That costs will indeed rise is the only certain and unambiguous thing in a volatile, uncertain, complex and ambiguous (VUCA) world.
Margins are vanishing, driven down by cutthroat price competition, downward price pressure from clients, upward price pressure from suppliers and the inflationary rise in the cost of doing business. As a result, companies have become more preoccupied with finding the next place to shave off costs rather than planning the next great product to sell.
Traditional cost-cutting, however, may lead to false economies. Cutting the wrong costs (e.g., value-adding activities) may lead to much higher overall costs or losses elsewhere. Rightsizing may actually end up as wrongsizing.
Here are five false economies to avoid:
• Downsizing the frontline staff to cut costs may inadvertently cut sales. According to a survey by the American Society of Quality, 64 percent of customers walk out of a store or service outlet if the lines are too long, 22 percent of customers leave because they cannot find assistance and 26 percent leave because of dissatisfaction with the attitude of a salesperson. Fatigue and stress due to understaffing may demoralize staff and affect the quality of customer experience or engagement.
• Understaffing production units to save on manpower costs may lead to burnout, costly defects, rework, accidents, and lower productivity. Understaffed operations often require regular and expensive overtime. The company may get less output or less quality per overtime hour or per overtime peso.
• Using lower quality materials or less skilled labor to save money may make the product defective, less desirable, or less saleable.
• Suppliers squeezed on price and payment terms may reciprocate with unreliable deliveries and quality, or abandonment of the contract.
• Penny-pinching on obvious costs ― such as executive perks, office supplies, advertising, training, subscriptions, after-sales service, travel, and client entertainment ― may result in little impact or long-term adverse consequence.
Cut waste, complexity to cut cost
To take any cost reduction program to the next level and get real, sustainable results, the cost paradigm should shift from cut cost to cut waste.
“Cut cost” is a confusing mandate. It is associated with cutting corners and cutting jobs, which will elicit little cooperation. “Cut unnecessary cost” or, better yet, “cut waste” is a clearer mission that can be deployed company-wide.
It will likely be supported by the entire organization since processes are the main source of waste and all employees are process-owners.
Waste can come from poorly designed, inefficiently managed, and complex processes. Complex processes due to poor planning and process design drive up costs and manpower requirements, causing huge overtimes, overhead, and overstaffing.
These wasteful processes can be found in sales, manufacturing, operations, logistics, finance, customer service, IT, personnel, R&D, and procurement. Spotting and stopping these hidden wastes must be done through process analysis.
Continuous cost or waste reduction must be done through continuous process improvement. Cost-efficient processes are simple, short, seamless, and continuous. Therefore, the cost paradigm must also shift from “cut costs” to “cut complexity.”
With process analysis, you may realize that to cut costs, it is necessary to increase costs in the right places; and that understaffing could be more wasteful than overstaffing. For example, reducing the staff or capacity of a bottleneck process to cut costs can lower overall capacity and lead to expensive idle time, queues, and inventories in non-bottleneck processes.
Investing in the capacity of bottleneck operations will actually reduce waste as well as the total overall cost of the production or service line.
Spot waste, stop waste
Spotting waste and stopping waste require leading indicators. Accounting reports and financial ratios are lagging indicators of cost performance.
Like the silent killer disease cancer, cost creep is asymptomatic. It shows up in financial reports as huge cost overruns after the fact.
Key financial metrics (i.e., inventory turns, asset turnover, margins, cash cycle, etc.) are strongly driven by process and supply chain efficiencies. The cost of process failures may account for a significant portion of the cost of goods sold. Defects and rework have actually been known to account for about 30 percent of manufacturing costs.
Unfavorable labor and material usage variance must be fixed via process analysis rather than by cost-accounting analysis, as these are mainly due to the inefficient use of resources. Moreover, budgeted cost standards may incorporate waste if they were based on historical data and not on best practices.
In this case, zero cost variance will not necessarily mean efficiency or competitiveness.
Since process failure precedes financial failure, leading process indicators must be used to stop cost creep at the source.
Examples of these indicators or early warning signs are frequent emergency purchases or hires, short lead time on requests, stockouts, overstocking, regular overtime, frequent downtime or delays, high defect or rework rates, late starts or workers unable to immediately start work when they arrive, long lead times, long setup, low capacity utilization, and line imbalance evidenced by very busy work stations flanked by idle workstations.
Without process knowledge and process analysis, there is a risk of cutting the wrong cost the wrong way in the wrong places for the wrong reasons using the wrong information.
New tools can help spot and stop wastefulness. The critical ones are lean technologies like value stream analysis or lean process mapping, target costing or lean budgeting, “poka-yoke” or mistake-proofing and “andon” or visual management.
Rene T. Domingo is an associate professor at the Asian Institute of Management’s Department of Analytics, Information, and Operations (AIO). He is an expert on lean systems and quality management, especially as they pertain to the manufacturing and service industries. For more information, e-mail RDomingoMT@AIM.edu or visit AIM.edu.