122-Reducing Costs by Paying a Lower Rate for Your Inputs
Corporations have just completed the latest quarterly profit reports for publicly traded companies. Two-thirds of the publicly traded companies beat their forecast profits. Many of these companies failed to reach their forecast revenue numbers, but still reached their profit targets, or better, by reducing their costs. Since there is so much focus on the power of cost reduction in today’s margin environment, I thought it would be interesting to review the ways that a company can reduce its unit costs. To make it more interesting, I decided to use stories that I have seen over the last week in order to illustrate these techniques.
In our StrategyStreet system, there are four major approaches to reducing a product’s unit cost:
- Reduce the rate of cost for an Input used to produce the product (theOutput). An Input is an employee, a purchase or a capital outlay.
- Reduce the Inputs not producing Output.
- Redesign products or processes to reduce activities, thereby reducing the Inputs the activities require.
- Use fixed cost activities with more product Output.
Reducing the rate of cost that a company pays for an Input of people, purchases or capital reduces the effective number of units of Input required. A less expensive employee, one with a lower rate of cost per hour, is equivalent to a company’s only using a fraction of the original Input. For example, an employee earning $10 an hour is effectively half of the person earning $20 an hour.
As an alumnus of McKinsey and Company, I am fortunate to receive their fine McKinsey Quarterly. I always find something of interest in this periodical. The most recent issue contained an article entitled, “When to Divest Support Services.” In this article, McKinsey notes that many companies make strenuous efforts to reduce the costs of “support services” including commoditized corporate functions such as finance, human resources and purchasing, along with IT functions and some other industry-specific functions. McKinsey has done research that suggests another approach for some companies: selling the support services to larger, more established companies, who specialize in these support services. McKinsey conducted a study that looked at thirty transactions where corporations had sold their support services to other companies. On average, the selling companies received an immediate cash injection of two and a half times the book value of the assets transferred. Then, the companies realized cost savings on those functions that were as high as 40%.
This “sale and lease back” arrangement is a creative way for a company to reduce the rates it pays for these support functions. The sale and lease back reduces the combined rate for people, purchases and capital the company pays to complete the sold cost functions. This approach reduces the rate of cost by changing the source of the services to a less expensive supplier. The new supplier enjoys its lower cost because it has greater purchasing power and total focus on the support service functions.
Over the last twenty years, we have studied and categorized several thousand examples of cost reduction initiatives. In that study, we have found that you can reduce the rate of cost a company pays for an Input by using the following techniques:
- Purchase in larger quantities
- Reduce the quality of the Input used
- Change the components of the rate of costs
- Use subsidies offered by third parties
- Request the supplier to lower the price of the Input
- Change the source of supply to a less expensive supplier
- Expand in-house activities to reduce the rate
Over the years we have gathered these cost-saving techniques in order to use them in brainstorming examples. The examples help you cover all the bases. Over the course of many years of doing cost reduction work, I have failed to look at several techniques that might have been useful in the situation I was studying because I did not have these examples as thought starters and reminders. We have gathered these techniques to help you be more comprehensive in your cost reduction efforts. You may see all these cost reduction concepts and their examples by visiting the Improve/Cost/Brainstorming Ideas section of StrategyStreet.
The company who sold its support services for 2 1/2 times their book value and then saved up to 40% using the new cost approach is a particularly notable example of effective outsourcing. These business outsourcing specialists have the advantage of a laser focus on their costs and value added. This gives them significant advantages over their corporate counterparts. We have seen the same effect in earlier blogs. See HERE and HERE.
Outsourcing is the business practice of hiring a party outside a company to perform services or create goods that were traditionally performed in-house by the company’s own employees. Outsourcing was first recognized as a business strategy in 1989 and became an integral part of business economics throughout the 1990s.
Overall, over 50% of companies use some form of outsourcing. It is a concept with staying power. Outsourcing is a phenomenon primarily of larger businesses. For example, only 29% of businesses with fewer than 50 employees outsource, while 66% with more than 50 employees employ the process. The industry’s growth has been choppy but continues into 2022. Over 80% of pharmaceutical firms employ outsourcing. Roughly 70% of financial, retail and transportation firms also use outsourcing.
THE SOURCES FOR STRATEGYSTREET.COM: For over 30 years we observed the evolution of more than 100 industries, many hostile. We put their facts into frameworks applicable to all industries and found patterns. Strategystreet.com describes the inductive results of these thousands of observations and their patterns.