Manufacturers can find big cost savings and profits without looking offshore
American manufacturers are at a crossroads, under unprecedented pressure to provide an increasingly diverse range of products, with ever-shorter lead times. At the same time, they must continue to reduce costs in order to remain competitive against China and other low-cost producers.
In an effort to contain costs, many U.S. companies have already opted to source some, if not all, product offshore, resulting in the loss of hundreds of thousands of jobs and partial or total closure of manufacturing assets. But jumping to an alternative such as outsourcing, without looking at all the data and conducting a systematic decision analysis, can be a big mistake. Outsourcing can result in suboptimized assets, increased lead times, and rising unit costs—effectively negating its intended savings.
Some companies have found a better way to make decisions about what to make, for whom, and where. Instead of jumping on the outsourcing bandwagon, they have examined their business practices with an eye to eliminating a dangerous— and costly—element: complexity.
The Distinction Between Variety and Complexity
Variety is a good thing. Having a variety of customers ensures that if some go out of business or change suppliers, there will still be a market for your products and services. And offering a variety of products and services delights customers—and keeps them coming back for new, useful iterations of the tried and true.
Complexity, on the other hand, is a killer. The following definitions clarify the difference between helpful variety and costly complexity:
- VARIETY is the portfolio of products, services, customers, and other activities that add value and profits to a business.
- COMPLEXITY is the number of products, services, customers, and other activities that don’t add value.
Variety is produced when your products, services, customers, and other activities meet measurable standards for cost and current and future value. Variety can be transformed into complexity whenever a product, service, customer, or other activity creeps into your business unnoticed or without consideration as to its contribution to value and profit. When this happens often enough, you find yourself performing an excessive number of low-value activities, which have a disproportionate cost-to-value relationship. These activities are responsible for a significant portion of your costs, but they don’t generate much profit.
We’re not recommending a return to a Model T choice level for customers. Clearly, the 21st-century consumer is far too sophisticated for that. Today’s organizations need to retain a portfolio of customers and products, and they need to constantly add new customers and new products to the portfolio. Not to do so would be organizational suicide. The goal, therefore, is to offer variety, but with a minimum of complexity in its delivery.
Complexity in Action
To illustrate the complexity trap, let’s look at the product-customer mix of a medium- size manufacturer with which we once worked:
- The top 25 percent of customers represented 78 percent of total sales
- 25 percent of products accounted for 83 percent of total sales
- 25 percent of parts held equated to 89 percent of inventory
- One quarter of suppliers amounted to 91 percent of the purchasing spend for the business
Statistics such as these bear out the validity of a variation of the Pareto Principle of 80/20 called the Rule of 50/5. This rule states that the lower 50 percent of an organization’s customer-product chain will account for less than 5 percent of the organization’s value added.
While the application of the Pareto Principle focuses management on the top 20 percent of items, the Rule of 50/5 directs the organization’s efforts toward eliminating— or at least more efficiently managing—low-value activities.
Applying the Rule of 50/5 to the product-customer mix of the medium-size manufacturer in our example, the lower 50 percent of activities as a percentage of total sales translated to:
- Customers 4.5 percent
- Products 3.8 percent
- Inventory 4 percent
- Purchasing 1.1 percent.
Low-value activities drain precious resources. Low-volume products tie up production lines; slow-moving inventory jacks up storage costs; and all customers—including those who don’t buy much—make demands on sales and service reps. The presence of this low value is one of the primary drivers of organizational cost inefficiency.
When presented with a detailed analysis of organization complexity for the first time, a leadership team will often wonder how such a situation could have occurred, given the vast amount of data that integrated ERP systems provide about customers and operational performance. But all data isn’t equal, and our research has shown that organizational leaders often fail to take into account data related to three common sources of complexity:
1. Standard Cost Systems
Standard Cost Systems have one major flaw: Standard costs for low-volume items or activities are too low, while standard costs for high-volume activities are overstated. This is because Standard Cost Systems distribute overhead evenly among all activities at a standard rate. Activity-Based Costing (ABC), on the other hand, assigns overhead to each activity according to its actual cost and, therefore, provides managers with much more accurate data about how much each activity contributes to the company’s profits.
Our research has shown that, due to the inaccuracy of Standard Cost Systems, it is not unusual for the costs assigned to high-volume items to be overstated by 7 to 10 percent, while low-volume items are understated by 300–800 percent. So in an effort to cut costs and remain competitive, management continues to target the wrong areas making matters worse rather than better.
When they finally get a handle on the true cost of their operations, leadership teams are often shocked to find out how much time and money they have spent selling unprofitable products to customers they should not have been dealing with, and how many of their human resources have been tied up making improvements to products they shouldn’t have been making in the first place.
2. Performance and Reward Systems
One of the greatest human resource challenges that organizations face is how to create a reward system that equitably recognizes individuals from all functions, on all levels, for their contribution to the organization. Failure to do so results in the creation of the second enabler of complexity: the performance and reward system.
Measures of functional performance frequently encourage complexity. For example, in Purchasing, unit price continues to be the key measurement of success; quality and delivery are considerations, but they are rarely given more weight than price in the final decision to buy or not to buy. When quotes are sought, the new price is compared with the current cost, but savings analyses rarely quantify all the additional indirect costs of supplier additions: qualification, engineering approval, specification, maintenance, inventory segregation, etc.
Salespeople’s performance is often measured by new customer count and sales volume. To gain sales, increased product/service variation is offered to customers without taking into account the true cost impact on manufacturing and inventory.
In one agricultural equipment supplier with whom we worked, an engineer identified a potential eight percent cost reduction on a particular component by creating a light-duty and a heavy-duty version. He was commended for his innovation, but the costs of additional tooling and making changes to the product catalogue and spare-component manual were never fully measured. And not only was the price of the high-end application not raised, but the light-duty component was pitched at a lower price point—further cutting into the projected savings.
The net effect of these performance system misalignments is the constant addition of low-value activities, as individuals are rewarded for activities that ultimately cost rather than save.
3. Management Control Systems
Management controls systems—or rather, their lack—are the third common source of complexity. To keep complexity from entering the organization, management must put in place systems that challenge and approve the addition of products and services to ensure that they provide variety, not complexity. This can only be achieved through structured, formal decision-making processes using timely, true-cost data. Each proposed change to products and service must be evaluated against objective criteria to. Those that do not create value must be rejected.
This is no easy challenge. It often means that sales organizations must challenge their customer and product-line base. It goes far beyond the periodic removal of slow-moving items from the catalogue, which many organizations equate with “removing complexity.” In fact, complexity is only removed when individuals and assets across the organization are redirected to higher-value activities.
One of the fundamental rules of complexity management is that it must occur within the parameters of company strategy. In our experience, those organizations that most effectively reduce and manage complexity do so by focusing on the strategic vision and core values of the organization. Nor does the responsibility for reducing complexity lie within one functional area of the business. A successful complexity-reduction effort requires close collaboration among all functions: Sales, Finance, Manufacturing, and IT.
Following is a step-by-step process that we recommend to organizations that want to achieve complexity reduction.
Step One: Develop a more realistic picture of the true cost of operational activities.
As we’ve already discussed, when more accurate costing information, such as that obtained from an ABC system, replaces that of Standard Cost Systems, the good products look better, the bad products look worse, and a critical mass of marginal activities is identified, on which decisions must be made and actions taken. Unfortunately, given the structure of current information systems and human resource constraints, most organizations do not and probably never will carry out the sophisticated cost analyses required by the ABC approach. And because Standard Cost Systems impact every major component of a manufacturing business—inventory valuation, pricing, margins, and capital justifications—most businesses shy away from taking on the Herculean task, settling instead for “tweaking” annual standards.
How then can you obtain timely, accurate costing information that management can use to make key product/service decisions? The best methodology we know to accomplish this is the “True Cost” concept developed by VernLuepker and George Elliott , which recommends the following actions:
- Building an overview cost structure model of the business
- Stratification of existing activities products, services, and customers into decile groupings
- Reality testing of applied versus real overhead consumption
- Developing an adjustment factor for each group
- Factor-based adjustment to reassign overhead costs accordingly and where appropriate.
Step Two: Develop functional action plans.
As we discussed earlier, complexity reduction is the responsibility of all business functions; therefore, the second step in complexity reduction is to organize your “volume- adjusted” activities into a matrix-based structure. This will enable you to identify the primary functional areas in which projects must be carried out, as well as the cross-functional projects that will need to be completed.
Step Three: Develop Project Plans for Improvement.
In this phase, a broad spectrum of activities must be undertaken: from the straightforward elimination of obvious problematic activities to complex exit strategies, outsourcing of supply, or product substitutions. The following matrix illustrates the range of activities typically undertaken.
Once low-value activities have been removed, there is still much work to be done. Many tough decisions need to be made. Time, money, and people need to be refocused on high-value activities. Organization structure may need to be rethought to ensure that enough resources exist and that they are all being directed toward high-value activities. Those that aren’t must either be redirected or let go.
Step Four: Revise Management Systems
Experience has proven to us that unless the removal of complexity is accompanied by changes to core management systems such as performance and control, complexity will creep back into an organization within two years. This means that many existing “performance scorecards” must be rethought, and new, aligned metrics for performance improvement must be developed.
Along with changes to performance metrics, there must be the development of “gatekeeper” systems and reviews to ensure that all proposed new activities meet prescribed volume and profitability criteria before they are made part of the system. Similarly, routine reviews of existing activities must be carried out to identify those that fall below performance standards. Once these deviations are identified, corrective actions must be decided on for each.
Complexity reduction is without a doubt a major profit opportunity. In addition to its direct financial benefits, eliminating complexity frees up time that can be used to focus on new opportunities. It can also keep companies from taking drastic actions, such as moving production offshore. How many of these products—and the jobs that went with them—might have remained in America if, instead, a comprehensive complexity reduction program had been put in place?