Costs Summary Outline

This section is intended to help you to diagnose the competitive costs of your business and to save you time and cost in gaining a good understanding of your business situation.

Once you have completed this section, your next step would be to move to the Improve Costs section.

Throughout the text, you will find links to information that offer further insight on the topic. The green links are glossary pop-up boxes. In addition, at the end of each section, you will find questions and links to analyses that will guide you through your diagnosis.


Managing Costs: Introduction

Part 1: Quantifying Cost Reduction Objectives

Measuring Current Shortfalls in Financial Performance

Capsule: The Company uses public financial data to establish reasonable targets for return on investment and its two major components. It measures its performance gap and sets priorities to close the gap.

Matching Competitive Cost Advantages

Capsule: There are three places to look for competitive advantages: rates of cost, approaches to managing functional costs and productivity, or Economies of Scale. The first two of these are visible to the Company and enable the Company to evaluate its opportunities to match competitive advantages.

  • Rates of Costs

    Capsule: A company achieves low rates of costs because of the sources, the size, or the timing of its purchases. It may also have an advantage due to the components of the rate of costs.

  • 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 to the cost advantages these new approaches might yield. Always, though, the Company must protect the customer relationship.

Increasing Margins by Improving Customer Mix

Capsule: The Company may close part of its shortfall in financial performance by improving margins through selling a greater proportion of sales to Core customers.

Part 2: Measuring Current Economies of Scale

Creating Countable Measures of Productivity

Capsule: Productivity measures the ratio of cost Inputs divided by Outputs for customers. Productivity is best measured in physical terms by tracking the basic costs of the Company through the cost functions in the organization and their Intermediate and Final Outputs for customers.

  • Productivity and Customer Benefits

    Capsule: Productivity is a measure of the number of Inputs required to produce the Outputs for customers. The Company may analyze the physical Inputs by evaluating the chain leading from the basic costs of the business through the cost drivers in each organizational unit to the final Output. The best measure of physical Output for customers is usually a customer order.

  • Building Block Costs

    Capsule: Every business is a composite of three ultimate Building Block Costs: People, Purchases and Capital.

  • Cost Functions in the Organization

    Capsule: The Company is a set of organizations managing Building Block costs. These organizations are cost functions. Every department of the Company is a cost function. Each of these functional cost organizations of the Company employs the Building Block costs of People and Purchases. Some also employ Capital.

  • Intermediate Cost Drivers

    Capsule: The Company's functional cost organizations produce parts of the final product. These parts are the Intermediate Cost Drivers of the final Output. The ideal Productivity cost tracking system would establish a direct relationship between the Building Block costs in each cost function through the Intermediate Cost Drivers to the final Output.

  • Components of Productivity

    Capsule: Productivity has two separate components. The first, the Efficiency of the Input, is the ratio of Inputs/ICD. The second, the Effectiveness of the Intermediate Cost Driver, is the ratio of Intermediate Cost Driver/Outputs (ICD/O). Productivity is the product of the two components (I/O).

Measuring Economies of Scale in Each Cost Function


Economies of Scale implies that a bigger company should have a lower cost than a smaller company due to the fixed costs in the cost structure. The Company can determine its rate of creation of Economies of Scale by measuring its Productivity as it grows. Still, size alone will not create low costs.

  • The Concept of Economies of Scale

    Capsule: Costs go down as a company gets bigger because some costs rise more slowly than sales rise. So, bigger companies should have lower costs than smaller companies. This is the implication of the term "Economies of Scale."

  • Productivity and Time

    Capsule: An increase in Productivity creates Economies of Scale between a larger company and a smaller company. The same increase in Productivity reflects Economies of Scale when the Company compares its current size and cost structure to an earlier period in the Company’s history.

  • Caveat on the Belief in Size

    Capsule: A company should not put too much belief in the simple advantage of size. Most industry market share leaders do not lead their industries in Return on Investment. Size can confer advantages, but only if management sets specific targets for unit costs.

Measuring Economies of Scale by People Type

Capsule: The Company employs at least three different types of People: "Do", "Supervise" and "Think". Each of these types of people grows at different rates compared to the rate of growth in Output for the customer. So the Company should measure each separately in order to manage Economies of Scale.

Next: Introduction

After you have completed this section and the analyses, you should have a superb picture of your current cost structure. Turn next to the Improve Costs section, where you will develop new ideas to increase the productivity and Economies of Scale of your Company.