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So you want to lower costs?
So You Want to Lower Costs? Roger W, Schmenner
The myths of cost accoyn ting must be exposed for costs to truly be * lowered.
0
ver the past decade or so, there has been a revolution in the thinking of many manufacturing managers about what it takes to be productive both on the factory floor and throughout the manufacturing enterprise. Initiatives on total quality man-
a problem? Why haven’t the new ideas taken over even more swiftly than they have, regardless of the inattention or ignorance of senior management? Implementing these principles takes education and effort, that is certain. But that isn’t the problem. In most instances it’s not because it’s hard to implement these ideas that has deterred manufacturers from adopting them more broadly. It’s that they really haven’t been tried. What is creating the logjam? What blocks the initiatives? Blinders
involvement, and computer integrated manufacturing, among others, reflect this new thinking. Increasingly, there are success storie-Western ones-about companies that have turned themselves around or have grabbed significant leadership positions in their markets and have, in the process, become “world class.” The success stories themselves are being backed up more and more with statistical evidence that validates the philosophies embodied in these initiatives. Despite all this, however, these ideas have had only a limited impact. World-class manufacturing has not been as contagious as was once hoped. This has left many managers frustrated. Some are frustrated that their companies do not practice any of these new initiatives. Others fret because these initiatives exist only as pilot projects or isolated events-pinnacles of excellence-within their companies; they have not been propagated throughout the companies despite what these managers feel is overwhelming evidence about their efficacy. Frustration stems, too, from having to depend so much on a fickle senior management’s “getting religion” about . these new manufacturing ideas. Many of the success stories start with some senior manager’s conversion of spirit which enables the rest of the organization to embrace and adopt new principles. This is simply too hit-or-miss for many; would that progress were not so idiosyncratic! But if these new manufacturing principles and philosophies are so good, then why is there . 24
Although there may be several explanations for this logjam, the one I propose for consideration is that managers are blinded by the way costs and efficiency are traditionally viewed and how they are managed. Too many managers are trapped by their thinking about what costs are and how they can be lowered. Only by eradicating the preconceived notions-the myths-these managers have about costs and efficiencies can they be free to embrace and understand what the new manufacturing principles have to say. This is the theme I wish to explore, first by noting some of the “myths” that have developed about cost reduction, and then by affirming the realities. Consider the following four statements, all “myths” of traditional systems to evaluate factory performance, but all practiced, at least in part, by many companies: Myth #l. The costs of a product can be calculated and a particular cost, x, reached. This can then be imbedded in the cost accounting system, published, and used for a variety of purposes. Myth #2. Product cost structures are useful ways to indicate what can be done to lower costs. Thus one should look at the proportion of total costs-materials, labor, overhead-for hints as to what can be done to lower them. Myth #3. Costs come down because you budget them aggressively and then control them. Myth 4. Costs drop when labor efficiencies and machine utilizations increase. Let’s examine each of these myths in turn. Business
Horizons
/July-August
1992
MYTH #l: PRODUCT
COST
T
he first myth deals with the computation and the existence of product costs. Cost accounting systems are devoted to calculating product costs. A product’s cost is assumed to be composed of a variety of items that can be totalled, or “rolled up,” to give management the single best estimate as to what the product’s cost is. Unfortunately, for many managers a product’s published cost on seemingly countless computer sheets is often viewed as immutable, at least over the short run.’ What managers too often fail to recognize is that a product’s cost only takes on meaning when you must make a decision. Costs are “situation specific”; they do not exist apart from a particular set of circumstances. Thus, one cannot really talk about a product’s cost without concurrently understanding why that cost is needed. Consider an example. The Ajax Bottling Company bottles liquor of various kinds for private label sale. Much of that liquor comes from other sources, so the company must purchase bulk quantities of liquor, pay taxes on those bulk quantities, and then draw off from the bulk quantities for a particular bottling run. For any single bottling run, the company must acquire thegpecific bottles, labels, caps, and cartons to join with the bulk liquor already purchased. Among these items, only the bulk liquor is inventoried. Taxes are paid on each case as completed. The question is, “What is the cost of a case of bottled liquor?” At first blush, this seems an easy problem. One merely needs to add up the costs of the liquor itself, the packaging, the taxes paid, the labor required for the bottling, and any overhead allocations. However, suppose the decision at issue, the decision for which you need the cost figure, is how many cases to run off at any one time. For such a decision to be made, one needs to contemplate the tradeoff of producing a lot at once, thus incurring the additional cost of holding extra cases in inventory before they are needed for sale. This needs to be compared with the option of producing just what the marketplace is purchasing, thus incurring extra costs of setting up the bottling equipment to run more often and in smaller lot sizes than you otherwise \ would. The costs that are relevant to this particular situation, however, are not all of the “first blush” costs that were so easily toted up above. Some of those costs are sunk costs already incurred. The liquor that was delivered in bulk and the taxe,s that were paid on that bulk liquor are both costs that do not change with the number of cases in a particular bottling run. As sunk costs, they are not relevant to the decision at hand. The cost of So You Want to Lower Costs?
the product is no longer x in this situation; it is something different: JL Even more is at stake. In many companies labor is kept on the payroll despite minor variations in demand. Therefore, in a very real sense, labor, at least in the short run, is a fried cost to many companies. It simply does not vary much with the amount of output the company produces. Indeed, the company frequently feels it is more responsible and more profitable in the long run to hang on to its work force despite temporary variations in demand. Suppose this were true in our case of Ajax Bottling. If labor is a fixed cost for any bottling run, then it is a cost that has already been incurred and is thus not relevant to the decision of how many cases to run at a given time. It ceases to be a cost that is variable with the number of bottles in the run. In this instance, for the decision on the length of the bottling run, the case cost that is relevant is neither x nor y, but something still different: z. The relevant costs for the bottling run are simply the cost of the packaging materials purchased specifically for the run, plus the taxes paid once the bottling is completed. The liquor itself, the bulk liquor taxes, the labor, and any overhead are all irrelevant to the decision, Even though it may strike some as strange that the liquor’s cost itself is irrelevant in this situation, the logic is compelling. This is not an isolated instance. Many companies suffer from such “cost mirages.” These are costs that managers think exist, but when it comes down to actually using them for. a decision they vanish because they are no longer relevant to that particular decision. To reiterate, costs are “situation specific,” and thus one “size” will not fit all. Costs must be tailored to each decision situation. When managers use a single computeroutput number for a product cost, no matter what the situation, they almost always do themselves and their companies a disservice. MS’TH #2: COST STRUCTURE
0
rice we understand these ambiguities of cost, we can become better prepared to examine Myth #2, which concerns the usefulness of the product cost structure for reducing costs. A product’s cost structure, though a sensible division of the kinds of cost that can make up a product, is really not very much help when it comes to cost reduction. When we examine a traditional cost structure, we see a variety of costs: materials, direct labor, various types of overhead. If we understand cost reduction to be the reduction of each element of the cost structure, we are pushed to particular and sometimes peculiar courses of action. For example, we might be pushed to reduce vendor costs by deal25
ing with new vendors or by pressuring existing vendors for lower prices. We might also be trapped into paring the direct labor cost line items even though they may be small percent-ages of the cost of goods sold. The reasoning goes that direct labor is some“When managers use a thing we can affect sing/e computer-output by reducing head counts, provoking number for a product wage concessions, or cost, no matter what the shifting production to a lower wage part of situation, they almost the country or a always do themselves lower wage country. Examining the cost and their companies a structure might also disservice. ‘I* lead us to reduce overhead head counts, ban the acquisition of “nonproductive assets,” or route the product in such a way that taxes are lowered. These are fairly crude ways to lower costs. A directive from the top to reduce indirect head counts, for example, typically does little to assist managers with exactly which heads to set rolling. (Deming’s indictment of zero defects pleas, that slogans never taught anybody how to do a better job, is reminiscent.) What the manager needs is help restructuring what the indirect labor does, so that a reduced force can still accomplish what must be done. Moreover, this traditional view of cost reduction often doesn’t amount to much because it doesn’t lead to identifying where waste exists. And it is in eliminating waste that major cost reductions can be made. Clearly, any cost reductions will be documented on the various lines of the cost structure. The issue, though, is how one approaches cost reduction and not how one keeps score on it. Going at it on a line-by-line basis is not nearly as fruitful as isolating the waste and then eliminating it through refashioning the process or redesigning the product. MYTH
G
#3: BUDGETING
iven the traditional view that the cost structure provides the “hook” by which to lower costs, it is but a small leap to be seduced by Myth #3, that costs come down * because you budget them aggressively and then control them. Existing factory performance evaluation systems provide many of these controls. There are the aggressively set budgets. A manager examines variances of actual performance to budgeted performance and then seeks to work on those variances until the budgeted costs are adhered to and favorable variances return. Man26
agers delude themselves into thinking they are good at cost reduction merely by keeping a lid on their budgets and by keeping their variances in check. In reality, the good managers at cost reduction are those who eliminate entire items of cost. Variances and the mentality they foster are a very poor method of showing the way toward cost elimination, How are costs eliminated? The new manufacturing ideas, backed up by both stories and statistics, plead that costs are eliminated largely by paying attention to (1) improving quality, (2) reducing the time it takes to get the product into the hands of the consumer, and (3) investing in new or improved process technologies. It is these ideas that lead to cost reduction. How are costs reduced? Quality production reduces the costs of poor quality, an axiom made famous by Philip Crosby (1979). These are the costs of failure (scrap, rework, warranty, field service), the costs of detection (too many quality control inspectors), and the costs of prevention (training, work with vendors). They can be high, say, 15 to 20 percent of a product’s cost, and typically can be lowered precipitously, releasing dollars to the bottom line. Reducing lead times of all sorts exposes waste, duplication, possible unnecessary steps, excess inventories, extraneous information, ineffective layouts, needless handling, capacity imbalance, and factory chaos caused by engineering changes and rescheduling. Lead time reduction is a singularly effective means of pinpointing where a process is deficient (where non-value-adding activities intrude on value-adding activities) and, consequently, where costs can be reduced. More and more, companies of all types are reaping these advantages of time-based competition. New process technologies reinforce the above points. New technologies are often particularly valued because they improve quality. Furthermore, the most effective process improvements are those that are integral to the process itself-not isolated-and thus help speed the passageof materials and information through the operation. In a recent article, Blaxill and Hout of the Boston Consulting Group (1991) decry the traditional mechanisms for lowering overhead costs: either chopping heads more or less indiscriminately, or trimming product lines and capacity. They argue that such an approach fails because it ignores the fact that overhead costs (specifically the indirect people of the factory) are essentially controlled by the type of process used. Improve the process with better yields, quicker throughputs, and more integrated materials and information flows, and the overhead will come down. More than that, its character will change to incorporate more “process improvers” and fewer “proBusiness Horizons /July-August
1992
For even the simplest of new icieas, Urwick believed, was closer to that of an elephant than a human. He thought it extremely important FOI management professors to realize that the speed at which new ideas can effectively be ai~sorbeci anti put into operation, in an organization of any size, is much slower than the speeci at which they can be generateci by inciiviciuais. Along these lines he noteci that although the history of management haci its beginning about the year 1900, it had already passeci through what many felt was about four or five eras. However, the current era was no longer being perceived as a couple of centuries, or even a generation, but rather was being measured in terms of ciecacies. This telescoping of history he attrihuteci to the rapiciity with which academics were writing books anti promulgating new thoughts. Aithough movement was certainly ciesirabie, he beiieveci it was essential that the speed be kept at a level that wouici allow industry and the academy to move forwarci together. As to what was being taught in the acaciemy, Urwick Felt that-with administrators normally acquiescing-professors were generally teaching what they wanted to teach, insteaci of what stucients wanteci to learn, and si~oulci learn. In particular, Urwick believed that what academics taught were the issues about which they wanteci to write. While students were being exposed, as they should be, to a mis of both liberal and professional eciucation, the selection of the ingreciients anti their proportions was being dictated more by the interest of the faculty than the neecis OF business. Having advanceci well beyonci the point at which it was recognized that management is not just common sense, or a collection of stanciardizeci a~lci ciassifieci experiences, what was being offereci was nevertheless a Fragmenteci array of knowledge representative of the unique interest of inciividuai teachers. The consequence, Urwick Felt, was a collection of subjects, a curriculum that cielighteci prol’essors but ciici little to provide suitable preparation for the students who wouici one day be managers. Urwick went on to note that when he was an undergraduate, he had aireaciy made up his minci to go into business. He was furious with Oxforci, however, because the university ciid not teach him anything he wished to learn; management was not an accepteci ciiscipiine at the time. But acceptance was achieved over the years, and management was now a recognized fieici of study in the acaciemy. Urwick felt, however, that students still could not study what they wanted to learn, if that happeneci to ciiffer from what teachers believed they should learn. Such a situation would not have been so intolerable if what ys offereci were in keeping with the neecis of business and reflective of a collective jucigment as to Umick
on
the Business
Academy
the required knowledge in the Field. But Urwick understooci that this was not the case. What was being presenteci to stucients was a multiplicity of loosely related courses, most of which were solely seiecteci by academics in keeping with their personal causes and concerns. ABOUT THE STRUcTzlRE
U
rwick Felt that most of the principles of aciministration, such as those acivanced by Fayoi, Taylor, Mooney anti Reiiey, Graicunas, anti Foiiett, are as applicable to the university as they are to the Factory. There is a general theory of aciministration, accorciing to Urwick, that can be used equally well by industry, government, and the acaciemy. IHowever, Urwick believeci it was not generally being useci by government, which would Finci that as a result it wouici not i3e able to move aheaci as fast as it would like, regarciiess of how well intentioned it may be. Neither was the theory being used as it shouici be by the academy, even though it Formed the basis of what was generally being taught in the sciioois. Urwick felt that significant reliance by the acaciemy on committees, For example, subjected schools to more of the weaknesses of this Form of operation than was necessary. Because a conmittee has neither bociy nor soul, it normally encourages irresponsibiiity, assumes authority without any corresponciing accountabii“As to what was being ity, anti tencis to be taught in the academy, slow and ineffective. Moreover, committees U-wick felt that-with often suffer From administrators normally many psychological problems, which acquiescing-professors inciucie members were generally teaching trying to impress each other, irrelevant ciiswhat they wanted to cussion, anti gamesteach, instead of what manship for gamesmanship’s sake. Howstudents wanted to learn, ever, committees are and should learn. “ useful For considering policy, examining issues, anti promoting unity. Thus, although committees can be effective, Urwick believed they must he useci seiectiveiy-not as the stanciard primary means of operation. It was Urwick’s feeling that because of the strong attention and commitment of Faculty to their ciiscipiines, it was not unusual For a number of other objectives to spring up in the academy that were inconsistent with the general purpose of schools OF business. The momentum generated 27
with cost reduction. Look instead to programs of quality improvement and time reduction because these tools can point out waste and inefficiency. Progressive companies all over have adopted JIT manufacturing philosophies. However, many still cling to the same kind of accounting reports they have “always” used, which can dilute the power of such philosophies. In progressive companies, these reports have either been abandoned or they now carry much less weight as other objectives crowd them out. 3. Costs come down because they are eliminated, not because they are controlled. Companies, of course, still ought to compile budgets and try to meet them. Budgets merely need to be put in proper perspective, however. They are a control cjevice to keep costs from increasing, not a device to lower costs. The creative ways to lower costs are typically discovered not in the budgeting process, but entirely outside that process, with someone or some team analyzing the process (or product) itself and seeing how it can change to be more efficient. The tools are time, process flow charting, statistical quality control, experimentation, re-layouts, and lower inventories-not budgets and variance analysis. 4. Labor efficiencies and machine utilizations have little to do with cost reduction. The “waste” they highlight is often inconsequential. Some company units, in such companies as Square D and Tektronix, have abandoned such measures and are all the more effective for doing so. The more companies rid themselves of the old-style thinking about cost reduction and the more they are willing to jettison the old ways of evaluating performance in favor of the realities listed above, the better, I argue, is the chance that the new ideas about manufacturing can take over and really show their worth. The old ways of thinking about costs blunt a company’s ability to ferret out waste, and thus its ability to eliminate it. Cl
28
Notes 1. Fortunately, cost accountantsare typically amongthe managersenlightenedabout the limitations of cost definitions of various types. Despitetheir reputationsas only slightly more important to the company than the corporate lawyers, cost accountantscan help in this regard. Many managerswould do well to talk more to their cost accountants. References
M.F. Blaxill and T.M. Hout, “The Fallacy of the Overhead Quick Fix,” Harvard BusinessReview,July-August 1991, pp. 93-101.
Philip Crosby, Quality Is Free(New York: McGraw-Hill, 19791.
RogerW. Schmenner,“Boosting Productivity: Ideas that Work,” AME ResearchReport (Wheeling, III.: Association for Manufacturing Excellence, 1991). RogerW. Schmenner,“The Merit of Making Things Fast,” SloanManagementReuiau,Fall 1988,pp. 11-17. George Stalk and ThomasHout, CompetingAgainst Time(New York: Free Press,1990).
Roger W. Schmenner isa visiting professor at IMD, Lausanne, Switzerland, and a professor of operations management at the Indiana University School of Business, Indianapolis.
Business Horizons/July-August1992
The myths of cost accoyn ting must be exposed for costs to truly be * lowered.
0
ver the past decade or so, there has been a revolution in the thinking of many manufacturing managers about what it takes to be productive both on the factory floor and throughout the manufacturing enterprise. Initiatives on total quality man-
a problem? Why haven’t the new ideas taken over even more swiftly than they have, regardless of the inattention or ignorance of senior management? Implementing these principles takes education and effort, that is certain. But that isn’t the problem. In most instances it’s not because it’s hard to implement these ideas that has deterred manufacturers from adopting them more broadly. It’s that they really haven’t been tried. What is creating the logjam? What blocks the initiatives? Blinders
involvement, and computer integrated manufacturing, among others, reflect this new thinking. Increasingly, there are success storie-Western ones-about companies that have turned themselves around or have grabbed significant leadership positions in their markets and have, in the process, become “world class.” The success stories themselves are being backed up more and more with statistical evidence that validates the philosophies embodied in these initiatives. Despite all this, however, these ideas have had only a limited impact. World-class manufacturing has not been as contagious as was once hoped. This has left many managers frustrated. Some are frustrated that their companies do not practice any of these new initiatives. Others fret because these initiatives exist only as pilot projects or isolated events-pinnacles of excellence-within their companies; they have not been propagated throughout the companies despite what these managers feel is overwhelming evidence about their efficacy. Frustration stems, too, from having to depend so much on a fickle senior management’s “getting religion” about . these new manufacturing ideas. Many of the success stories start with some senior manager’s conversion of spirit which enables the rest of the organization to embrace and adopt new principles. This is simply too hit-or-miss for many; would that progress were not so idiosyncratic! But if these new manufacturing principles and philosophies are so good, then why is there . 24
Although there may be several explanations for this logjam, the one I propose for consideration is that managers are blinded by the way costs and efficiency are traditionally viewed and how they are managed. Too many managers are trapped by their thinking about what costs are and how they can be lowered. Only by eradicating the preconceived notions-the myths-these managers have about costs and efficiencies can they be free to embrace and understand what the new manufacturing principles have to say. This is the theme I wish to explore, first by noting some of the “myths” that have developed about cost reduction, and then by affirming the realities. Consider the following four statements, all “myths” of traditional systems to evaluate factory performance, but all practiced, at least in part, by many companies: Myth #l. The costs of a product can be calculated and a particular cost, x, reached. This can then be imbedded in the cost accounting system, published, and used for a variety of purposes. Myth #2. Product cost structures are useful ways to indicate what can be done to lower costs. Thus one should look at the proportion of total costs-materials, labor, overhead-for hints as to what can be done to lower them. Myth #3. Costs come down because you budget them aggressively and then control them. Myth 4. Costs drop when labor efficiencies and machine utilizations increase. Let’s examine each of these myths in turn. Business
Horizons
/July-August
1992
MYTH #l: PRODUCT
COST
T
he first myth deals with the computation and the existence of product costs. Cost accounting systems are devoted to calculating product costs. A product’s cost is assumed to be composed of a variety of items that can be totalled, or “rolled up,” to give management the single best estimate as to what the product’s cost is. Unfortunately, for many managers a product’s published cost on seemingly countless computer sheets is often viewed as immutable, at least over the short run.’ What managers too often fail to recognize is that a product’s cost only takes on meaning when you must make a decision. Costs are “situation specific”; they do not exist apart from a particular set of circumstances. Thus, one cannot really talk about a product’s cost without concurrently understanding why that cost is needed. Consider an example. The Ajax Bottling Company bottles liquor of various kinds for private label sale. Much of that liquor comes from other sources, so the company must purchase bulk quantities of liquor, pay taxes on those bulk quantities, and then draw off from the bulk quantities for a particular bottling run. For any single bottling run, the company must acquire thegpecific bottles, labels, caps, and cartons to join with the bulk liquor already purchased. Among these items, only the bulk liquor is inventoried. Taxes are paid on each case as completed. The question is, “What is the cost of a case of bottled liquor?” At first blush, this seems an easy problem. One merely needs to add up the costs of the liquor itself, the packaging, the taxes paid, the labor required for the bottling, and any overhead allocations. However, suppose the decision at issue, the decision for which you need the cost figure, is how many cases to run off at any one time. For such a decision to be made, one needs to contemplate the tradeoff of producing a lot at once, thus incurring the additional cost of holding extra cases in inventory before they are needed for sale. This needs to be compared with the option of producing just what the marketplace is purchasing, thus incurring extra costs of setting up the bottling equipment to run more often and in smaller lot sizes than you otherwise \ would. The costs that are relevant to this particular situation, however, are not all of the “first blush” costs that were so easily toted up above. Some of those costs are sunk costs already incurred. The liquor that was delivered in bulk and the taxe,s that were paid on that bulk liquor are both costs that do not change with the number of cases in a particular bottling run. As sunk costs, they are not relevant to the decision at hand. The cost of So You Want to Lower Costs?
the product is no longer x in this situation; it is something different: JL Even more is at stake. In many companies labor is kept on the payroll despite minor variations in demand. Therefore, in a very real sense, labor, at least in the short run, is a fried cost to many companies. It simply does not vary much with the amount of output the company produces. Indeed, the company frequently feels it is more responsible and more profitable in the long run to hang on to its work force despite temporary variations in demand. Suppose this were true in our case of Ajax Bottling. If labor is a fixed cost for any bottling run, then it is a cost that has already been incurred and is thus not relevant to the decision of how many cases to run at a given time. It ceases to be a cost that is variable with the number of bottles in the run. In this instance, for the decision on the length of the bottling run, the case cost that is relevant is neither x nor y, but something still different: z. The relevant costs for the bottling run are simply the cost of the packaging materials purchased specifically for the run, plus the taxes paid once the bottling is completed. The liquor itself, the bulk liquor taxes, the labor, and any overhead are all irrelevant to the decision, Even though it may strike some as strange that the liquor’s cost itself is irrelevant in this situation, the logic is compelling. This is not an isolated instance. Many companies suffer from such “cost mirages.” These are costs that managers think exist, but when it comes down to actually using them for. a decision they vanish because they are no longer relevant to that particular decision. To reiterate, costs are “situation specific,” and thus one “size” will not fit all. Costs must be tailored to each decision situation. When managers use a single computeroutput number for a product cost, no matter what the situation, they almost always do themselves and their companies a disservice. MS’TH #2: COST STRUCTURE
0
rice we understand these ambiguities of cost, we can become better prepared to examine Myth #2, which concerns the usefulness of the product cost structure for reducing costs. A product’s cost structure, though a sensible division of the kinds of cost that can make up a product, is really not very much help when it comes to cost reduction. When we examine a traditional cost structure, we see a variety of costs: materials, direct labor, various types of overhead. If we understand cost reduction to be the reduction of each element of the cost structure, we are pushed to particular and sometimes peculiar courses of action. For example, we might be pushed to reduce vendor costs by deal25
ing with new vendors or by pressuring existing vendors for lower prices. We might also be trapped into paring the direct labor cost line items even though they may be small percent-ages of the cost of goods sold. The reasoning goes that direct labor is some“When managers use a thing we can affect sing/e computer-output by reducing head counts, provoking number for a product wage concessions, or cost, no matter what the shifting production to a lower wage part of situation, they almost the country or a always do themselves lower wage country. Examining the cost and their companies a structure might also disservice. ‘I* lead us to reduce overhead head counts, ban the acquisition of “nonproductive assets,” or route the product in such a way that taxes are lowered. These are fairly crude ways to lower costs. A directive from the top to reduce indirect head counts, for example, typically does little to assist managers with exactly which heads to set rolling. (Deming’s indictment of zero defects pleas, that slogans never taught anybody how to do a better job, is reminiscent.) What the manager needs is help restructuring what the indirect labor does, so that a reduced force can still accomplish what must be done. Moreover, this traditional view of cost reduction often doesn’t amount to much because it doesn’t lead to identifying where waste exists. And it is in eliminating waste that major cost reductions can be made. Clearly, any cost reductions will be documented on the various lines of the cost structure. The issue, though, is how one approaches cost reduction and not how one keeps score on it. Going at it on a line-by-line basis is not nearly as fruitful as isolating the waste and then eliminating it through refashioning the process or redesigning the product. MYTH
G
#3: BUDGETING
iven the traditional view that the cost structure provides the “hook” by which to lower costs, it is but a small leap to be seduced by Myth #3, that costs come down * because you budget them aggressively and then control them. Existing factory performance evaluation systems provide many of these controls. There are the aggressively set budgets. A manager examines variances of actual performance to budgeted performance and then seeks to work on those variances until the budgeted costs are adhered to and favorable variances return. Man26
agers delude themselves into thinking they are good at cost reduction merely by keeping a lid on their budgets and by keeping their variances in check. In reality, the good managers at cost reduction are those who eliminate entire items of cost. Variances and the mentality they foster are a very poor method of showing the way toward cost elimination, How are costs eliminated? The new manufacturing ideas, backed up by both stories and statistics, plead that costs are eliminated largely by paying attention to (1) improving quality, (2) reducing the time it takes to get the product into the hands of the consumer, and (3) investing in new or improved process technologies. It is these ideas that lead to cost reduction. How are costs reduced? Quality production reduces the costs of poor quality, an axiom made famous by Philip Crosby (1979). These are the costs of failure (scrap, rework, warranty, field service), the costs of detection (too many quality control inspectors), and the costs of prevention (training, work with vendors). They can be high, say, 15 to 20 percent of a product’s cost, and typically can be lowered precipitously, releasing dollars to the bottom line. Reducing lead times of all sorts exposes waste, duplication, possible unnecessary steps, excess inventories, extraneous information, ineffective layouts, needless handling, capacity imbalance, and factory chaos caused by engineering changes and rescheduling. Lead time reduction is a singularly effective means of pinpointing where a process is deficient (where non-value-adding activities intrude on value-adding activities) and, consequently, where costs can be reduced. More and more, companies of all types are reaping these advantages of time-based competition. New process technologies reinforce the above points. New technologies are often particularly valued because they improve quality. Furthermore, the most effective process improvements are those that are integral to the process itself-not isolated-and thus help speed the passageof materials and information through the operation. In a recent article, Blaxill and Hout of the Boston Consulting Group (1991) decry the traditional mechanisms for lowering overhead costs: either chopping heads more or less indiscriminately, or trimming product lines and capacity. They argue that such an approach fails because it ignores the fact that overhead costs (specifically the indirect people of the factory) are essentially controlled by the type of process used. Improve the process with better yields, quicker throughputs, and more integrated materials and information flows, and the overhead will come down. More than that, its character will change to incorporate more “process improvers” and fewer “proBusiness Horizons /July-August
1992
For even the simplest of new icieas, Urwick believed, was closer to that of an elephant than a human. He thought it extremely important FOI management professors to realize that the speed at which new ideas can effectively be ai~sorbeci anti put into operation, in an organization of any size, is much slower than the speeci at which they can be generateci by inciiviciuais. Along these lines he noteci that although the history of management haci its beginning about the year 1900, it had already passeci through what many felt was about four or five eras. However, the current era was no longer being perceived as a couple of centuries, or even a generation, but rather was being measured in terms of ciecacies. This telescoping of history he attrihuteci to the rapiciity with which academics were writing books anti promulgating new thoughts. Aithough movement was certainly ciesirabie, he beiieveci it was essential that the speed be kept at a level that wouici allow industry and the academy to move forwarci together. As to what was being taught in the acaciemy, Urwick Felt that-with administrators normally acquiescing-professors were generally teaching what they wanted to teach, insteaci of what stucients wanteci to learn, and si~oulci learn. In particular, Urwick believed that what academics taught were the issues about which they wanteci to write. While students were being exposed, as they should be, to a mis of both liberal and professional eciucation, the selection of the ingreciients anti their proportions was being dictated more by the interest of the faculty than the neecis OF business. Having advanceci well beyonci the point at which it was recognized that management is not just common sense, or a collection of stanciardizeci a~lci ciassifieci experiences, what was being offereci was nevertheless a Fragmenteci array of knowledge representative of the unique interest of inciividuai teachers. The consequence, Urwick Felt, was a collection of subjects, a curriculum that cielighteci prol’essors but ciici little to provide suitable preparation for the students who wouici one day be managers. Urwick went on to note that when he was an undergraduate, he had aireaciy made up his minci to go into business. He was furious with Oxforci, however, because the university ciid not teach him anything he wished to learn; management was not an accepteci ciiscipiine at the time. But acceptance was achieved over the years, and management was now a recognized fieici of study in the acaciemy. Urwick felt, however, that students still could not study what they wanted to learn, if that happeneci to ciiffer from what teachers believed they should learn. Such a situation would not have been so intolerable if what ys offereci were in keeping with the neecis of business and reflective of a collective jucigment as to Umick
on
the Business
Academy
the required knowledge in the Field. But Urwick understooci that this was not the case. What was being presenteci to stucients was a multiplicity of loosely related courses, most of which were solely seiecteci by academics in keeping with their personal causes and concerns. ABOUT THE STRUcTzlRE
U
rwick Felt that most of the principles of aciministration, such as those acivanced by Fayoi, Taylor, Mooney anti Reiiey, Graicunas, anti Foiiett, are as applicable to the university as they are to the Factory. There is a general theory of aciministration, accorciing to Urwick, that can be used equally well by industry, government, and the acaciemy. IHowever, Urwick believeci it was not generally being useci by government, which would Finci that as a result it wouici not i3e able to move aheaci as fast as it would like, regarciiess of how well intentioned it may be. Neither was the theory being used as it shouici be by the academy, even though it Formed the basis of what was generally being taught in the sciioois. Urwick felt that significant reliance by the acaciemy on committees, For example, subjected schools to more of the weaknesses of this Form of operation than was necessary. Because a conmittee has neither bociy nor soul, it normally encourages irresponsibiiity, assumes authority without any corresponciing accountabii“As to what was being ity, anti tencis to be taught in the academy, slow and ineffective. Moreover, committees U-wick felt that-with often suffer From administrators normally many psychological problems, which acquiescing-professors inciucie members were generally teaching trying to impress each other, irrelevant ciiswhat they wanted to cussion, anti gamesteach, instead of what manship for gamesmanship’s sake. Howstudents wanted to learn, ever, committees are and should learn. “ useful For considering policy, examining issues, anti promoting unity. Thus, although committees can be effective, Urwick believed they must he useci seiectiveiy-not as the stanciard primary means of operation. It was Urwick’s feeling that because of the strong attention and commitment of Faculty to their ciiscipiines, it was not unusual For a number of other objectives to spring up in the academy that were inconsistent with the general purpose of schools OF business. The momentum generated 27
with cost reduction. Look instead to programs of quality improvement and time reduction because these tools can point out waste and inefficiency. Progressive companies all over have adopted JIT manufacturing philosophies. However, many still cling to the same kind of accounting reports they have “always” used, which can dilute the power of such philosophies. In progressive companies, these reports have either been abandoned or they now carry much less weight as other objectives crowd them out. 3. Costs come down because they are eliminated, not because they are controlled. Companies, of course, still ought to compile budgets and try to meet them. Budgets merely need to be put in proper perspective, however. They are a control cjevice to keep costs from increasing, not a device to lower costs. The creative ways to lower costs are typically discovered not in the budgeting process, but entirely outside that process, with someone or some team analyzing the process (or product) itself and seeing how it can change to be more efficient. The tools are time, process flow charting, statistical quality control, experimentation, re-layouts, and lower inventories-not budgets and variance analysis. 4. Labor efficiencies and machine utilizations have little to do with cost reduction. The “waste” they highlight is often inconsequential. Some company units, in such companies as Square D and Tektronix, have abandoned such measures and are all the more effective for doing so. The more companies rid themselves of the old-style thinking about cost reduction and the more they are willing to jettison the old ways of evaluating performance in favor of the realities listed above, the better, I argue, is the chance that the new ideas about manufacturing can take over and really show their worth. The old ways of thinking about costs blunt a company’s ability to ferret out waste, and thus its ability to eliminate it. Cl
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Notes 1. Fortunately, cost accountantsare typically amongthe managersenlightenedabout the limitations of cost definitions of various types. Despitetheir reputationsas only slightly more important to the company than the corporate lawyers, cost accountantscan help in this regard. Many managerswould do well to talk more to their cost accountants. References
M.F. Blaxill and T.M. Hout, “The Fallacy of the Overhead Quick Fix,” Harvard BusinessReview,July-August 1991, pp. 93-101.
Philip Crosby, Quality Is Free(New York: McGraw-Hill, 19791.
RogerW. Schmenner,“Boosting Productivity: Ideas that Work,” AME ResearchReport (Wheeling, III.: Association for Manufacturing Excellence, 1991). RogerW. Schmenner,“The Merit of Making Things Fast,” SloanManagementReuiau,Fall 1988,pp. 11-17. George Stalk and ThomasHout, CompetingAgainst Time(New York: Free Press,1990).
Roger W. Schmenner isa visiting professor at IMD, Lausanne, Switzerland, and a professor of operations management at the Indiana University School of Business, Indianapolis.
Business Horizons/July-August1992