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COSTS AS LOST PROFITS: THE WORLD CLASS VIEW

By Rene T. Doming

World class manufacturing, which the Japanese companies pioneered, is known for its radical practices to improve quality, reduce inventory and cost that have translated into dramatic increases in profitability and productivity. But more important than the practices are the equally radical management philosophies behind them that drive these companies to excellence. For instance, just-in-time manufacturing, an inventory system, is derived from the philosophy that "Inventory is evil." The Total Quality Control (TQC) system is based on the doctrine of "Doing it right the first time." Kaizen or non-stop productivity improvement comes from the philosophy "There is always a better way" and "Anything that works is obsolete." Finally, the world-class cost-reduction movement is based on the belief that "Cost is potential profit."

Cost is profit

A world class company is cost-conscious in a very different way. By treating all costs as potential profit, it does not consider cost as a necessary component or basis of price. Cost becomes "profit that is lost."

The traditional and current way looking at cost is based on the premise that:

SALES = COST + PRICE

In other words, cost is a given or computed value to which you add whatever profit or margin you want to make to get the selling price.

The world class cost outlook is based on the equation:

PROFIT = SALES - COST

This is mathematically equivalent to the first one, but philosophically different. From this second perspective, cost is anything that you deduct from sales and reduces your profit. In other words, any cost could have been profits or PROFIT = SALES if cost did not enter the picture. This novel view of costs and expenses, operating or non-operating, as potential profits, is a potent philosophy that guides many Japanese companies in cornering and competing in international markets. The implications of this new paradigm on costs are staggering, and so are the opportunities, as we shall see.

Let us reflect again on the two equations:

1) SALES = COST + PROFIT
2) PROFIT = SALES - COST

Let us take two companies, company X, a typical company that espouses formula 1, and company Y, a world class company that lives by formula 2. Both will launch a new product in the market; let's simulate how they might differ in approach. Company X will start by getting the production cost estimate - raw material, labor, overhead, etc. Then its management will decide how much margin to make on the new product based on past experience or over-all corporate profit goals. Finally, knowing the cost and profit, it will set the selling price - and start selling.

Company Y will start with the customer, by asking him how much he would be willing to pay for the new product in case it comes out. The company does not question nor bargain with the desired price given by the customer who is assumed to be always right. Then company Y asks its manufacturing people for the production cost of the new product, employing everything the company has got: kaizen, value analysis and value engineering, productivity techniques, etc. Profit (or loss) is eventually derived as the final step; sales of the new product begins if profit is appropriate as determined by management.

For company X, the decision-making sequence or priority sequence is

COST -> PROFIT -> SALES,

while for the world class company Y, it is

SALES -> COST -> PROFIT.

Another big difference is how the three variables are treated. Mathematically, those at the right side of the equation are called independent variables, meaning they are given, or decided by somebody. Those at the left side, normally only one variable, is the dependent variable, which is not decided nor determined independently; it is the consequence of the magnitude and relationship of the dependent variables. What this means is that for company X, profit, a right side and independent variable, is decided - by management, as we have seen. Sales, a left side and dependent variable, is the direct result of adding the given cost to the decided profit.

For company Y, sales, an independent variable, is not a result of any calculation, but is a given value - given by the customer. Also, profit, a dependent variable, is not decided or given by anybody, not even by management; profit is the consequence or result of what is given by the customer - sales - and what is decided by the company's efforts - cost.

Let's see who would make money, or more money. Assume both companies will launch a new type of ball pen. Company X estimates its production cost at $1 or 100 cents; its management decides to add a 20% margin, typical of most of its other products. The profit turns out to be 25 cents, so the company tries to sell the pen at $1.25 a piece. Company Y starts by asking customers, students for instance, how much they would buy its new proposed pen. After looking at all other ball pens flooding the market, the customers say that they would be willing to pay only 95 cents for such a pen. Then company Y asks its manufacturing people how much it would cost to make such a pen, given a 95 cents price. The factory accepts the challenge and with its best efforts, it could produce it at 90 cents a piece. At 5 cents profit per pen, the management of company Y decides to go ahead, launch the product, and start selling.

Question: How much profit will company Y make per pen? 5 cents. Right. How much will company X make? 25 cents. Wrong. Company X will make zero profit, since all the customers will buy from company Y which sells the pen at the lower and desired price of 95 cents. For company X, sales and profit are both zero, fictitious, and imagined. Only its cost is real. For company Y, everything is real - sales, cost, and most of all, profit. At this point, company X folds up or may go into other businesses and leave company Y alone.

To be cost competitive is to be price competitive

But the war is not over yet - company Y has just won a battle. With a big volume of initial sales that results in economies of scale and the non-stop kaizen and cost-reduction program of the company, production costs start to decline - say to 85 cents. They can stick to the same price of 95 cents, and now make more profit at 10 cents per pen. Kaizen continues in spite of the profits, and costs continue to slide - this time to 80 cents. The company can now start lowering its price to 90 cents, and still profit 10 cents per piece. Customers are happier, and more competitors, say, companies A, B, and C fold up because none could sell at 90 cents which may be well below their production cost.

As kaizen and quality improvement continue, the good things in life happen to company Y; costs go down, profits continue to increase, sales and market share rise until virtually all competition disappear. This is the unending saga of how Japanese companies dominated one industry after another, and will continue to do so. Their ultimate secret is their cost, which we do not know and will never know. We only know the prices they offer, but we cannot use our own costs as reference because this may be irrelevant to their costs which may be light years lower. Lower costs give them the power to price marginally, such that they make money on sheer volume generated by their lower prices.

Cost competitiveness is to price competitiveness. Low cost, especially ultra-low cost, is a marketing advantage, a marketing weapon, that gives your sales force freedom and flexibility to match, beat, or wipe out the competitor is a price war. Conversely, high cost ties up their hands and serves as a severe handicap especially in competitive, "fast brake" markets in which they have to make on-the-spot price decisions to clinch a sale. Ultra-low cost puts the company in a no-lose situation, and his competitor in a no-win one. A cost superior company can price low enough that his competitor cannot match but can still earn some margin; or in the absence of competition, it can maximize profits into mega-profits by pricing as high as the market could bear. In either case, a high cost competitor loses - either the customer or its profits.

Cost reduction is better than sales increase

Let us now have a short exercise to demonstrate the power of cost reduction. In terms of profitability, which is better - a 10% increase in sales or a 10% reduction in cost? Spare a couple of minutes to think over your answer to this question before proceeding further. Let us now take a hypothetical company A whose current sales is $100, cost is $70, and therefore has a $30 profit. To simplify, assume that it is a single product company, uniform price, and all costs are basically variable. Let us now look at the two scenarios.

 
current
10% sales increase
10% cost decrease
sales
$100
$110
$100
cost
70
77
63
 
-----
-----
-----
profit
30
33
37
% profit increase
10%
23%

Suppose another company B has a higher cost of $90, let's see the results of the two scenarios

 
current
10% sales increase
10% cost decrease
sales
$100
$110
$100
cost
90
99
81
 
-----
-----
-----
profit
10
11
19
% profit increase
10%
90%

This illustration shows several disturbing and enlightening conclusions. Cost reduction improves profitability much better than sales increase by order of magnitude. A sales increase will increase profit only by the same percentage - 10% in both companies. However, a cost reduction will increase profit by more than the percentage cost was reduced - more than 10% in both cases. Note that as your cost of production increases in relation to sales, the positive effective of cost reduction on profits is magnified: from 23% increase at 70% cost to 90% increase in profit at 90% cost.

Cost is a gold mine in the company's backyard that we fail to see because of the paradigm that cost is fixed, immovable, and uncontrollable blocks our view. We may not have to send our tireless salesmen to far-flung places to chase customers, or to further twist the left arm of the customer while our competitor twists the right arm. A concerted effort to reduce cost or even shave off a few percentage points - 1% reduction may even do - will go a longer way in boosting profits. This is not a call to stop all marketing efforts; it is a call to give the same concern and efforts we give to cost reduction as we give to marketing. Doing both simultaneously would be ideal; cost reduction effects on profits are multiplied by the sales volume generated by marketing efforts.

The positive effects of cost reduction on profitability may differ once we let go of our simplifying assumptions, and allow for the law of economies of scale to operate, to take discounts, semi-variable costs, and other peculiarities of your operation, product, and industry into consideration. You may try to do the same exercise as above. But the conclusions should not change; cost reduction is more potent in enhancing profitability than sales increase. And that the higher your costs, the more effective (profitable) is cost reduction by order of magnitude.

Cost increase is worse than sales decline

As you may have suspected, cost is a double-edged sword, that can cut either way with the same ruthlessness. It can jack up profit with the same vigor that it can squash it. If cost is left unmanaged or left by itself, like a balloon, it rises - and rises faster and faster. The effect of costs increases is the exact reverse of cost reduction. Any cost increase will have more disastrous effect on profits than sales decline of the same percentage. Furthermore, the negative effects of cost increase is multiplied several times the higher your cost component. The following illustration based on the previous example shows this other character of cost.

Company A

 
current
10% sales decrease
10% cost increase
sales
$100
$90
$100
cost
70
63
77
 
-----
-----
-----
profit
30
27
23
% profit increase
-10%
-23%

Company B

 
current
10% sales decrease
10% cost increase
sales
$100
$90
$100
cost
90
81
99
 
-----
-----
-----
profit
10
9
1
% profit increase
-10%
-90%

As most companies have experienced, cost increase can wipe out profits faster than sales decline of the same magnitude. Cost control, better yet, cost reduction, is indeed a must, not an option for survival. World class companies do not waste the heroic efforts of their sales force; through continuous cost reduction, they make sure their marketing efforts result not only in a sale, but a profitable sale.

Cost is transparent to the customer

Another fact about cost is that companies seldom realize that "Cost is transparent to the customer". As long as the customer gets the right quality at the right time at a price that is reasonable, affordable, and competitive, he doesn't care nor care to know about your costs and profits. As long as he gets value for money, he doesn't care nor mind if you make 10% or 1000% profit, or whether your cost is 99% or 5% of price. In other words, he will keep on buying as long as he perceives he is getting the expected value from his purchase. Unlimited cost reduction and profitability, as long as you do not compromise quality and product delivery, is a right, privilege, opportunity, and most of all, power, that customers, with their indifference, grant sellers and producers by default.

What are the strategic implications of cost transparency and cost-as-profit outlook? The first is that cost is not inherent in the product or the industry. World class companies do not take industry cost averages as standards or even as guides. With their continuous cost reduction programs, rather than be affected by industry norms and practices, they affect and pull down the industry cost standards. They become the cost leaders in the industry, and eventually, also the price leaders.

To a world class company, there are no such things as fixed costs, uncontrollable costs, or given costs. A huge part of this "untouchable" costs are really unnecessary costs due to mistakes and bad decisions made in the past, often by the previous management, that have continued as standards. The world class company assumes that all costs are controllable, preventable, and reducible. This belief is what drives them to do kaizen, or non-stop improvement.

The second important implication is that all costs are unnecessary unless proven otherwise. This goes several steps beyond zero-based budgeting - it is zero-based costing, zero-based business. In other words, for cost reduction, the floor is the limit. The aim is zero cost - an allied objective of zero defect and zero inventory. If cost is floor's the limit, then profit is sky's the limit. It is common to see world class companies achieve 800% to 1000% ROI or profit margin. To them, the business textbook examples of 20-30% targets, often seen in the boardrooms of most companies, are child's play.

To see cost is to reduce cost

How could a company start the world class cost-reduction movement? First, it will have to get everybody together to start digging this gold mine, called cost, in the company's backyard. Cost should be made the concern and responsibility of every employee. Everybody is not only a quality center, but a cost center as well. Every employee has both a quality responsibility and a cost responsibility. To help them carry out this responsibility, critical and relevant costs should be made obvious and available to all employees. World class companies make such costs visible to everybody so that they may attract attention and prompt action. In world class cost reduction, ignorance is not an excuse.

In many Japanese world class companies, the costs of all parts and supplies are posted on the factory bulletin boards for everyone to see. The costs of every kind of defect or destroying a part of a product are also displayed. These include material costs and the cost of wasted labor and utilities consumed by such defects. Costs of non-tangible items may also be shown - cost per hour of machine downtime, electrical consumption per machine, overtime, etc. They even reveal the sales figures and income statement regularly to all employees - union members or not. The management is less concerned with the leakage of such information to competitors through its employees than with preventing employees from destroying and squandering company assets and resources because of sheer ignorance of their costs or value.

If a small part, say a bolt, is accidentally dropped on the shop floor, probably no worker would bother to pick it up and return it to the tray. Somebody may even step on it or kick it knowingly. But replace that bolt with a 10 cents coin, its true cost to the company - somebody would immediately pick it up. Now, if every worker is made aware that each bolt costs the company 10 cents, then everybody would handle each bolt as if it were a 10 cents coin.

World class companies achieve mega-profitability through persistent, relentless, and non-stop quality improvement and cost reduction, while maintaining the ultimate in customer satisfaction. Profit to them is not a goal nor a target; it is the natural consequence of world class management, of putting the customer first, and managing everything else with complete freedom and open-mindedness.


 

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