This post is dealing with “for profit” organizations (although may very well appeal to others as well). Top management of these organizations is supposed to be leading them to continuously and consistently increase their revenues, profit and profitability while at the same time ensure their sustainability (thus adding to the profit/profitability commitment, commitments to other “non financial” stakeholders, such as employees, society, suppliers etc.).
As profit is mathematically the result of subtracting cost from revenues, it stands to reason that top management directs its attention in these two avenues. In the first, it is their job to lead the company to continuous growth in revenues. But, as growing revenues is recognized and accepted as being somewhat out of direct control and highly dependent on cost, top management second area of attention is cost, and more so – cost reduction.
Increasing revenues is perceived to be possible result of creation of new opportunities – New products in existing markets, or existing products in new markets, or new products in new markets (why is it that mostly the option of existing products in existing markets is neglected?). And, as mentioned it is also perceived to be a possible result of lower costs.
Clearly, if lower costs are not required for increasing revenues, it is required for increasing profit and profitability.
Reducing cost is perceived to be a result of improvement efforts, and in the endless journey of increasing revenues, profit and profitability, the focus is heavily tilted to one key performance measure – cost and cost reduction, accordingly much of the improvement effort is invested in that direction (that said, there are other improvement efforts done by companies in other areas such as: Human resources and quality, maybe not directly related to cost reduction, nevertheless many times related to lack of choice. Meaning it is done as a key stakeholder is no longer willing to accept the existing reality and “forces” the improvement).
So, is cost reduction really the key performance indicator top management should focus on? To answer that, maybe one should try and answer two questions:
- What is the ultimate target for the key performance indicator? (and what does reaching that level of performance mean?)
- How is the key performance indicator effecting other performance indicators?
Well, obviously to answer the first question one should ask what is the optimal level of performance the key indicator can (and should reach)? If you consider answering this question about cost, you immediately face a conflict. This is because, simply put the best cost performance is when cost is zero, however zero cost will also (mostly) indicate that the company no longer exists. Thus you may try and answer this question in some sort of a proportion, however what is the optimal one?
And, how does cost reduction affects other performance indicators? Well, mostly not too good. Reducing costs at times may not have negative effects, but more often than not, it does negatively affect almost any other performance indicator. It may bring some immediate improvement in profit/profitability however it leads to elongating lead-times, deteriorating quality, increasing inventories, reducing productivity, deteriorating reliability (level of service), reducing sales and eventually to reduced profit and profitability.
All of these negatives are stemming from the fact that cost is treated as the sum of all costs, thus cost reduction is a result of reduction of any cost, anywhere. The thing is, that you can “cut’ the cost view in any way you want by assigning it to ‘entities” (such as – customer, marketing channels, markets, products, resources etc.) and the choose to improve by focusing on those perceived to be the higher cost “consumers”. The fact you can look at cost at so many ways should already indicate there is something wrong here, as it unavoidably leads t inconsistency (meaning that an improvement initiative in one point of view can lead to deterioration in another). More important that that it should indicate that cost does not subordinate to the additive rule, so a Dollar saved anywhere, is not a Dollar saved for the company as a whole.
Yes, there are cost reduction efforts that are successful, but very few and very rarely and almost accidentally.
There is an alternative, beautifully aligned with the objective of increasing revenues, profits and profitability. Shift your focus to the one key indicator that will unavoidably improve all others – Lead time. Let’s answer the two questions:
The ultimate desired level of performance is zero. Yes, we would love our lead ties to be zero and not only this does not indicate that the organization does not exist any more, it will, on the contrary indicate the organization is set to deliver the utmost level of performance. This is because of the response to the second question
When lead time is zero, cost is at it’s lowest possible level, quality at it’s highest, so is productivity, inventory, reliability (customer service), sales are as high as you would like them to be, profit is at it’s highest level and so is profitability. Not to mention that competitiveness is at it’s top level.
Even though, it seems the zero lead time is not reachable, any improvement in lead time will positively effect all other performance indicators, consistently and without a doubt. It is the ONLY measure that when improved affects all other measures in the appropriate direction, any other measure when improved, may or may not, improve the others.
So, if you really care about cost, the best way to improve it is to stop focusing on it and shift your attention to the one key performance indicator that makes the difference – lead time. The rest will follow.