98-Big Cost Differences in an Industry – Part 1

 

Posted 4/23/09

The objective of every cost management system is to improve the Productivity of the Input (I) resources used to produce the final Output (O) product. These resources include the Inputs of People, Purchases and Capital. The Output is the unit of product sold. A simple measure of Productivity is Inputs divided by Outputs (P=I/O).

There are several stages in producing a unit of Output, so relatively few employees (one of the key Inputs) actually produce a unit of Output. Instead, most employees produce something else as an intermediate end product on the way to the final product. We call these intermediate end products Intermediate Cost Drivers (ICDs). So, to increase Productivity, you would like to improve the ratio of Inputs needed to produce Intermediate Cost Drivers (I/ICD).

You would also like to reduce the activities, or Intermediate Cost Drivers, you require to produce a unit of final product Output. In ratio form, this means you want to reduce the ratio of Intermediate Cost Drivers in the Output (ICDs/O).

The measure of Productivity then expands into two factors:

	Productivity = Inputs/Output = Inputs/Intermediate Cost Drivers x Intermediate Cost Driver/Output
	Or
	P = I/ICD x ICD/O = I/O

We have studied several thousand cost reduction efforts from the last 25 years. We believe that you can categorize all cost reduction efforts into one of four major concepts:

1. Reduce the rate of cost for the Input
2. Reduce the Inputs not producing Output
3. Reduce unique Intermediate Cost Drivers(ICDs) in products and processes
4. Spread fixed cost ICDs over new Output

To see some examples of these for cost reduction concepts follow the links below:
– reduce the rate of cost for the input
– reduce inputs not producing output
– reduce unique intermediate cost drivers
– spread fixed costs over new output

Your company might use these cost reduction concepts and examples to brainstorm cost reduction ideas for your businesses.

The current issue of The McKinsey Quarterly describes an interesting study that McKinsey has undertaken in the pharmaceutical industry. The study’s conclusions offer us the opportunity to categorize their findings into one of these four cost reduction concepts.

In Part 2, we will describe some of McKinsey’s findings and then tie the findings to the four major productivity improvement concepts above.

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Update 7/26

Cost reduction is such an important topic in all business environments that we decided to flesh out these four cost reduction concepts. Through our study of several thousand cost reduction efforts, we have been able to describe the major ideas under each cost reduction concept. We describe these below.

Reduce rate of cost for the Input used to produce the output

– Purchase in larger quantities.

– Reduce the quality of the Input used by using a cheaper form of the Input

– Change the components of the rate of costs to reach a lower total rate.

– Use subsidies offered by third parties to reduce the total rate.

– Request supplier to lower price of Input.

– Change source of supply to a less expensive supplier.

– Expand in-house ICDs to reduce the rate of purchased ICDs.

Reduce units of Input not producing ICDs

– Assist Input in increasing ICDs by measuring and recognizing efficiency, better training, and elimination of downtime.

– Shift demand to use unproductive resources or to reduce the unproductive resources by shifting locations or time periods for work

– Improve the accuracy of the demand forecast to better match with capacity

– Use short-term sources of Input to meet peak demand

– Use other unemployed Input in Purchases and Capital

– Speed the process with sequence changes, specialized teams, relief of bottlenecks and centralized planning.

Reduce unique intermediate cost Drivers

– Redesign the product to reduce performance standards  or eliminate/change components. The resulting product must still meet all customer requirements.

– Redesign the process of producing the ICD to standardize, automate, reduce movement and eliminate errors

– Eliminate customer activities with low value to the customer

Spread ICDs over more Output

– Acquire similar organization to spread fixed costs

– Use fixed cost ICDs with more customers through outsourcing for others or finding new customer segments around the fixed cost ICDs

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