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Operational Excellence: Know Your Cost Structure
By Bob Prosen
A thorough understanding of a company’s cost structure and the use of continuous process improvement provide the foundation for many business decisions.
Without accurate cost information it’s impossible to set optimal prices, forecast performance, isolate areas that negatively impact cash flow, determine what to stop doing, identify what to automate, and decide how best to manage costs.
It’s also critical to undertand cost drivers in order to grow a profitable business while investing in areas that improve profitability and de-investing in ones that don’t.
Operational excellence is how margins are maintained. It is about efficiency, effectiveness, and doing the right things right the first time.
While sales are essential to profitability because they fuel business growth, when sales fall short of the top of the line, or there is pricing pressure, most companies must cut costs to maintain margins and stay afloat.
Unfortunately that often means eliminating people. It’s best to keep a constant eye on costs instead of slashing payroll as a last-ditch effort to make ends meet.
Know Your Cost Structure
The first step toward operational excellence is to thoroughly understand your company’s cost structure.
This provides the foundation for sound business decisions across the entire company.
Without accurate cost information, it’s impossible to set proper prices, forecast performance, isolate areas that negatively impact cash flow, or determine what to stop doing, what to automate, how to allocate funds, or how best to manage budgets.
It’s also critical to understand cost drivers in order to grow a profitable business while investing in areas to improve profitability and results while de-investing ones that don’t.
How To Apply This Knowledge
All too often leaders become slaves to their financial accounting systems and wait too long before taking action.
If you don’t completely understand your cost structure, you’re at a competitive disadvantage.
Take whatever steps necessary to get the information you need. There is no excuse for not knowing.
It’s amazing how many companies struggle to accurately determine their true cost of doing business (the cost of labor, fixed and variable costs, direct and indirect expenses, overhead, costs by market segment, customer, geography, or product).
Clear cost accounting allows a company to focus its energies on winning in the marketplace and achieving its objectives instead of debating the numbers internally.
Management’s primary objective in operational excellence is to fully understand all costs of doing business and maintain the proper balance of cost in relation to revenue.
That’s the best way to ensure that you maintain margins.
If you are in a commodity-based business, you must be a low-cost producer. If you sell differentiation, your prices must support a higher cost structure.
It’s that simple!
The goal is not across-the-board cost minimization, but rather optimization in support of achieving your business objectives.
For public entities such as schools and local governments, the objectives are to accurately understand all the costs of running the organization and to ensure budgets are properly allocated and funds are used efficiently to achieve the organization’s top objectives.
Operational excellence is a vital element since these organizations operate primarily on fixed budgets, with little opportunity to increase funding.
However, if you don’t understand and track your costs in sufficient detail, it’s impossible to know where to make the necessary adjustments to improve profitability.
This is not the place to guessing,the risk is too great.
Devote resources to determining not only your own but your competitor’s cost structure.
Adjusting Your Cost Structure
When you grow your company, you grow your cost structure. You want to make sure you’re growing it in the right proportion to revenue by adding cost only in areas where revenue is increasing and where margins and profitability can be maintained or improved.
Strategic investments are viewed differently from other types of costs.
These investments must be made using strict justification and approval guidelines.
Every department should use the same approach to enable effective comparison and selection of the appropriate investment alternatives.
These standards include use of approved financial justification methods such as NPV, ROI, EVA (economic value added), and payback, approved hurdle rates, proper depreciation schedules, and approved investment categories.
Tight-spending authorities are required to maintain control over the total cost of investments and minimize contingent expenditures.
In addition, post-investment audits at the conclusion of a project are essential to help managers make better future investment decisions. In all cases, managers should be held accountable for investment outcomes.
The cost candidates that should be considered for growth include production and delivery costs, sales, customer service, and product support.
The latter two cost categories should only grow in support of the company’s service strategy.
These costs are all directly attributable to revenue increases.
Realize that to increase profitability you either have to:
- Increase prices
- Only allow these costs to grow in decreasing proportion to revenue
- Manage costs tightly. They shouldn’t grow unless some predetermined efficiency standards are met
- Includes all overhead cost areas
- Human resources
- Support costs.
If not closely managed, these costs mysteriously grow by one person or investment at a time until they represent a significant and unnecessary burden on the business.
In lieu of increasing these costs, look for alternatives:
- Outsourcing functions such as recruiting, training development, payroll, and copy reproduction
- Deploy technology such as PDAs to allow employees to manage their own schedules
- E-mail and follow up on calls without administrative support
- Automate expense reporting, document approval processes, and benefits administration
- Reduce rework and redundancies such as billing errors and warranty claims
Often, companies increase overhead because, for example, line organizations are not getting effective centralized corporate support, and therefore the company adds their own local support resources. You must not allow this to happen.
One way to minimize incremental overhead costs is to develop an approval process where every requested increase receives senior management’s attention.
It’s not okay to allow these costs to grow just because the company is meeting its profitability objectives.
This may sound burdensome. However, it’s far better to take the time to think through these decisions when times are good than be forced to take draconian actions when tough times arrive.
Always run lean, particularly when your company is doing well. That’s the perfect time to increase cash reserves and invest in the future. Get into the habit. The dividends are great.
Managing costs is a balancing act.
To carefully maintain margins and help avoid reactive cost cutting, all costs must be explicitly tied to the business plan.
This enables you to modify costs in a disciplined and well-planned manner as the company accelerates or decelerates.
July 18, 2012