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Directions to Reduce Unit Costs With Improved Productivity

The Improve Costs section of StrategyStreet helps any functional cost center manager reduce the unit cost of producing Intermediate Cost Drivers within a work center by increasing the Productivity of the Inputs used to yield the final Outputs. The focus of the innovation ideas in this section of StrategyStreet is the reduction of physical units of Input costs needed to produce physical measures of Outputs for customers. This work assumes that the Company has a clear statement of the benefits that each functional cost organization must provide its customer.

Productivity is the ratio of the cost Inputs divided by the Outputs. In turn, the cost Inputs (I) are the three Building Block Costs of People, Purchases and Capital. Few work centers produce an actual Output (O) for the customer. Instead, they produce Intermediate Cost Drivers (ICDs) which are contributors to the final Output. The easiest physical measure of final Output to find and use is a customer order. Using ICDs in the calculation, Productivity has two component parts: Efficiency of the Input (I รท ICD) times Effectiveness of the ICD (ICD/O) produce Productivity (I/O).

To improve Productivity, we examine each Building Block Cost (i.e., the Inputs, or I) separately. We suggest that you focus your initial cost management efforts on the People Input. We describe and count the Intermediate Cost Drivers (ICDs) that each Input produces in the work center. Then, we reduce costs by improving Efficiency of the Input and Effectiveness of the ICD. To improve Productivity, we work independently on its two components. We improve Efficiency of the Input by reducing the Building Block Cost Inputs (I) required to produce a particular ICD. We raise Effectiveness of the ICD by eliminating some unique ICDs, or some occurrences of an ICD, and by stretching some fixed cost ICDs over more final Output (O). For a complete explanation of this approach to cost management, please see Diagnose/Costs/Measuring Current Economies of Scale.

We explain our organization of the innovation examples in the following sections:

  • Improvement in the Efficiency of the Input
  • Improvement in the Effectiveness of the ICD
  • Innovation Examples

Improvement in Efficiency of the Input

To improve the Efficiency of the Input ratio, I/ICD, we focus all our attention on a particular I, for example, on the People in our work center. For the moment, we leave the ICDs as they are. We produce the same set of unique ICDs and in the same quantities. In Efficiency improvement, we seek to reduce the number of people (I) required for each ICD the work center produces. We have two levers for improvement in Efficiency:

1. Reduce rates paid for the Input (I), which reduces the total number of I. This action reduces the amount of Input used for a particular ICD because using an Input with a lower rate of cost is equivalent to using a fraction of the original Input. For example, a person earning $10/hour is effectively half of the person earning $20/hour. Shortcut to Examples>>

2. Reduce available units of Inputs (I) not producing an Intermediate Cost Driver (ICD). This action makes Input levels more directly variable with the quantity of the ICD by reducing the amount of the available Input that is wasted or idle. For example, an employee (I) might produce one subassembly (ICD) per day. During that day, the employee spends a total of one hour waiting for parts for the subassembly. If the Company could eliminate that one lost hour of the employee's work day by providing parts in a more timely manner, the Company could reduce the number of employees (I) needed to produce the same subassembly (ICD) by 1/8th. Shortcut to Examples>>

Improvement in the Effectiveness of the ICD

To improve ICD/O, the Effectiveness of the ICD, the cost improvement actions focus on the ICDs. We assume that we have done what we can to improve the I (e.g., People) cost by reducing both rates and unproductive resources. We turn our attention to reducing the ICDs. Here, we either eliminate the unique ICDs (e.g., a step in the manufacturing process) or reduce the quantity of a unique ICD used to produce a final Output (e.g., the number of "set ups" required on a paint line).

3. Reduce unique ICDs by redesigning the product or the process. This action eliminates the specific activity or ICD used to produce the Output (O). A unique ICD is one of the activities in the work center's value added to the final Output (O). It is separate and distinct from any other activity in the work center. For example, the fastening of a part onto a subassembly and a quality control check of the subassembly would be unique ICDs. Shortcut to Examples>>

4. Increase the Output (O) over which a fixed cost ICD is used. This action reduces the quantity of a unique fixed cost ICD used to produce a unit of Output by increasing the units of Output. For example, a new product design or a new process patent are both ICDs that have virtually limitless opportunity for use. These are fixed cost ICDs. You pay for them once and you can use them over a virtually unlimited amount of Output. Their ICD/O ratios are limited only by the current demand level for Output. Shortcut to Examples>>

We support each innovation concept on the outline with numerous examples. Each example lists the SIC of the industry, the year it occurred, and a short write-up describing a situation where the cost improvement idea is used or implied, as illustrated here:

EXAMPLE:

REDUCE RATE OF COST/Form Co-ops Among Smaller Customers

INDUSTRY SIC

YEAR

EXAMPLE

5112

1997

Small stationers joining to form buying cooperatives in order to lower costs to compete with office superstores like Office Depot, Staples.

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