The Focus on Cost Minimization is a Bastardization of Capitalism

When you optimize for cost, you are not properly allocating resources

“Capitalism is an economic system that focuses on a free market to determine the most efficient allocation of resources and sets prices based on supply and demand.”

Investopedia

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If you look closely at modern corporate America, from startups through Fortune 500s, you’ll notice one overriding rule about how they allocate capital: reducing cost. The thing is, that’s not capitalism. While reducing cost does inflate your profits, if you are not saturating your market, which almost every company is not, then you are probably missing out on potential income by not efficiently maximizing your production. Let me explain.

I think many CFOs would be surprised to learn that capitalism is not defined by reducing costs, but by maximizing profits. Specifically, that reducing costs is not always the most efficient allocation of capital. I’ve mostly seen this from the startup world, but my friends at larger companies tell me it’s just as prevalent there. Let’s look at some areas where cost-cutting clearly is not in favor of maximizing profits.

For one, companies do not invest in their human capital. In fact, in business school, we were taught not to. Every company I have worked at has looked at each employee as a one small replaceable cog in a giant machine and paid them the absolute minimum they could get away with (save for a few sectors like finance and FAANG). Where I see them making dumb decisions is that many times, these employees are the ones building your work product which is then sold. This makes them a profit center, not a cost center. This area is worthy of investment to increase their productivity and output, not simply one for a bare minimum spend.

An example would be most companies’ attitude towards engineers, which I see all too often. Companies hire very low-end engineers, usually with 1-3 years experience, hire a lot of them, then work them very, very hard with long hours and strict deadlines. Many burn out, morale is low, and churn is high. But since they are just replaceable, who cares? And since they are a cost center, the cost should be minimized.

But…this is a software company. In the analogy of a factory, your engineers are the factory and its workers. You don’t invest in a cheap, worthless factory, do you? It’s what is making your product! Additionally, with engineers, you get what you pay for. Hiring engineers that are 20% more expensive will get you 50-100% more production. Trust me; I do it all the time. And it scales up from there. Other work is similar. Want more production? Pay more. And then you need fewer workers, which leads to cost reduction in other many other areas. Or, you can keep the same amount of workers, produce more, and raise your income and thus your profits.

It consistently baffles me that no one invests in good workers anymore. When I run companies, I don’t just hire good; I hire the best. Because anyone who has worked with a 10x engineer knows they are worth their weight in gold. And I fill my companies with them. Plus I hire top designers, the best finance people, and - always - the best sales guy money can buy. And it works. I invest. I don’t cheap out. And it makes a company grow faster than your head can spin.

So, what we have here is a misunderstanding of capitalism, or a misapplication of it. Properly allocating resources would be hiring at the equilibrium of output and cost to maximize production. But that’s not what companies do! Companies consistently, from startup to Fortune 500, hire the cheapest labor they can find. This flies in the face of capitalist theory! And it is in fact not capitalism at all. It’s something else. And it’s disgusting and nefarious.

So there’s the first misallocation of resources. Let’s look at another.

Almost every mechanic I’ve interacted with in the last five years has nothing nice to say about modern cars. “Appliances on wheels” is the phrase I’ve heard repeatedly. My last car had all sorts of issues, as well as the car before that. Both were leases of brand-new cars during the warranty period.

So goes the saying: “They don’t make them like they used to.”

I think it’s fair to say that many (not all) manufacturers have significantly reduced cost at the expense of quality in the last decade or two. And I would say that, in many cases, this has damaged their brand. I can think of numerous instances where a brand I was loyal to started reducing their quality, and that led me to no longer be a customer.

Now, think about brands that do invest in high quality products. Specifically, think of Apple. They may make their items overseas, but I don’t think anyone would say an iPhone is made of cheap materials, not any of their other products. And guess what? They are the largest and most profitable company in the world.

Yet, most companies do not learn from this lesson, and they try to cut every corner in production. Again, it’s microeconomics. There is an equilibrium between manufacturing cost, that is, how cheaply you can build your product, and how many you’ll sell (i.e. customers you’ll keep). But instead, I’d venture that the majority of manufacturers these days do everything in their power to minimize production cost to get away with bare minimum quality, much to the detriment of their brand.

Again, this is a misallocation of capital by focusing on cost rather than profits.

And lastly we have the old classic: international outsourcing.

Now, this isn’t to say this always goes bad, but it frequently does. I have been brought in numerous times to clean up a project outsourced overseas. What I generally find is a horribly written mess so unsalvageable that I just start from scratch. What’s even more humorous to me is that I get the original job done faster and cheaper than if they hadn’t even outsourced it in the first place.

Outsourcing comes with all sorts of problems. As an engineer, I’m mostly going to use the example of using overseas engineers here, as that is what I am most familiar with. Trying to cheap out on overseas engineers generally slows down your time to market, dramatically increases your communication issues, and gets you - sorry - a much less reliable product prone to errors.

And as stated above, at a software company, this is your factory producing your product that you sell. You’re really going to cheap out on it that much? Don’t you want it to be in perfect condition?

While they didn’t outsource it, I have a good example. At a FinTech company I worked at, there were two sides to the business - its classical side and my side (sorry, I cannot go into greater detail). The classical side was all engineers who came from coding camps, the American version of outsourcing, who copied and pasted code from Stack Overflow and frequently needed a lot of help. When we installed Sentry, an error monitoring service, on their software, we discovered they had around 12,000 unhandled errors a day. As this was a FinTech company, this showed up as a massive drain on their customer service team, as people’s money was being mishandled.

On my side of the business, we had about two errors a week despite a similar amount of traffic. My staff was myself and two other engineers with high-end degrees in computer science.

I’m not trying to brag. It made us rather unpopular to show how poorly the rest of our coworkers were building software. But it was a good definitive proof that hiring proper talent leads to a better product, which leads to higher profits. Which brings me back to my original argument.

All of this is to say that the obsession with reducing cost in fact damages companies rather than, as the very definition of capitalism says above, focusing on profits. There are, of course, many other ways they misapply this; these are just three examples. But it’s time for a shift away from cost minimization and back to profit maximization.