Companies, by the nature of the business, have a difficult time staying “lean.” As they grow in size, they become bloated, a condition that ultimately impairs revenue growth, profitability, and shareholder value. Sooner or later, the fact that the company’s cost structure becomes bloated confronts most management teams across most industries. This condition is a common occurrence. So, why does it happen? Moreover, what steps can companies take to resolve this problem?
An excessive cost structure
is a common occurrence.
Consider the following situations that drive cost that we have noticed across numerous companies.
- Too many product lines spread across markets give rise to unintentional business complexity – in the supply chain, sales and marketing, product development, and administrative processes. The direct consequence is to increase costs, waste resources, and significantly lower margins.
- Companies with long value chains become weighed down by massive cost structures. Long value chains tie up large amounts of capital and infrastructure. They also expose the company to competitors to conceive new models of value delivery and ultimately disrupt the firm’s competitive position.
- Numerous growth initiatives increase the size of the organization, adding complexity to the administration of the business and burdening the company with high indirect costs. These costs include expanded top management functions for executive control and direction over all personnel, departments, facilities, and activities such as human resources, accounting, finance, public relations, contract administration, and legal.
- Excess production capacity induces significant economic costs, such as the leasing, loan servicing, or the opportunity cost of the capital employed, the administration of the assets, depreciation on the plant, equipment and machinery, and any additional unused fixed costs, including utilities, fixed labor costs, floor space, building maintenance, taxes, insurance, and so forth.
- Product lines with small market share and low growth, i.e., “dog” product lines, carry a high cost. Given low share, these product lines don’t benefit from competitive economies of scale, they incur increasing inventory-to-sales ratios, and take increasing marketing costs as a percentage of sales.
- Companies with asset-intensive operations incur high overhead costs, including PPE depreciation, inventory carrying costs, and indirect labor, to name a few. Traditional cost accounting arbitrarily adds a percentage of overhead expense to direct cost to allow for an estimate of total costs. As the rate of overhead cost rises, this allocation becomes increasingly inaccurate because costs are not caused equally by all the products. Unless overhead costs are allocated appropriately, product lines with actual negative net margins are not always visible to management and add significant cost.
- Mature and declining markets lock up valuable resources with the end-of-lifecycle product lines. These product lines generally serve few customers and carry considerable costs because: (1) parts are difficult to find given they are no longer being supplied, (2) end-of-lifecycle products may not be compatible and need constant upgrades, and (3) they usually require a high level of technical support. The resulting overhead cost is disproportionately high because it cannot be amortized over large product volume.
- Industries with extensive value chains (i.e., with 10 or more steps) give rise to significant variations in profit margins and return on capital at each stage. This condition exposes companies operating at unfavorable stages in the value chain to poor cost economics. The luxury-goods industry illustrates the vast discrepancy in profit margins between retailers (low margin) and product manufacturers (high margin).
- Companies in consolidating industries operate in a market where the capacity to produce exceeds demand, so prices drop. The combination of lower prices and overcapacity drives a downward pressure on profitability and utilization, creating an environment where a low-cost structure becomes essential to the survival of the firm.
- Increasing input costs impact expenses directly. These costs include wages, commodities, utilities, transportation, and third-party services such as legal, accounting, and engineering. The net effect is an annual increase of 2% to 3% in producer prices, which may be overlooked initially but becomes more evident over time.
- Companies operating in industries undergoing disruption can incur shifts in their ability to deliver products and the economics of production, including their ability to maintain cost performance as determined by investments, assets, equity, availability of supplies, workforce productivity, or and other measures.
If left unattended, these situations give rise to excess hidden costs that can detract as much as 10% or more from the bottom line and call for an immediate exercise in reducing cost. But which approach should be used?
Hidden costs can detract
10 pp or more from EBIT.
If management teams are to respond effectively to these conditions and to achieve the ambitions they have set for themselves, short-term improvements alone will not get the job done. Quick measures such as improving procurement, reducing personnel, and increasing operating efficiencies can be beneficial, but they are not sufficient as they don’t get to the root of the problem. Consequently, cost-cutting doesn’t stick, and costs creep back even stronger.
Short term improvements are
Managers need to think in broader terms in light of how much cost reduction they need: Which activities drive value? Which activities make or could make the organization more competitive? How should we restructure the business to take advantage of projected market trends? Which activities are essential, and how can we make them more effective? How can we align the cost structure to market demand and supply? Alternatively, do we need to change the business
Our next article, “The Challenge of Cost Reduction,” explores these issues and what it takes for managers to attack the drivers of cost, the levers at one’s disposal, and how to deliver lasting value.