Conventional wisdom and common sense suggest that the greatest ongoing expense for most companies is labor. Keeping labor costs in line will maintain or even boost profitability, so that management fable goes. But more and more companies are concentrating an increasing portion of spend on third-party suppliers this “virtualizing” their operation rather than struggling with internal labor and physical overhead. This forces leaders to re-think what it means to be a “company.”
As any number of headlines will attest, struggling companies and their CEOs turn to layoffs as a first, almost knee-jerk response to dwindling earnings in order to quickly cut costs and satisfy shareholders. Case in point, the Lehman Brothers bankruptcy that set off the Great Recession in 2008 resulted in the near immediate loss of 8.8 million jobs, many of which have still not been replaced in the five years since.
Or maybe they already have – with suppliers and third-party resources that sit outside the organization.
The Great Recession produced a number of consequences, and one of them was redefining what it means to be a ‘company.’ Thanks to a phenomenon we call corporate virtualization, the ‘company’ is no longer just the collection of employees and internal resources required to deliver the product/service to market. It now has a far more encompassing and externalized definition and includes a universe of third-party suppliers who are critical but sit outside the organization. Companies in many industry sectors are looking more regularly to these third-parties, significantly skewing the balance between labor and non-labor costs by directing most of their spending outside the organization.
We conducted and recently published a comprehensive analysis of financial data for nearly 2,000 global publicly traded companies and found support for this notion of virtualization among the numbers. Across a wide swatch of industry sectors, from retail to manufacturing to professional services, and across countries and continents, the study showed that corporations today are directing, on average, nearly 70% of revenue toward externalized, non-labor costs with only 12.5% going toward internal, labor costs.
In fact, in nearly half the companies analyzed, labor costs account for less than 20% of revenue with non-labor expenditures chewing up more than 60%.
And while the analysis suggests that the extent of this virtualization trend varies from industry to industry, the scenario holds true even within professional services sectors where people power is the most marketable resource and commodity.
Why should the average CEO care?
Right off the bat, CEOs need to understand that slicing workforce numbers as a first course of in response to tough times, which has been the most common approach to belt-tightening, is fundamentally flawed. As a matter of fact, of the companies whose financial data we analyzed, a reduction in their labor costs by 1% would have netted only a .7% increase in EBIDTA. On the other hand, the same 1% reduction in non-labor costs would prop up EBITDA by just over 4% – a difference of nearly $95 billion dollars in revenue.
So why the continued focus on headcount cuts? In addition to the widespread overestimation of their potential impact on the bottom line, cutting jobs has been a CEO’s first response because, simply said, it’s more visible, it’s easier and it’s in their control.
In reality, redundancies can be both short-sighted and counter productive. While they appear to be a good temporary cost-savings fix, they can also hollow out an organization, stripping the company of the critical internal resources necessary to operate the business, which in turn impacts revenue.
Some enlightened CEOs are beginning to recognize the diminishing returns from labor costs and are instead looking to cut in areas perhaps less visible but ultimately more impactful, finding that it’s more effective to look for ways to improve efficiencies within its supplier network, as the research suggests. Examining how the organization works with suppliers and working more closely with them not only has the capacity to reduce costs, it can spur innovation, reduce risk, improve productivity and increase the chances of achieving corporate goals.
In addition to working with existing suppliers, perhaps its time for CEOs to reexamine the supplier landscape in full. A whole universe of specialist suppliers have emerged in the age of globalization that are capable of delivering on the most particular requirement at a more favorable price point.
Perhaps the time is right to explore not the dollar amount being paid for a particular supply, but the value of each dollar spent. Improved knowledge, insight and management of the supplier network is never a bad thing and doing so can pay the CEO ancillary dividends beyond short-term cost savings, like protection of brand and reputation. In some case virtualization can run away from the CEO if the network of supplier relationships isn’t properly managed.
When it was first reported that horsemeat had infiltrated IKEA’s iconic Swedish meatballs, it was the furniture giant itself, led by CEO Mikael Ohlsson, that took the brunt and found itself in an embarrassing crisis situation, not the unknown, ambiguous supplier most likely responsible for the snafu.
And when earlier this year a handful of Apple suppliers based in China were cited by a government watchdog for labor abuses, it was the Apple brand that was splashed across the headlines of the mainstream technology and business press around the world, and it was Apple CEO, Tim Cook who was made to answer to the allegations and ultimately forced to create a supplier handbook and code of conduct.
Warren Buffett said it takes twenty years to build a reputation and five minutes to ruin it. In today’s era of virtualization, others can ruin it for you just the same.
The virtualization trend shows no sign of abating. In the last three years, the companies analyzed in our study have increased their external spend by nearly 4% (as a percentage of revenue). We expect this number will only grow. Through recognition and awareness, CEOs can seize the opportunity to not only lift financial results but operational performance and brand reputation as well.
Matthew Eatough is CEO of Proxima, (www.proximagroup.com), a London-based international procurement and sourcing consultancy operates across the U.S. and Europe, and manages over $10 billion in operational spend from clients across a broad range of industries including consumer products, healthcare, media and entertainment, and retail.