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Look for Total Company Cost Reductions Related to a Customer

Jul 10, 2008
Many companies have experienced putting in cost reductions that seemed to cause higher costs. How does that occur, and how can it be avoided?

Vendors of all kinds of products and services describe enormous cost benefits . . . but rarely offer guarantees that should cost benefits will occur. Beware of such potential conflicts of interest where selling you more may not help you.

Outsourcing has proven to be a new business model for many that eliminates that problem. The outsourced supplier gets paid for pre-agreed-upon results. If the vendor makes a mistake in putting the deal together, the vendor has to solve the problem.

As an example of how conflict of interest can be a problem, many operating executives report that new computer systems recommended by the corporate financial staffs to allow operating people to get more information about costs and production fail to deliver improved costs but certainly did increase the overhead in the business. If you could have counted the deck chairs on the Titanic even faster, would that have helped matters?

Many such investments in consulting for cost reductions from computing systems were provided by a company's auditing firm, and partially reflected a desire on the part of the company's senior financial management to have more financial clout with the firm's auditors when questionable accounting treatments and issues arose. Should senior financial management lose their jobs, the accounting firm will also help them find a new one. So conflicts of interest can arise in many different directions related to cost reductions. Watch out!

Even when such conflicts of interest are not involved, too narrow a focus can be just as deadly. Many companies retain a mental model of cost reduction that doesn't apply any more, if it ever did. You not only have to learn new ideas to become an effective cost reducer, you also have to eliminate old ideas that are wrong.

Many readers will be familiar with Adam Smith's description of pin manufacturing. With specialization and mass production, the cost of making pins falls. While that is true, its relevance is limited to situations where customers want and need lots of identical, low-cost pins.

In today's world, most people want something made just for them. Automobiles, personal computers, and clothing are all now available to fit the purchaser in combinations that may not be wanted or needed by anyone else. As a result, the company that offers one type of product or service with little or slow customization will find itself at a big disadvantage to companies that provide lean manufacturing or services.

Not only are such standard or difficult-to-customize offerings less attractive to customers, they usually cost more money before you are done. This occurs because you have to take a risk that some of these standard items will not be consumed, thus creating waste in finished inventory and unsuccessful efforts to sell those items.

In addition, the investment in creating large volumes of standard items is much higher per item for specialized capabilities and working capital. Further, customers often don't want or need parts of the standard offering which make all of the costs involved in adding them a waste of time and money.

Imagine a customer whose employees take the low-cost straight pin and bend it slightly to create a pin that holds tags to clothing more securely. Any efforts or costs to make the standard pins even straighter and resistant to bending is of no benefit to this customer.

Also, optimizing the costs of providing your offering isn't the only cost you have. You also have the costs of marketing and distributing the product. Lower your marketing and distribution costs enough, and you can still have a lower total cost even if custom making offerings is somewhat more expensive.

In fact, most companies do not think about what an account's total costs are to their company as the result of how activities interact in a system to provide offerings. That's a key mistake. Any system that optimizes the costs of each portion of the system for that activity will create important inefficiencies for the rest of the system that will raise overall costs.

For a service company, this may mean having one type of service contract. You pay so much per year or per visit, and you get a certain type of service.

Copier service companies often combine maintenance and toner tied to a minimum annual charge. If a copier customer finds it needs maintenance infrequently, this is an expensive way to buy toner. If a customer has a lemon for a machine, the maintenance agreement is a great deal for the customer and a disaster for the service provider.

Cost-conscious customers with lemons will always buy the maintenance agreements while those who have high-performing copiers will pay for service on a per visit basis and buy their supplies from the lowest-priced supplier. As a result, the copier service company sees its cost per customer rise to reflect the most poorly designed and manufactured copiers. Yet the standard contract certainly does limit selling and administrative costs (which was probably the purpose), an area that is vastly less important than how many maintenance visits and parts you have to supply to a customer.

Not only does a company have to think about total costs of an account, it needs to do so in terms of specific customers. One commodity maker of building materials became the profit leader in its industry, despite having a small market share by using this approach. While competitors offered all products to all customers and shipped from each plant, the savvy small producer looked at which potential and current customers were the most attractive to gain and hold.

The small company focused its attention on those where it could gain a large cost advantage over the most effective competitors. Then the small producer examined how it could increase its relative cost position even further by optimizing its total costs versus those competitors for these accounts.

The company's analysis showed that it should become a specialist in certain types of products and not produce the rest of its customers' needs. The company should also locate its facilities so that each one could be specialized to make even fewer products than before, but with even longer production runs (following Adam Smith's advice) to cut costs and improve quality.

The added facilities should also reduce the shipping costs and time to customers by placing the factories producing the items closer to each customer. As a result, the company was able to develop high market share positions in these low-cost items that it could expand upon geographically, further enhancing its cost position versus competitors. With additional strategic acquisitions and expansions, the company was able to duplicate this success in other territories.

Another example of this same approach is Martin Marietta Materials, a producer of rock products for the construction industry. While the company was owned by Martin Marietta (Martin Marietta Materials is now an independent public company), its management was encouraged to see its business as a total system to be optimized, much like the parent company did for its government clients in providing complex engineering solutions.

For example, a visit by the parent company's CEO caused him to think about ways that loading and billing could be automated so that trucks could be expedited through the company's facilities.

Similar to the construction materials company, the rock products company has analyzed how to source its rock in ways that provide cost advantages over competitors. For a particular customer, quarried rock may come by ship from Nova Scotia, crushed rock from a neighboring state by rail car, and sand by truck from a local gravel pit. Optimizing use of all three forms of transportation allows access to lower-cost rock sources than local competitors have while meeting customer delivery needs.

As you think about these examples, you can see the problem with much cost reduction activities. These efforts are focused on optimizing one part of an operation rather than the whole system of the company's activities.

In either the building materials or rock products examples, the optimum cost solution for a single facility would be much higher cost and less competitive in servicing customers than complementing the use of facilities and transportation. In traditional cost analysis, each operation would be straining to deliver as much volume as possible in order to spread the fixed costs of the facility.

In doing so, the operation would be using high-cost materials and requiring customers to incur unnecessary shipping costs. No one would be looking at reducing the cost of serving each customer while improving customer benefits.
About the Author
Donald Mitchell is an author of seven books including Adventures of an Optimist, The 2,000 Percent Squared Solution, The 2,000 Percent Solution, The 2,000 Percent Solution Workbook, The Irresistible Growth Enterprise, and The Ultimate Competitive Advantage. Read about creating breakthroughs through 2,000 percent solutions and receive tips by e-mail by registering for free at

http://www.2000percentsolution.com .
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