10.3 Prioritizing Costs
To "spot" the invisible parts of an iceberg, a ship's captain relies on A sound wave emitting devise used to map an object’s position and shape.. Radar systems work by emitting a sound wave that bounces off of "unseen" objects. When the echo returns, the radar system maps an object's position and shape. Using radar, the captain can avoid running into the hidden, submerged portion of the iceberg. To help you manage hidden costs, you need a similar capability. Strategic Cost Management is that capability. Although not as precise as radar, strategic cost management helps you make costs visible so that you can see, understand, and strategically manage them. To begin, you've got to spot all relevant costs. Let's discuss three lenses that can help you look in the right places.
Strategic Positioning Analysis
Harvard's Michael Porter argues that to succeed, you need to follow one of two strategies.1 You can be an industry's low-cost leader or you can offer truly distinctive products and services. As you can imagine, each strategy requires different behaviors. Each strategy also drives different types of costs—and a different approach to managing costs. You need to know what strategy your company is pursuing so you can determine which costs are important—and which costs might not be so relevant! Consider, for example, how strategic positioning influences purchasing decisions at two great companies.
Low-Cost Leader
Walmart is famous for its "Everyday Low Price" (EDLP) strategy. As a buyer for Walmart, your goal is to obtain the very best price possible. Your focus is on price reduction tactics. You leverage volume buys to reduce supplier costs—and the prices you pay. The bottom line: You make it a habit to buy products and services from the supplier that offers the lowest price.
Differentiator
BMW, by contrast, isn't as worried about costs. In fact, to help BMW build the "ultimate driving machine," you focus on buying innovative, high-quality components and services. But, as you know, quality and innovation often cost more. Of course, you still want to keep costs down, but your supplier-selection criteria are very different. Commitment to quality and technical know-how are at the top of your list. The bottom line: You are willing to pay more to protect your image as a manufacturer of prestigious cars. Indeed, it would be silly to squeeze a supplier for a few pennies per part if the end result was an image-damaging product recall.
Strategic positioning analysis helps you stay focused on the costs—and tradeoffs—that really matter.
Value Chain Analysis
Not long after Michael Porter made strategic positioning popular practice, he introduced the value chain to remind decision makers that value creation is holistic. 2 Porter pointed out that value creation takes place across different activities within your firm (see Figure 10.2 Panel A). Porter distinguished between two types of activities: Primary The activities used to define, design, build, and deliver products to meet customer needs. and Activities to keep your company operating profitably and smoothly (e.g., human resource management, PSM)..
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Primary Value-added Activities. Primary value-added activities are responsible for defining customer needs and then designing, building, and delivering the products to meet those needs.
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Support Activities. Support activities are the things you must do across your entire organization to keep your company operating smoothly—and profitably.
Porter also called attention to the fact that value creation extends to your supply chain partners—i.e., both suppliers and customers (Panel B). Porter's message is simple: To win in business you don't just need to perform each value-added activity very well but you also have to work well together. If anybody chooses to "do his or her own thing," the value chain breaks. In this case, the chain really is only as strong as its weakest link!
Panel A: The Value Chain
Panel B: The Value System
As a purchasing professional, what is your key takeaway? Answer: You need to do the analysis to know how your decisions will affect value creation—and costs—across the entire value system. You also need to be able to communicate to other managers how their decisions affect you. Remember the saying at Intel: "If you don't have the numbers, it is just your opinion." Your job is to do the analysis needed to move beyond opinion to facts.
In the late 1980s, J. Ignacio Lopez, an unorthodox purchasing guru, revolutionized GM's European purchasing practice. He ended cozy supplier relationships, tearing up long-standing contracts and demanding ever-lower prices and ever-higher quality. GM's CEO, Jack Smith, was so impressed that in 1991 he promoted Lopez to run GM's worldwide sourcing organization. Lopez's methods drove $2.5 billion in savings over the next two years, leading Smith to say that Lopez had "stopped the bleeding" at GM.
In 1993, when Volkswagen CEO Ferdinand Piëch promised Lopez that VW would build Lopez's dream "modularized" car plant, Lopez took his vaunted purchasing system to VW. The facility was eventually built in Resende, Brazil. At the time, the plant was completely unique. Seven core suppliers set up shop in a facility built by VW. Each supplier built and operated its own assembly line to build a major vehicle module. The modules were then assembled into a finished light commercial truck. Fewer than 20% of the workers in the plant actually worked for VW.
Critically, the suppliers were responsible for providing their own capital equipment and managing their own inventory. Naturally, VW's costs decreased dramatically. However, the suppliers' costs went up—significantly. As you can imagine, when contracts came up for negotiation, the suppliers asked for a price increase. Dependent on the suppliers for success, VW buyers wanted suppliers to make a profit—but not too big of a profit. Unfortunately, no one had a clear view of the true costs of managing a "modularized" supply chain. Conflict ensued. VW and its supply partners learned that the inability to fairly and accurately evaluate the cost tradeoffs across the value system makes it impossible to act as partners in profit.
Cost Driver Analysis
Once you understand which costs are important and realize that your decisions create tradeoffs, you need to identify what we call "cost drivers." The activities or decisions that create costs. are the activities or decisions that create costs. Cost drivers can be just about anything and they vary across industries. For example, Figure 10.3 compares the cost drivers across the semiconductor and wiring harness industries. The only similarity in cost structures is "other." The processes are very different and so are the cost drivers. Looking at Figure 10.3, where would you focus to control costs in each industry? Whatever your industry, your goal is to identify the big cost drivers—you know, the drivers that can help you make a big impact on bottom-line results. Let's take a look at two other examples of how understanding cost drivers can help you make better decisions.
Quality As A Cost Driver
Quality Guru Joseph Juran believed that some quality costs are visible—and others hidden. 4 Does that sound familiar? In fact, Armand Feigenbaum, one of Juran's colleagues, coined the term "hidden plant" to communicate that 15-40% of a plant's capacity exists to find and fix defective work. 5 Because quality is a driver of so many other costs, you want to address quality as early in the purchasing process as possible. If you can improve quality upstream, you can often lower costs for the overall value system. Juran introduced the costs of quality versus the quality level to show how different types of cost—i.e., failure versus prevention—impact total cost (see Figure 10.4). By the way, Juran also warned that perfect quality is often too costly. So, be careful what you wish for. And, do the analysis to know how much quality you and your customer are willing to pay for.
Accenture's Cost/Value-Driver Model
Accenture, a leading consulting firm, developed a basic strategic cost management model to help you decide which cost drivers to focus on (see Figure 10.5). The model focuses on time frame (short-term versus long-term) and nature of effort. Let's take a closer look.
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Tactical Actions. To get quick results—i.e., Actions that can be undertaken quickly and easily. The term is derived from the idea that it is easy to pick fruit that is hanging on the low branches of a tree.—you attack non-strategic costs. For example, you might switch to a lower-cost supplier of office supplies or launch a P-card program. The key is to keep your eyes open so you can spot and take advantage of small opportunities. Don't forget, over time small savings add up. Importantly, you can use these early savings to help fund the more costly, strategic cost initiatives.
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Sustained Cost Reduction. Sustained cost reduction requires a shift in organizational mindset—a real challenge for most managers. Your goal is to cultivate a culture of continuous improvement. You bring your knowledge of supplier selection and supplier relationship management to non-traditional areas such as R&D, Legal, and Marketing to help them improve their operations. You need to engage these managers in a thorough spend analysis to see where the money is going. Then you need to work together to find creative cost-reduction solutions. For example, you might set up a web catalogue or invite suppliers to participate in the early stages of new product design.
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Strategic Actions. Big impacts require big changes—typically to your business model, to your organizational structure, or to the nature of your buyer/supplier relationships. You'll find that these changes take time and require sustained investment. They are also risky. You need personal and professional credibility to push these cost/value drivers.
To summarize, too many managers view cost management as “cost cutting.” They don’t take a strategic view. Not knowing how to determine the size and shape of the cost iceberg, they run the risk cutting the wrong costs and undercutting their firm’s value-creation capability. You can’t afford to do that! Rather, you need to understand what costs are important, how your decisions affect organizational capabilities, and what your cost drivers really are. As you make costs visible, you can apply some specific analytical tools that will help you make better decisions, cutting non-value-added costs throughout your value chain. Next, let’s introduce and talk through the use of some critical analytical costing tools.
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