Money matters

Resolving cost-related issues in any organisation calls for an uncluttered understanding of the root cause of the cost and focus on that. This can happen, if there is a clarity on the sources and causes of cost. Read on for more insights...

M Hariharan

The normal practice, if a company is not doing well, is to demand that every employee cut costs by 15 per cent. It is akin to telling

each employee, ‘take 15 per cent less food’, or ‘restrict the number of words in a report to 85 per cent of the intended length’. What many of us call as cost control is nothing more than expense control. The expenses appearing in the profit and loss account are listed, percentage of the expenses on sales is calculated and aspirational targets to reduce the expenses are set.

Expense appearing in the profit and loss accounts is the result of the management decisions taken. These decisions impact revenue, cost and investments. Addressing costs call for addressing the causes of cost, while reduction in expenses involves cutting them down, often without understanding the impacting factor of the cost. For example, material cost is considered as a percentage of sales and compared across periods. Then the attempt is made to reduce the material cost in isolation by forcing the purchase in-charge to look for alternative sources. Without any concern about the repercussions on the delayed material delivery, adverse impact on conversion cost & material losses and on the post-sales utilisation by the customer, the purchase in-charge ends up cutting the material purchase price. Material costs might have changed from the previous accounting period due to myriad reasons including change in material prices, product mix, input mix, material wastes and operating practices.

If an increase happens, the blame is on factors beyond one’s influence and control (global meltdown); and in reverse situation, the credit goes to superior operating practices. Either way, companies sweep the reasons for variation under a singular major cause.

There are four sources of causes for cost which are as follows:

Economic factors: These include price level changes, government policies, social issues and other factors beyond one’s control and influence.

Design factors: These include design of product, process, supply chain structure and organisation structure. They are normally within one’s influence and control.

Operational factors: These revolve around the fulfillment of design and are influenced by the economic factors and design. These factors are normally within influence and control.

Attitudinal factors: These involve the way people react to a situation and the culture of the organisation. These are also influenced by the design of organisation structure and may or may not be within influence.

Now let us analyse these factors in detail.

Economic factorsThis is the often seen ‘pass-the-buck’ for any cost increase. For instance, reasons like ‘input prices have gone up’; ‘our suppliers are in a monopoly market’; ‘wages have gone up’, ‘government has changed the rules’; or ‘The green lobby is creating lot of problems’ are the most common. Hence, it is essential to isolate the economic factors first. Addressing

Tackling root causes of cost

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these factors call for a more strategic focus than a simplistic operational focus. The following is an inclusive list of economic factors:

Changes in price level: Prices are influenced by many factors, both macro and micro-economic. Macro-economic factors include demand-supply gaps, speculation of commodity prices, cost of living index going up leading to labour cost changes. The impact of these on the bottom line is to be isolated before comparing costs across periods. Otherwise, this will vitiate the sense of direction. Addressing these causes is to be at a strategic level of freezing the sources for longer duration. However, the flip side is when the prices fall.

Micro-economic factors of an individual firm impacting the prices due to their monopoly position in the market, union level wage agreements, normal trend being followed within the company for salary increase (this drives the attitude) are again to be addressed at a strategic level. Developing alternative sources (design), relook at the practices within the organisation for salary hikes, relook at the agreements are some ways of influencing these causes.

Costs going up due to this factor are normally not a worry, if it impacts all the players and the given product is a necessity for the customer. Companies palm off the cost impact to the customers. However, if it impacts only a particular firm, then it indicates that the company is in trouble. Design plays a crucial role here; if a modular design can be created to change the dependence on any one input, which thereby minimises the impact, or design a supply chain where the company is integrated with the upstream sources (holding the mining rights, and thereby minimising the price level changes).

Government policies: Changes in tax structures, money market policies, restrictions and removal of restrictions on import play a significant role in adding to costs. For example, the design of supply chain is influenced by not only distances and nearness to sources, but also as

a result of speculation on introduction of GST. These again, in the ultimate analysis, will impact the whole industry and not only a specific firm. However, it will certainly impact differently, if various players are in different impact zones like a SEZ or FTZ. Even if competing within the domestic competition does not impact differently, if a firm competes globally or with global competition internally, then it has a huge impact on the cost structure.

Triple bottom line (TBL) requirement: Global concern for measuring a firm’s performance based on people and profit makes the environment and society a non-negotiable necessary condition for survival of the business. Firms are expected to avoid exploitation and spend on creating carbon credits as they grow. It certainly impacts the costs internally for the firm. However, over a period of time, it hopefully, will impact all the firms. Whatever may be the situation, the impact of focussing on TBL will certainly impact the internal cost, mostly in an adverse way. But, it is often worth it.

Design factorsDesign can create or destroy. More than 90 per cent of the costs are committed by the time a firm goes for a detailed design (of the product, process and supply chain or organisation structure). Trying to reduce the cost after the damage is done is more like catching the bull by the tail. Once committed, a company should address the design issues to achieve significant cost impact.

Design of the product: Product design plays a major role in the lifecycle cost of the product and the process. Any attempt to reduce the cost after the design is complete can have only a limited impact. For example, in the case of material costs, design has the greatest impact on the cost. Methodologies like target costing (in conjunction with value engineering and quality function deployment) can help the firm to design tomorrow’s cost through today’s design.

Design of the process: Design of the product plays a significant role in the design of the process as well. Still process design independent of the product design impacts the operations cost significantly. Outdated technology, unreliable process due to faulty process design, inappropriate processes are capable of playing havoc with the cost structure.

Design of the supply chain: If a customer wants online delivery directly, a company will need to keep stock nearer to the customer. This is essentially a supply chain design driving the cost structure. Creating supplier clusters, cross docking, milk run design, choice of the channel of distribution and sourcing, etc, all play a major role in the cost structure.

Design of the organisation structure: For men may come and men may go; but I go on forever. (The Brook by Tennyson). Similarly, men may come and men may go, but the organisation structure goes on forever. Many firms still follow the pyramidal organisation structure created by DuPont Plc in the early 20th century. Organisations may be divided as functional or strategic business unit (SBU) or matrix or flat as it

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is called for minimal levels of hierarchy. The structure drives the communication channel & the decision-making process, and ultimately the cost as well.

Operational factorsThis is the favourite ‘scapegoat’ for any cost increase. Bosses often are heard saying, ‘cut the cost everywhere; we need to tighten our belt’. Operations can only control cost and cannot reduce or manage cost beyond the boundaries of economic and design factors. Operations can fulfill and destroy, but cannot create. Design can create a far greater damage. But, operational inconsistencies, strains and penchant for creating waste all make a heady cocktail of cost increase. The three Ms – Muda, Mura and Muri – emerge out of operational inefficiencies.

Wastes – Muda: Defects, overproduction, waiting, transportation, inventory, movement and extra-processing, the seven wastes identified by Taichi Ohno, who propounded the Toyota Production System, are essentially triggered at the operational level. Though the structure of the supply chain, process and product do influence this, these seven wastes can emerge independent of the design.

Lean thinking principle of aligning the process to the purpose (customer value), and thereby focussing on the six out of seven zeros (zero defect, zero lot size, zero lead time, zero breakdown, zero handling and zero setups) can minimise the Mudas.

Inconsistency – Mura: Variability in processes, surges and inconsistencies force organisations to have capacity more than what is actually required. It becomes imperative to commit resources, men, machine and inventory to minimise the shock of the variability. Hence, the cost has a tendency to increase. Focussing on the seventh zero (zero surging), and thereby improving the process capability is critical for minimising Mura. Six Sigma focusses on this.

Strain – Muri: Strenuous processes, postures, movements, strain on machines, men and other resources are

the third ‘M’ of the infamous three Ms of Muda, Mura and Muri. Many of the quality initiatives focus primarily on the operational stability. The major role of operations is to ensure stability.

Attitudinal factors Afterall organisations are so-called as they are made up of people. People behave in the way their performance is measured. For example, selling price is not driven by the competition or customer or cost; it is driven by the month-end pressures of the salesman to achieve the target. Costs are incurred because there are budgets. The project completion time gets stretched to accommodate the padding that had been done during planning.

Outdated performance measures: The purpose of a performance measure is to implement and validate strategy. Strategy has to be in sync with the changed environment. If there is a change in environment, it is believed to be temporary. This leads to a delay in formulating a strategy to meet the changing needs. It is necessary to adapt one’s performance measure to fulfill the strategy. Strategy is for the future, but delayed with reference to the changing environment; whereas performance measurement is for the past delaying to adapt to the strategy. There is an in-built anachronism among change in environment, strategy and performance measure.

Short-term focus: Performance measures tend to focus on short-term achievement of targets. Even a CEO’s shelf-life is not more than three years. ‘Who cares what will happen to my successor; I need to cover my back (called as CYA syndrome)’

‘We follow the same attitude with our environment as well’ or ‘let me focus on reducing the purchase price; cycle time reduction is not my area of concern,’ called as not in my back yard (NIMBY) syndrome. All these attitudinal factors lead to locally optimising the cost but the overall cost may tend to increase.

Fulfilling a budget through reprimand: Discretionary cost is a cost triggered at the discretion of the management, like research, sales promotion, training, CSR, etc. In these cases, a budget based on a percentage of sales target is given to the functional heads. If the budget is not exhausted, they may get a cut in the next year. We often find a high surge in these expenses in the last three months of the year.

Attaining sustainable cost advantageProfit is a mind relaxant. People tend to splurge when they do well, but get to stingy levels when they do badly. To consistently address cost, a cost-aware culture is critical. It is important to realise that cost is an effect and not a cause. Addressing the effect by taking one-off initiatives rarely deliver sustainable and significant cost advantage. It is essential to address the sources of the causes of costs. In many firms cost ownership is unclear. Sustainable cost advantage emerges out of tackling, taming, tracking and trapping the cost. This can be done only by scientifically addressing the causes.

M Hariharan practises consultancy in the field of cost management, lean thinking, constraint management, management control system

and business excellence as Founder Director, Savoir Faire Management Services. Savoir Faire develops cost information systems to support pricing, outsourcing and control decisions using the cost excellence (CE©) model. He is also a renowned trainer on the impact of customer focus, competitor actions and goal conflicts on the bottom-line of the business. Email: sfgroup@vsnl.com

Design can create or destroy. A company

should address design issues to achieve

significant cost impact.