The Seven Principles of Effective Cost Management
by George Elliott
Effective cost management is the central measure of accountability for business leadership. Cost management includes effective strategy implementation as well as providing the resources and process discipline to enable and ensure the highest possible level of quality, reliability and productivity at the lowest overall cost. It is not about “cost” in the sense of “cutting cost.” Rather, cost management is the process of optimizing performance. It is as much strategic as it is operational.
Passionately embraced and implemented, the following seven principles provide both a robust business model and the essence of a cost management ethos. Together they provide a road map to business success.
Provide Clear, Consistent Performance Objectives
The first step in any undertaking is to ensure clear and aligned expectations. This is especially true in cost management, where many managers’ only cost experience is in “cost cutting,” such as staff reductions, product and facilities rationalization, and cutting capital budgets. While these actions are sometimes necessary, effective cost management lies in an everyday process discipline that continually addresses the root cause of excess staff, unprofitable and overexpanded product lines, and the justification and implementation of marginally effective control systems. Effective cost management deals with the underlying systems which create the need for such structural cost elements.
For example, in an industry where low cost is the primary driver of business success, there are four pivotal drivers or determinants of cost: production scheduling, maintenance effectiveness, product offerings and technical knowledge. Each can be either a tool of cost effectiveness or a “root cause” of low value cost. Understanding this distinction is the first step in effective cost management.
The second element, aligned expectations, is equally important. Even with clear revenue expectations, an aggressive, well-meaning sales and marketing organization can offset its hardwon top-line successes by adding products, packaging options and channels to market that, in fact, add far more cost than the projected benefit of increased sales.
Similarly, there are potential cost trade-offs between traditional procurement cost saving processes and manufacturing’s need for process stability and variation reduction. This is especially true in the pharmaceutical, alternative medicine, dietary supplements and food processing businesses where product integrity and consistency are the lifelines of business success. For effective cost management, performance expectation and objectives must be aligned so as not to offset one area’s accomplishments by increasing costs in another.
Provide Knowledge, Tools To Succeed
The meanings of the words “knowledge” and “tools” depends on one’s beliefs about the basic motivations behind human behavior. If an organization’s executive leadership believes most employees arrive at work with the willingness and desire to do their best, the job of employee motivation and performance is abundantly straightforward. Each individual’s level of knowledge and capability becomes the essential component of the employee’s ability to perform well.
For example, if an organization wants to optimize the trade-offs between volume, margin and manufacturing cost, the sales force—the very people responsible for revenue and margin—must have a solid understanding of manufacturing, standard cost, and the impact of their product and customer-related decisions on the broader organization. The same is true of the planning (scheduling) and production side of decision making. They, too, must have the relevant understanding of how each of their actions affects the customer, cost, inventory and product lead-times.
This same principle applies within the management ranks. To enable and ensure effective cost control, managers need to know the specific cost drivers of their business. They need to understand the difference between efficiency and structural cost. They need to technically understand the production and sales process as well as having detailed knowledge of the systems that drive the company’s day-to-day activities.
The deeper the executive knowledge of their organization’s cost drivers, the greater the opportunity for effective cost management versus cost cutting.
Understand True Costs
Standard cost is the basic component in a vast majority of business decision-making, from budget preparation, pricing and variance reporting, to strategy formulation and performance-based incentive plans. Standard cost data drives most new product pricing, advertising, marketing and capital investment decision making. The importance of accurate standard cost data cannot be overstated.
It is well-known and -accepted that when average applied overhead systems of standard costing are used, high volume product costs are overstated and low volume product costs are understated. What is less recognized, or at least acknowledged, is that the low volume product costs in such systems are often undercharged by as much as five to 10 times. To understand and accept the need for accurate product costing has always been a challenging management task.
It is extremely difficult to accept that the base data used for many years of decision making may be the root cause of many business shortfalls. This is especially true in product costing and pricing and in new product justification and introduction.
In study after study, the average applied overhead analysis targeted at the lower 50 percent (in volume) of all products offered account for less than 5 percent of sales volume and productive labor, are therefore assigned less than 5 percent of all overheads, yet account for 20 percent to 30 percent of all non-material cost. In other words, over 50 percent of products are sold at a loss. Until this cost distortion is acknowledged and corrected, major management decision systems—including long-term strategy formulation—remain extremely difficult to validate. Accepting such reality has been all but impossible for many of our finest executives.
Excellence: The Only Acceptable Performance Target
Organizations once based performance improvements on a simple comparison of past and current performance, what most call continuous improvement. Today, customers do not expect nor do they accept performance defects; they expect performance excellence.
One of the most important keys to effective cost management is to set the bar at excellence: minimum 1.33 Cpk quality; zero injury safety; zero late delivery; year-over-year product cost reduction; and predictable, regular technical up-skilling.
Technical knowledge, well-understood and aligned performance systems and absolute data integrity are all adding up to a performance culture, a cost management behavior ethos.
Reduce Organizational Complexity
Yesterday’s luxuries are today’s burdens. Today, the term “high-value” can be used to describe only the most basic of essential activities. In many industries, most organizations can afford only the highest contributing activities.
Organizations with the most effective cost management are constantly and boldly applying the test of relevance and value to every daily activity. They question everything. What does this activity do to create and maintain sales or improve margins? What additional costs will this activity add? What does this investment do to improve quality or provide added production flexibility? Products, customers, etc., that do not meet these standards must go.
For instance, if a sophisticated maintenance management system is not working, it is often better to shut it down and go back to the basics than to add the ongoing cost of fixing and maintaining a low value system.
Looking back at standard cost, if the 50 percent of product variety accounts for less than 5 percent of total sales, yet creates 20 percent to 30 percent of non-material variable cost, then product by product, they too must pass the test of contribution value.
Commit to Broad-Based, Knowledge-Driven Involvement
There are two very important reasons to focus on knowledge and involvement. The first is the simple truth that people who are not involved will not easily give their commitment. The second is that the ability to truly lead is not positional. It is earned through knowledge and respect. These two success elements, leadership and commitment, are central keys to cost-effective excellence.
As we review the seven principles of effective cost management, it becomes clear that excellence in each depends on what business strategist W. Edwards Deming called “profound knowledge.” The central factor of employee involvement or empowerment has always been the perceived quality of the decisions made and the problems solved.
Standard cost, complexity reduction, and maintaining a valued and credible performance system are all driven by the common denominator of knowledge-driven involvement. Only employees with the knowledge and opportunity to be successful decision-makers can pave the way for future business success.
Management Decisions Impact Organizational Cost
The most important principle of effective cost management is leadership’s understanding and acceptance of the reality that the majority of all organizational cost is structural. That is, costs are built into an organization by management systems and management decisions.
Decisions about the number of products, the customers they serve and the way the business is run all drive cost. It is “What We Do” versus “How Well We Do It” that determines the vast majority of an organization’s cost.
Therefore, the second part of this reality lies in management’s ability to accept change, to challenge their own past decisions and to aggressively embrace the power and potential of their employees. It lies in the ability to accept the fact that most organizational cost has been created and supported by past leadership decision making.
In the end, effective, process-driven cost management is founded in the culture of the company. It is a way of life. In many cases it is also the only path to organizational survival.
George Elliott is the chief executive officer of Elliott-Luepker & Associates. His consulting career is founded in a widely varied and highly successful care in manufacturing, materials, sales and marketing and extensive general management experience. He can be reached at email@example.com.