Category Archives: Cost Reduction

Efficiency is Never Bad. It’s the Focus on Cost-Cutting that Kills You!

Glancing through my notes, I came across this piece in S&DC Executive from the early spring that asked if “too much efficiency [can] be a bad thing”. I bookmarked it because articles like this really grind my gears. We have enough problems without respected publications publishing idiotic articles, such as this, that try to answer difficult problems with findings from studies that identify correlation, not causation. (And as Pinky and the Brain explained in their brilliant lesson in statistics, correlation and causation are not the same thing. Simply put, correlation measures the relationship betwee effects, which have underlying causes.)

And while I fully believe the results from the in-depth study that asked what drives financial performance and analyzed the financial performance of publicly traded U.S. manufacturing firms from 1991 to 2006, as reported in Volume 29: Issue 3 of the Journal of Operations Management, I reject the editorial staff’s claim that the results present empirical evidence to support the view [that too much efficiency is a bad thing]. Efficiency is never a bad thing. It’s the principles guiding the application of the efficiency that is the problem.

As the article states, if there is no slack in the supply chain when a disruption occurs, then this will cause operational problems that will result in a negative financial impact. But the decision to go all-out with a Just-In-Time (JIT) philosophy is not an efficiency decision, it’s a cost-cutting decision. Less stock means less inventory and carrying costs. So some firms, in their effort to save every penny, go ultra-lean and then run into serious problem when a demand surge or supply disruption hits.

Efficiency corresponds to the production, inventory, and logistical processes used to manufacture, store, and ship the goods. It’s streamlining the process to eliminate time and resource waste, not cutting production quotas to dangerous levels. It’s minimizing packaging and storage space requirements by maximizing package integrity and space utilization, not eliminating safety stock. And it’s optimizing the distribution network for quick and affordable shipping, not altering lot sizes to fill an existing truck or lane to save a few pennies on shipping costs (when there are dollars to be saved from a network redesign).

Efficiency is never bad. Only ill-conceived supply chain design decisions and overly ambitious cost cutting is bad. And anyone who thinks otherwise doesn’t understand what efficiency means.

Cost Reduction Strategies to Avoid

Cost reduction as a strategy is dangerous. First of all, a company that is too focused on cost might lose sight of value, which is what Supply Management is all about. Secondly, a company that is myopically focussed on immediate cost reduction is likely to make one or more of the following mistakes and actually increase costs in the long term.

Direct cost focus

This sounds like a great idea, since it’s where many organizations in manufacturing and CPG have the bulk of their spend, but the reality is that these are the categories that get analyzed year after year after year, while indirect categories fall by the way side. And the reality is that it’s much better to save 10% on 40 M then it is to save another 2% on a 100 M category. It’s twice the savings.

Landed cost focus

While it’s true that you can (theoretically) “book” a savings if a hardball negotiation gets you the same widget for $1, including transportation, that the organization used to pay $1.10 for, this is not really a savings if the widget is of lower quality and has a higher failure rate. If 15% break-down during the warranty window, when only 5% used to break-down, this has not only increased the average unit cost from 1.16 to 1.18 (in terms of functioning units), but tripled your warranty costs. If replacement costs turn out to be twice the product cost then, instead of paying an average of 1.20 per unit from a TCO perspective, the organization is now paying 1.30 per unit (from a TCO perspective) when the total cost of the lower quality product is calculated.

Year-over-year price reductions in multi-year contracts

This is my favourite example of cost reduction ridiculousness. Sometimes, anxious to meet the ridiculous mandate of 5% year-over-year cost reductions for the next three years, Supply Management organizations will try to negotiate three year contracts with year-over-year price reductions of 5% built in. And often they’ll exceed, and cost the organization approximately 15% more then if they just negotiated the best deal they could. Why? The supplier is going to have to make a profit each year it is in business. Since it’s likely not going to change the production methodology, the raw materials, or the labor that goes into making the product for the lifetime of the contract, the supplier knows that the price in year 3 has to be enough to be profitable. So the price it quotes in year 2 will be 5% more and the price in year 1 will be 5% more again in an attempt to insure it is still profitable in year 3. As a result, the organization ends up paying significantly more in the first two years than they could have paid by just negotiating the best, flat, deal possible. The right way to get year-over-year savings is to tackle different categories each year, not try to negotiate silly year-over-year savings in a single category.

Cost Leaders Do Not Sacrifice Quality or Customer Focus, Part II

Yesterday’s post talked about the principles of cost leadership and how cost leaders do not compromise quality and customer focus. It’s only low cost if quality, service, and other factors stay equal. Otherwise, it’s low cost up-front, higher cost (and loss) later on. If an organization is not on the cost leadership track, it should be. However, like any other initiative, there are a number of show stoppers and initiative killers that can prevent the organization from becoming a cost leader if they are not identified and addressed as soon as they materialize. As per the recent article on why businesses should shift from cost management to cost leadership in Chief Executive, these include:

  • Complexity
    If the initiative is not easy to explain and not easily understood by the stakeholders, it may stall before it starts.
  • Lack of Cross-Functional Support
    If there is no buy-in by key stakeholders across the board, failure is likely eminent.
  • Impatience
    Stakeholders will want to see actionable recommendations from any initiative quickly, and these actionable recommendations will need to be capable of being implemented in the near term.
  • Under-Resourcing
    Don’t attempt to build equity or buy-in by under-resourcing the initiative (to keep costs low); as the authors of the article note, this is equivalent to crippling the racehorse at the starting gate
  • Education
    Training will be critical for the success of a cost leadership initiative. A training component will need to be included. Moreover, training is often the best tool to reduce the fear and apprehension that goes with any new initiative.
  • Under-Communication
    Communication is critical for any initiative, and early wins must be publicized and recognized to maintain the support necessary for success.
  • Over-Hyping
    No initiative is perfect and all-encompassing. Don’t overestimate the potential impact of the initiative, and never, ever, say that the new system will fix everything.

Cost Leaders Do Not Sacrifice Quality or Customer Focus, Part I

I was pleased to see that this recent article over on ChiefExecutive.Net on why businesses should shift from cost management to cost leadership, that emphasized the need to control cost in the current economy, clearly stated that cost leaders do not compromise quality or customer focus. Every time I see a headline or article on cost management that emphasizes the need to identify low-cost producers, I get worried because, as many manufacturers who jumped on the outsourcing bandwagon have learned, low cost does not always translate into cost savings if quality is not maintained.

The article defines cost leadership as the:

  1. recognition as the lowest cost producer in one’s industry, without compromise in quality or customer focus
  2. realization of a long-term cost-centric culture where cost consciousness is a strategic and leadership preoccupation across functional lines
  3. dissemination of cost information with regard to customer, product, distribution channel, and the like that is timely, understandable, credible, and actionable to fuel continuous improvement
  4. establishment of aggressive and balanced performance targets across the value chain

And it’s a good definition. With costs rising across the board, cost control is very important, but cost control must take into account quality, customer needs, and continuous innovation. If quality is bad, costs will add up in repairs and returns and profits will drop as customers leave for your competitor. If the focus is not on the customer, market share will slowly decrease as your competitors begin to offer products and services that better serve the customer. And if continuous innovation is not employed, costs will creep back up.

The article also noted three practices of costs leaders that are worth diving into:

  • Less Is More
    Simplified products and services, even if they cost a little more up front, will usually cost a lot less over the lifetime of that product or service.
  • Customer Profitability
    Each customer should be profitable, and, more importantly, if you deliver a product or service to businesses, it should make them profitable.
  • New Formula
    If a product requires costly raw materials, or contains raw materials that are heavily regulated, or produces hazardous waste in its manufacturing, reengineering the product to use less costly raw materials, less regulated raw materials, or production processes that do not produce hazardous waste will significantly reduce costs while maintaining, or improving, quality in the process.

The article also highlighted a number of cost leadership initiative killers that you need to watch out for and address as soon as they are encountered. But that’s the subject of Part II.

To Maximize Value, Don’t Overlook Tail Spend

A recent article in the Sourcing Interests Group Newsletter on “understanding tail-spend management” noted that while ROI for tail spend categories will generally be lower than for core categories, those companies that keep their eye on the efficiency/effectiveness equation and approach tail-spend intelligently can still find significant savings that make the effort worth while. So how does an organization properly approach tail spend, which:

  • rarely includes direct materials
  • contains a disproportionately high percentage of spend from the furthest-flung subsidiaries
  • contains suppliers that no one in procurement has heard of
  • contains large percentages of non-compliance and maverick spend

Intelligently. And iteratively. Data must constantly be reviewed in the light of changing business requirements to determine the best course of action using the following process:

  1. Spend Analysis
    Focus in on the tail-spend data and figure out what is being bought, from whom, where, and for how much compared to market value.
  2. Filtering
    Focus on commodities that can be reclassified into a category that will have enough spend to be worthwhile.
  3. Sourcing Strategy
    Once the category with the biggest opportunity has been identified, determine the right sourcing approach. If a sourcing project is the right approach, accelerate it with standardized templates, RFX, and/or auctions.
  4. Spot Buy
    If the right strategy is to spot-buy in a weak market, then aggregate demand across the organization and spot-buy through e-RFX or automated auctions.
  5. P2P
    And, regardless of the right sourcing strategy, drive as much spend onto technology platforms, like P-cards, so that it can be tracked and analyzed.

And, most importantly,

  • use procurement technology
  • simplify processes and increase controls
  • establish resources and manage performance