The Fallacy Of Across-The-Board Budget Cuts

Forbes

9 hours ago

An across-the-board cut is often seen as just or fair. But such cuts rarely make economic sense.Cutting a hedge with electrical hedge trimmer
Early July is the time when many organizations review spending plans for the rest of the year or for the upcoming year. Some like universities are reeling from cuts in federal funding. A few firms are hurting from inability to pass on tariffs to customers or from the need to spend more on newer priorities such as AI. Regardless of the cause, you can bet on one predictably flawed managerial initiative to find savings – an across the board cut for all divisions in the enterprise.
Why are such cuts popular?
An across-the-board cut is often seen as just or fair or politically easy to sell to staff. But the idea makes little economic sense, especially if the profitability or the contribution of specific units or divisions is relatively easy to measure. Most companies have units or divisions that need to be shut down for good, either because they are unprofitable or because they are marginal to the central mission of the enterprise. In an ideal world, a budget crisis provides an opportunity to make such hard calls for closure of such entities.
Instead, CFOs prefer, in many instances, to cut say 10% of the budget of all divisions to find savings. As a result, entities with more potential to drive current or future growth or profitability are deprived of capital or headcount. And the weak unit that deserves to be shut down limps on to bleed more money for yet another year.
The consequences
A significant consequence is that divisions tend to be afraid of hiring, even if they need headcount, knowing that the dreaded middle of the year call will result in eliminating some headcount. This uncertainty slows down the division – size and timing of the cuts are always looming in divisional leaders' minds.
Another nuanced angle is an across the board cut from which number. Typically, these cuts are based on the budgeted numbers for a division, which themselves tend to be unrealistic and more often than not aspirational, given the new era of political and economic uncertainty that we face.
Repeated across-the-board cuts also encourage divisions to create cookie jar reserves in headcount or padded expenses. And, this in turn leads to budget numbers that cannot be trusted or results in under-investment in areas where the money should have gone to. Perhaps these secret reserves in divisions could have funded that AI project that the CEO wanted.
Why does this inefficient practice perpetuate?
Partly because CEOs and CFOs are averse to shrinking the enterprise by shutting down the unprofitable division. Some have a hard time prioritizing. Others do not fully understand the long-term harm imposed on profitable units whose budgets are slashed. Some point to the potentially positive impact on employee morale by suggesting that everyone in the firm is willing to sacrifice resources to bail out the weaker units. 'We are in this together!' is what CEOs often sell. On the contrary, across-the-board cuts hurt morale as employees anticipate the cuts and their anxiety leads to lower productivity.
What should managers do?
Map out revenue producing divisions by their profit and loss numbers, evaluate direct margins for the division, identify the weakest division that perpetually makes little or no direct margin and sacrifice them. Forget common overheads for now and focus on direct margin for this activity.
Examples of enterprises that do this well include Amazon that back in the day closed its' auction business because it could not effectively compete with ebay on that product line. Microsoft sold its display advertising business because it could not effectively compete with Google in that area. Instead, they focused on search and cloud computing.
In essence, the leaders at Amazon and Microsoft had the guts to shut down divisions that had not grown or were unprofitable, even when measured using direct margins, for five years and more.
Resist the temptation to cut tech and finance budgets
Needless to say, use the resources saved to double down on divisions that have greater future growth potential and are profitable. Moreover, resist the temptation to cut investments in divisions that build resilience for the entire company and/or bring accountability to the organization. For instance, many companies under-invest in technology, finance and legal units for different reasons. Unless the firm is run by an engineer or a technologist, technical debt (the gap between where the code and technology infrastructure needs to be given business trajectory relative to where it is) needs to keep creeping up over time. Technical debt weighs the firm down in the long run although the short-term pain is not obvious.
Finance and legal are often seen as compliance overhead by many CEOs. However, finance and legal can drive change and/or accountability if these are seen as units that can contribute beyond compliance and are viewed as co-decision makers with the CEO. The best-run companies tend to have strong finance leadership.
Examples of cases where across the board cuts do more harm than good
Universities are notorious for insisting that every school in the system take a pay cut or cut budgets by 10%. Universities tend to be consensus driven institutions which are ill-suited to trimming fat and for taking hard calls for cutting say the myriad statistics classes run in every school in the university (Agri statistics, statistics for psychology, for the education division, for anthropology, for biology, for economics, for environmental science, for political science, for sociology, for business, for different divisions in the b-school such as in accounting or finance or marketing and the like).
This is not to say that the context in which statistics is applied is unimportant. But surely, one can save money by consolidating some of the statistics classes offered in the university instead of requiring everyone to take a 5%-10% cut in their budgets. And this is just one example of where inefficiencies can be eliminated without materially affecting the quality of the educational experience students get.
The other domain where across-the-board cuts are common is the government. Instead of thinking hard about the social and/or economic desirability of cutting specific programs, it is politically much easier to ask every program or agency to cut 10% of their budget.
Are non-profits different?
One could argue that my foundational premise behind an across-the-board cut, that direct margins or contributions of divisions can be measured, is violated in non-profits such as universities and the government. That is perhaps true to some extent, but I worry that this argument is oversold. For instance, if someone argues that liberal arts need to be trimmed in a university, how does one figure out the marginal dollar or reputational contribution of liberal arts to the university? That is fair, but have we eliminated programs or classes or courses that potentially need to go on common sense considerations, even without a deep consideration of costs and benefits.
In government, if we don't really know the costs and benefits of a program, why did we initiate the program anyway? And there will always be interest groups who want nothing cut. So, an across-the-board cut is potentially more attractive in non-profits but only as a last resort after the relatively obvious laggards are eliminated.
So, if you are a leader thinking about an across-the-board cut, think hard about the tradeoffs involved before you pull the trigger.