Those who create innovate, others imitate. All of us thrive on borrowed intelligence. Creativity to improve the current status is the fountain head of innovation. We tend to “play safe” by following the beaten track, rather than trying out different route that is riskier. We are comfortable following the competition, as if the key competitor is Columbus, and we assume that we are sure of making the voyage.
In this piece I have tried to correlate the perspective of breakthrough management, propounded by Prof Shoji Shiba and linked it to the need for innovation as the bedrock of Cost Management.
Turbulent times “Brutal” Cost Cutting:
The present turbulent times may be perceived either as the age of opportunity or as the age of lost opportunity. We are in the middle of what is arguably the biggest economic crisis of all times. With the current scramble for shoring up the bottom line, companies resort to knee-jerk cost cutting. Cost cutting is related to as, ‘Not having more than three cups of tea per day, and sharing half a cup among three employees - that too once in three days drawn by lots’. R&D, training, advertisement & sales promotion and employee welfare are the areas, considered easier to ‘cut’ cost. Cost cutting is all about cutting corners. It seems to yield great results in the short-term, but, it tends to get ‘brutal’. Focusing on the Cost numbers and “analysing” the numbers as a percentage of sales or per unit, can not lead to sustained cost improvement. Cost is a symptom and not a cause.
Changing cost perspective
In my opinion, there are three stages of Cost Perspective as below:
Stage 1: Cost reimbursement perspective (C + P = S)
Life used to be simple. We used to apply for a Bajaj scooter, await allotment and on allotment sell the allotment at a premium. The product range became narrower; competition was prosaic, and profit making was too simple. Further, the cost was passed on to the customer, where apart from reimbursing the costs, he bestowed the manufacturer with profit. Here, the cost perspective was:
Cost + Profit = Sales
Thus, not only did the hapless customer reimburse the cost, but he was also made to pay for the manufacturer’s inefficiencies. But no sooner than later the party was over. As competition intensified, more and more suppliers gained entry into the marketplace, and sales price got out of control. Having got used to a level of ‘extravagance’, the cost too was out of sync. This resulted in a lower margin or even loss. As a result, this led to stage 2.
Stage 2: Cost reduction perspective (S – C = p/L)
Now, the cost perspective changed to:
Sales - Cost = Profit /Loss
Consequently, the pressure to keep the cost under check, led to cost cutting, cost control and cost reduction. Cost Cutting is “Brutal”, but Cost Control and Cost Reduction are scientific.
Cost Control – The First Eye of Buddha:
Correlating the Three Eyes of Buddha to understanding Costs, I perceive that Cost Control is the First eye – Maintain the Cost at Current Levels. There are many routes to control cost; but the methodology is a typical feedback loop.
Cost control is conformance to plan. As long as the actual performance is within the set standards, things are deemed to be under check.
This methodology is appropriate for micro-level control. It brings stability to the approach towards cost. However, it leads to two dangers:
1) We tend to get complacent, “Do not disturb the status quo, and when things are under control, why tweak it?”
2) We also tend to get localised and gets into a micro-level analysis, get myopic; but lose sight of the overall picture. The macro picture of the business thus gets lost in the process.
The first level of getting consistent is critical for graduating to the next level of incrementally improving, i.e. Cost Reduction.
Cost Reduction – The Second Eye of Buddha:
Cost reduction is questioning the base itself. It thus overcomes the complacency of cost control. However, for effective cost reduction, there should be a mechanism of cost control in place. Cost reduction calls for relentlessly questioning the purpose of incurring a cost. There are several quality tools that facilitate cost reduction to a great extent. Approaches like 3M (Muda, Mura and Muri), 5Ws & 1H, Why Why analysis, or any waste elimination / waste reduction methods if properly followed have a potential to achieve perceptible cost reduction.
Cost reduction, too, is more scientific, and has dangers to it as well. These include:
1) A tendency to get localised. Just as in the case of cost control, one tends to get into too much of a microlevel analysis and lose the overall business perspective. As Dr Goldratt will call it “Local Optimisation leading to Global Sub-optimisation”
2) A thin line of difference between cost reduction and cost cutting. If it loses the ‘science’ it becomes ‘brute’ cost reduction. In short, all the three approaches (Cost Cutting, Cost Control and Cost Reduction) lose the macro view of the business perspective.
Stage 3: Cost Management perspective (S – P = C)
The competition is further intensified. As more firms enter the market, pressure to reduce the price increases. Competitors consistently offer superior functionality and quality, but at the same price level or reduced prices. In such a scenario, we need more money to invest in operations as well as to upgrade and compete. Resources become scarce and we approach the capital market to tap the limited resources available with the investor. Our industry is not the only industry that approaches the investor. In fact, competing firms from different industries also reach out to them. Further, the common investor is least concerned about the type of industry – be it steel, dot com, etc. Rather, he invests in ‘that’ firm in ‘that’ industry that promises return, rise as well as realisation with acceptable associated risk (four Rs of investment). Unless the best combination of four Rs is given, one cannot tap the limited money on offer. Further, unless one promises ‘that’ level of profit, one cannot survive. Now, the cost perspective changes to:
sales - profit = cost
Here, the cost is ‘allowable’ cost. It is no more a cost reduction game but a profit management game. And, to manage the profit, cost has to be contained within the range of sales and profit.
Definition of cost management
I define Cost management as “any cost improvement that creates and sustains value for the customer better than the competitor”.
Though I have included the competitor in the definition, I am considering competition only as a reference point and NOT as a primary focus of the definition. Perspective of cost management is Customer Value Creation. A firm has to find ways of creating more value for the customer at lesser cost.
Sustaining Inequality of Value, Price and Cost
Sustainable profit is possible if and only if our customers perceive a higher value than the price they pay; and if and only if that Price results in an expected rate of return to the capital provider after recovering the costs of providing the product/service.
So only by sustaining the inequality of value, price and cost, we can sustain of profit improvement. So long as the customer is deriving a Value that is more than the Price he pays he will continue to patronise the provider. So long as the Price is greater than the Cost the provider can prosper.
It is ultimately the customer who provides the profit to a business enterprise. Many a times the service provider focuses on the value > price relationship and hopes that it will take care of the profit. But the cost to provide that Value may be more than the price sought. Value is perceived, and Cost is a reality whereas price is more of a policy. We end up focusing on the competition and inadvertently ape the competition as if the competitor is right. We end up in deeper mire than what we were.
On the other extreme, we focus more internally on cost and forget the customer in the bargain. As a consequence most managers do not understand is that in order to do well, any business has to concentrate on ‘Doing things better and not doing things less’. Revenue is the most critical growth driver to survive these turbulent times. The only way to survive is to sustain the growth. The key to better Profits and Profitability lies in maintaining Better Customer Focus and Better Value Delivery.
Simply put, cost management is not cost reduction. Rather, it is value creation – i.e. Customer Value and Economic Value
Profitable Combination of V, P, C Inequalities
There are 27 combinations of Value, Price and Cost Relationship (3x3x3) (extended further to 39 combinations of V,P,C considering degrees of variability). Some of the combinations are sure profit earners, while some of them a sure ticket to losses. There are others that may probably lead to profit or loss; there are a few other combinations that lead to unsustainable profits.
Of the combinations that are sure profit earners, there are five that emerge out of the third eye of Buddha.
These are:
Increasing cost a bit and increasing the value a bit more; for example, LG Golden Eye -the cost incurred for the product versus the value proposition for the customer. Value Engineering is an enabling methodology for this.
Reducing cost more and reducing value a little. This is normally not acceptable. However, it is appropriate if one seeks to segment the market and plans to serve a lower segment of the market. For Example, Nano fits this perspective. Here too Value Engineering is an enabler.
Reducing cost and keeping customer value constant; for example, the refrigerator handle- This is a Pure cost reduction initiative. In that sense, I am considering Cost Reduction as a subset of Cost Management so long as it doesn’t affect the customer value.
Keeping costs constant and increasing customer value; for example, finding alternative uses for the same product. I choose to call this as Value “Innovation”.
Reducing cost and increase Value. This is the height of Cost Management. This emerges out of understanding the ultimate customer value and delivering that to him at lesser cost. This is the break through level. Mera Wala Colour, Ready Mix Concrete, ATM, NovoPen (Insulin injection) are classic examples of this level.
Conclusion
To summarise, cost management is all about relentless customer value creation. Further, it focuses on creating economic value for the investor. It also validates the perspective of cost management in terms of bottom-line improvement. Cost management uses various methodologies, tools and techniques that integrate seamlessly to facilitate the perspective and focus of cost management. It is a never-ending journey, which calls for the survival of the fittest.
“In the struggle for survival, the fittest win out at the expense of their rivals because they succeed in adapting themselves best to their environment”
- Charles Darwin, The Origin of Species, 1859
Bibliography:
1) My interactions with Prof. Shoji Shiba and Dr. Sarita Nagpal during the VLFM and VSME programs
2) Techniques of Value Analysis and Engineering by Lawrence D Miles
3) My articles on Cost Management published in Modern Plastics and Polymers (an Infomedia publication)
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