Part 1: Quantifying Cost Reduction Objectives


Approaches to Managing Functional Costs

Capsule: Manufacturing and distribution businesses have different cost functions. Both these businesses, however, may see the development of new approaches to managing their respective cost functions. The Company should be particularly sensitive to new approaches to managing functional costs and the cost advantages these new approaches might yield. Always, though, the Company must protect the customer relationship.

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Symptoms and Implications:

The Company should compare itself to competition on the approach it follows to each of the key cost functions the industry uses. The purpose of this comparison is to bring to the surface new technologies or approaches that might be producing lower costs for one or more of the industry competitors. If the Company finds a new approach, it would analyze the benefits of adopting it rather than continuing with its current approach.

Every business has a distinct set of functional costs. The two major categories of business, manufacturing and distribution, have functional costs quite different from one another. For simplicity and ease of analysis, we find it helpful to group these functional costs into a set of four costs each for manufactured products and for distribution businesses. We then analyze the different approaches competitors use to managing each of these four major functional costs. All cost analyses must keep the customer relationship as the keystone. We discuss each of these points below.

Manufacturing Business Functional Costs

We simplify the major cost functions in a manufactured product into four: Create, Make, Sell and Serve.

  • The
    Create Cost function encompasses all research and development efforts, the costs incurred to design the product.

  • The
    Make Cost function includes the costs required to produce the product, getting it to the plant door.

  • The
    Sell Cost function covers all marketing, sales and shipping costs. In a manufactured product, Sell cost includes all the costs of creating customer awareness, differentiating the company and the product from its competitors and making the product available to the customer. These costs would include advertising, marketing, sales and most outbound logistics expenses.

  • The
    Serve Cost function includes all after-sales service for the product. In a manufactured product, Serve costs include all costs of warranties, part supplies, trained repair employees, service centers, customer hotlines, and so forth.

Distribution Business Functional Costs

In a wholesale, retail or distribution business, we simplify the major cost functions to four: Locate, Present, Sell and Serve.

  • The
    Locate Cost function would cover all the costs of selecting the site and constructing the building used for the distribution of products and services.

  • The
    Present Cost function includes the costs of choosing the products the customer may buy, purchasing those products and placing those products on display.

  • The
    Sell Cost function in a distribution business includes all the costs the Company incurs to sell the product. In a distribution business, Sell costs include the costs the company incurs to make the customer aware of the company and its products, to differentiate the company and its products from the competition and to help the customer find, choose and pay for the product.

  • Finally, the
    Serve Cost function includes all after-sale services the Company provides its customer. Serve costs include after-sale services such as handling returns and crediting the Final Customer for the returned product. These costs may also include the costs of installing the product for the Final Customer and training the customer in the product's use.

Functional Approach Cost Differences

The four functional costs that we use for manufacturing and for distribution businesses are not sacrosanct. You may find it more convenient to use a different set of functional cost approaches in your industry. The important objective is to develop a set of functional cost categories that enable the Company to understand different approaches to managing these functional costs in the Company’s industry and to quantify the impact that these differences have on unit costs of product sold in the industry.

The functional cost approach is the concept the Company uses to provide each of these major cost functions. There are three major drivers of differences in approaches to managing functional costs. The first is the decision whether a company should do something itself or outsource the task. The second is the method of acquiring facilities. The third is new technology. The functional cost management approach differences of interest are those that are new to the industry. These approaches may be harbingers of future lower costs in a major cost function.

In some cases, differences in approaches among competitors come down to the decision on whether to undertake the cost function "in house," that is, the Company would undertake the cost function itself, or to outsource the cost function to another company. For example, one company might manufacture most of its products. Another may choose to outsource the manufacturing portion of the product to a third party contractor. These are two different approaches to managing the Make Cost function. Many examples of outsourcing have developed over the last few years. In high-tech industries, the outsourcing of manufacturing to a contract manufacturer is a common way of doing business. In another example of differences in approaches to managing functional costs, one company may choose to manage its Sell Cost function by selling its products through intermediaries, such as distributors and wholesalers, while a second company uses its own direct sales force.

A second driver of differences in functional costs may occur in the way companies acquire their facilities. The leading companies in an industry will usually build new Greenfield facilities from scratch when they need significant new capacity. However, other companies in the industry, especially smaller companies, may reduce the Make Cost in the manufacturing function by acquiring closed or distressed facilities from another manufacturer and then recycling that capacity.

A third driver of differences in managing functional costs is new technology. This is a less obvious form of difference in approach to managing a functional cost because it occurs inside a cost function. Here, one company employs a technology that differs from another. This happens frequently in the manufacturing function. As an example, one company might employ industry standard production machines capable of producing three units of product per pass through the machine. But an innovation in manufacturing machinery enables the industry to buy new machinery with the capacity to produce four units of product with each pass through the machine. As companies begin to buy the new machinery and put it to use, a difference in the approach in the Make Cost function develops in the industry.

The company should be especially aware of new technology in its industry. It often does not appear obvious to all competitors in an industry that they should adopt a new technology. When an industry sees an emerging new technology in one of its cost functions, each competitor in the industry assesses the attractiveness of that technology for its own operations at its own pace. Some industry competitors choose to delay the adoption of the new technology until they are certain that the new technology will work effectively. They watch their competitors who adopt the new technology to see if they are successful with it. They estimate the cost benefits that these early adopters actually achieve. Then, they may choose to adopt the technology themselves.

One good indication that a new technology is attractive is the rate at which the technology expands its penetration of the market. If the early adopters continue to add the technology and if others decide to upgrade to the new technology, there is a high likelihood that a company employing the previous technology suffers from a cost disadvantage.

The different size segments of customers may cause companies who compete in each size segment to adopt functional cost approaches that vary in each segment. In particular, companies may serve Very Large and Large customers differently than they serve Small and Medium customers. For example, a company may sell directly to Very Large customers and use an Intermediary customer to sell to Small end users. When the Company finds this situation, it would evaluate its Functional cost approach for each size segment separately. It would compare itself to the low-cost competitor in each customer size segment.

Importance of Customer Relationship

In order to succeed in the long term in a market, it is critical for the Company to control the relationship it has with its major customers. This means that the concept used for the marketing and sales cost functions in the Company are particularly important to the Company’s success. The Company would not want to outsource a major part of its relationship with its most important customer segments, whether those customer segments are Intermediary or Final customers.

A corollary to this observation is that the Company must always evaluate alternative approaches to managing costs judiciously. The low-cost position any company has in a market is ownership of the customer relationship. Any cost reduction that jeopardizes the customer relationship and causes the customer to leave the Company, puts the Company into a poor cost position.

The low-cost position in any customer relationship is the position inside the customer relationship, rather than outside it. Being a competitor inside the customer relationship is worth at least 15% of sales compared to being outside. That hidden advantage is worth far more than the Economies of Scale generally available among Peer competitors.

Over the last several years, we have done extensive analyses of Economies of Scale available from one Peer competitor to another. Usually, these Economies of Scale differences amount to less than 5% of sales, in most cases considerably less. So, let’s assume for the moment that the maximum spread of Economies of Scale among Peer competitors is 5%. This 5% is far smaller than the cost advantage of being inside a customer relationship. We have found that a competitor trying to enter a customer relationship (i.e., Get In a relationship) must offer the customer potential savings, usually in the form of price discounts, of at least 15% in order to incite the customer to allow a new supplier into its current relationship. We have found this to be true as long as the incumbent suppliers are serving the customer well, that is, not failing the relationship. It is difficult in the extreme for one Peer competitor to sustain a permanent 15% cost or price advantage over other peer competitors for a long period of time. The implication, then, is that the ownership of the customer relationship is far more valuable than is the possession of the best Economies of Scale in the industry, as long as the company in the customer relationship is serving the customer well.

Once the customer has left a company for another competitor, the other competitor usually must “fail” the relationship for the first company to return to the relationship. Even then, the first company must assure the customer that it has amended its erroneous ways. This usually means that the company is in the highest cost position in the industry compared to virtually any other of its peer competitors.

Approach to Managing Cost Functions Examples>>

Approaches to Managing Functional Costs Questions

Analysis 57
Cost Advantages and Disadvantages Due to Differences in Approach to Managing Functions

  • What are the functional costs the industry undertakes for its customers? (Analysis 57)

  • What are the major choices available to manage these functional costs in the industry? (Analysis 57)

  • What new technologies or differences in approaches exist within any of these major cost functions in the industry?

  • Which of these approaches may to have a cost advantage over their alternative, based on the expansion of the companies using them?

  • What cost advantages or disadvantages, compared to its key competitors, does the Company have from its choices of approaches to managing functional costs?

  • How large are the maximum Economies of Scale advantages from one peer competitor to another in the industry? The Company may measure these relative costs by evaluating the Return on Sales in the low-cost peer competitor compared to the Return on Sales of the high-cost competitor.

  • Assuming that the incumbent suppliers in customer relationships are serving the customer well. How great must the discount offered to the customer be in order to incite that customer to give serious consideration to changing its supplier in one of the roles in its relationship?

  • How much greater, as a percentage of sales, is the cost advantage of being in a customer relationship rather than out of it?

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