Growth-Oriented, Cost-Effective Organization

To succeed at cost transformation, you need to start with a blank sheet and ignore sunk costs. This is the mindset underlying zero-based budgeting as well as Peter Drucker’s famous question “If you weren’t already in this business, would you enter it today?” Applying this lens to every project, line item, and role allows leaders to look at the cost structure strategically, which is imperative, because there may be no topic more strategic than where you spend your money.

But simply challenging every line item isn’t enough in our analysis—and on its own may feel like a disjointed and endless effort. We believe you also need to take five critical steps.

Connect costs to outcomes.

Treat every dollar spent as an investment in creating the value that you give your customers and in the specific cross-functional capabilities needed to deliver that value. Costs should no longer be locked inside organizational silos that get protected and thus are disconnected from growth. Budgets must be discussed in depth with the leadership team and prioritized to focus on what truly supports your strategic goals and the capabilities that will help you achieve them.

A great example is IKEA. The company has long been guided by a succinct principle that makes this promise to customers: “We do our part. You do your part. Together we save money.” After opening his first retail store, in 1958, the company’s founder, Ingvar Kamprad (the I and K of IKEA), drove employees to pursue any cost-saving opportunity that didn’t affect the quality of the merchandise, the customer experience, or the efficiency of operations—a practice that continues to this day. IKEA’s designers, for instance, work continually on packaging to reduce its materials and size so that the company can fit more pieces into a container, save money, and offer lower prices. That congruence between strategy and execution is rare in product design. In many companies products are designed by people who aren’t responsible for managing expenses. But IKEA connects its design to all the outcomes for the customer, including cost. If you visit the company, its cost consciousness is apparent. For example, executives almost always take guests—even VIPs—to eat in IKEA cafeterias rather than fancy restaurants, to avoid any expense that might be passed on to customers.

Simplify radically.

Companies often take their activities for granted and make incremental adjustments rather than take a bold, holistic look at what businesses, product lines, SKUs, or operations should be part of their future. Most also underestimate the cost of complexity, measuring only direct costs rather than system costs. One way to get a better perspective is to imagine a new competitor arriving in your segment without the burden of all your past decisions. How would it compete? What products, activities, solutions, and services would it create? How would it simplify the customer offering to create the highest value?

The Dutch company Philips had a storied history in, among other things, lighting and personal electronics, but in the mid-2010s it decided to concentrate on health care and divest, spin off, or sell every other kind of business. Philips knew that to succeed it needed to focus management’s attention solely on health care. With this tremendous simplification came new investments in the capabilities that supported a much bolder health care strategy—which led to major innovations in health products and services.