Jimmy Anklesaria, F.C.A., LL.B., M.B.A.
Jimmy Anklesaria, F.C.A., LL.B., M.B.A., President and CEO Anklesaria Group, Inc., Del Mar, CA 92014, 619/755-7119, firstname.lastname@example.org.
Abstract. As companies in supply chains look for ways to differentiate themselves in the 21st Century, technology, quality, service and timely delivery may not be the answer. However, providing all of the these at a lower cost than that of a rival supply chain will ensure long term profitability and survival. Managing costs through the supply chain requires a clearly defined, easily implementable, written strategy. This article shifts the focus from "allocating costs" to "managing" them. It demonstrates how to develop a written cost management strategy using Anklesaria's AIM & DRIVE (R) process: a proven, winning methodology applied at many Fortune 100 companies.
What is a Strategy? The word "strategy" has been defined in the Random House Dictionary to mean, "a series of strategisms". It is a series of ideas, actions and methodologies that direct a team, organization, company or supply chain toward a common, predetermined goal. A strategy is like a river. It originates with a concept or idea (like a spring). It follows one clear direction (a river can only flow downhill toward another larger body of water). Along the way, other ideas and players with a common focus join the team and move in the same direction (a river is joined by tributaries and other rivulets that move in the same direction as the main river). When a problem is encountered, the strategy team falls back on its preagreed plan of action to tackle the problem, using innovation and flexibility to deal with unforeseen situations (a river encounters rocks and other obstacles but finds its way around, under or through them, even if it must create the Grand Canyon to do so). The goal of a strategy should be well defined and known to all parties (a river has a clear destination which may be a large lake, sea or ocean). Finally, a good strategy, like a river, will not turn back and disappear because of an obstacle in its path.(3)
Do We Really Need Cost Management Strategies? Many managers are of the view that strategies are not required in managing costs. These are the majority (unfortunately) who grew up in the days when cost reduction only seemed possible through "negotiation". The days of the "hatchet" are over. One cannot expect to slash costs by barking out orders from the top. "Cut head count, cut travel, cut training, cut R&D, cut supplier profits, cut, cut, cut...". There has to be a common focus in order for a supply chain to be successful in this fiercely competitive market place. The common focus is the end customer - the only one who puts money into the supply chain. Companies like IBM have moved toward the concept of providing "business solutions" for its customers and have seen a tremendous rebound in market share, profitability and stock price as a result.
Demonstrating Leadership in the Supply Chain. Most companies in the supply chain are reluctant to talk about costs. One reason is that most of them do not truly understand their costs. That's quite understandable since the word "cost" is defined differently by various links in the supply chain. Beyond the traditional acquisition price that buyers focus on, marketing looks at the cost of lost sales from being late to market, manufacturing is concerned with the cost of a line shutdown, finance is interested in the cost of money and development looks at the cost of a prolonged design cycle. It takes a leader to bring the chain together. A leader is a company that promotes the idea of a supply chain joining together to write and implement cost management strategies, without getting into the hidden secrets of one another. Remember, in developing a cost management strategy one does not have to share detailed cost data, but rather show a willingness to share relevant information and work toward a common goal of reducing both supplier and customer costs.
In spite of short term "bottom line" pressures from management and the call by some consultants to "...reestablish tension in buyer-supplier relationships and leverage the free market"(4), some world class companies are slowly but surely moving toward a totally new type of relationship with their key suppliers. A relationship based on respect and admiration for one another that results in a competitive advantage for both sides. In the early 1990's Hewlett-Packard led the way by taking the bold step to engage its key suppliers in the development of written cost management strategies. Later Texas Instruments, under the leadership of supply process managers like Jim Watson, John Wiley and Ernie Cook, showed that a cooperative approach could work even in the intensely competitive semiconductor industry. Feedback from suppliers, especially the Japanese ones, was most encouraging. At IBM, Gene Richter, Chief Procurement Officer, brought Big Blue back into the reckoning with the rapid deployment of cost management strategies across production as well as nonproduction suppliers. In the utility industry, Arizona Public Service has done an outstanding job thanks to the vision of Frank Nagy, VP Procurement. Al Cummins, Director of Corporate Sourcing, has done the same for Eastman Kodak and John MacLean, VP Procurement, for American Airlines.
The Aim & Drive Process (R). Once you have convinced yourself that there is an alternative to the slash and burn, hatchet job in reducing costs, the logical next step is to come up with a process that helps manage costs through the supply chain. There is no reason why this has to be complex. Cost management is a straightforward, implementable, eight step process of AIM & DRIVE (R):
1. Agreeing on the Need to Manage Costs Through the Supply Chain. Let's not waste precious time developing a strategy if it's only going to gather dust on a bookshelf. Before going further you've got to ask yourself: "Am I interested in managing costs through the supply chain, thereby becoming more competitive, along with my suppliers and customers"? If the answer is "yes", you are ready to proceed with the rest of the steps. A typical AIM & DRIVE( session begins with a review of the business plan by senior management from both the customer and supplier. This is in order for each (or all, in case there are more than two links in the supply chain involved) side to have a broad idea of the "goals" of the other. A small "tiger team" may be created to review the flow of funds through the supply chain in order to determine which cost or group of costs require a written strategy. In selecting the primary cost to be managed, the team may use Pareto analysis, or select a line item that is over a certain hurdle value (say $1,000,000), or a cost element that does not meet the first two criteria, but varies significantly from a standard or target cost and such variation adversely affects the profitability of the project. Once the team has "agreed" to manage a particular cost, it is important to invite other "ten meter managers" to join the team. In this paper we will use the example of "The Cost of Technical Manuals for a Laptop Computer" as our primary cost to be managed.
2. Identifying Critical Costs in the Supply Chain. Based on the selected primary cost, it is necessary to map the process. In this example the team would map the process from the time the customer decides to use a printed technical manual to accompany the laptop, until the manuals have been inserted in the fulfillment kit. A primary cost needs to be broken down further into secondary and, if necessary, tertiary costs. Secondary costs are sub costs of the primary cost. In the example, secondary costs would be development, material, printing, and logistics. The cost management team then evaluates whether there is a need to break down any of the secondary costs further. For development, the tertiary costs would be design, technical writing, editing and translation into other languages. In the case of material, it may be paper, ink, chemicals, metals and packaging material. One does not have to think about who spends the money (customer or supplier) since it is the supply chain costs that matter. Having broken down the costs into secondary and tertiary costs, the next step is to determine which of these costs are future cash flows. The reason for this is that it makes no sense to attempt writing a strategy on one-time costs that have already been incurred. Finally, the selected costs should be ones that are impactable by the team. Let's choose a tertiary cost - paper, which is a future cash flow and certainly impactable by a cost management team, and proceed to step three of the AIM & DRIVE( process.
3. Measuring Secondary & Tertiary Costs. Once impactable, future cash flows are identified by members of the supplier-customer team, the next stage is to apply a measurement process to each cost. This is by far the most difficult part of cost management, yet a very critical one. A cost that is not measured is usually not managed. Accounting systems over the past decades (job, process and standard costing) have focused on measuring costs for the purpose of allocating overhead. Modern systems like Activity Based and Process Based Costing may appear to be more sophisticated. However, these costing systems are merely more refined in the "allocation" process.
It is most unfortunate that both traditional and modern cost accounting systems have succeeded in confusing more people than helping them measure costs. It is a pity that no one "listens to the customer" and designs a system that is easy to understand and implement. So, we'll use a system of our own when the traditional or modern system fails to measure costs in a way that enables a lay person to make sound business decisions. This system has been in place for centuries as academics and accounting professionals battle to come up with more complex systems to measure costs. It's called "COMMON SENSE". However, since we need to use a more "sophisticated" term, we'll refer to this new process as Formula Based Costing (TM).
The objective of Formula Based Costing (TM) is to generate a list of cost drivers through the use of algebraic equations. A cost driver is a measure of an activity that causes a cost. A driver represents a "causal relationship" between an activity and a certain cost. Therefore, there is a cause and effect relationship established which means that a change in a given activity should result in a change in the cost that is driven by that activity. This is like the basis of an algebraic equation where a change to any variable on the Right Hand Side (RHS), immediately changes the value of the Left Hand Side (LHS), also known as the result.
In the example, if one were to write a formula for paper as a tertiary cost it would be something like this:
($/year) = $/pound * pounds/sheet * sheets/manual * manuals/kit * kits/laptop * laptops/year
You will notice that the RHS cancels out to equal the LHS ($/year = $/year). $/Year is a proper measure of a cost (budget). Each variable on the RHS of the equation represents the true meaning of the word "cost driver".
4. Defining Key Cost Drivers and Developing Strategic Options. The most difficult part of measuring costs is to extract a list of cost drivers. Once this is accomplished in Step-3 of the process, the next step is to select the key cost driver/s. You will then have to focus your attention on developing a strategy for the selected drivers. Selecting a driver as a key cost driver can be done by a cross functional team by observation or by using a sophisticated matrix that is beyond the scope of this article. By definition, a key cost driver is one that, if impacted, would result in the reduction, elimination or change of an activity that causes a cost. The process of selecting a key cost driver involves weighing the cost elements, determining the level of impact each cost driver has on the various secondary/tertiary costs, calculating the weighted cost drivers, establishing the current levels of the drivers and their respective potential for improvement and finally deciding whether the driver can be impacted by the team. Having selected the key cost driver/s, one has to determine "how" the driver/s will be managed. This involves brainstorming a list of strategic options or alternatives.
In the example, assume that the "#sheets/manual" is the key cost driver. In answering the question "what is the number of sheets per manual a function of?" the response would be:
5. Reducing , Changing or Eliminating Activities That Cause Costs - The Strategy. Costs do not disappear with the wave of a magical wand. The options for the key cost driver/s have to be formulated into precise strategies. These strategies then have to go through a rigorous risk-benefit analysis. The team should make sure that the risks do not violate any constraints like financial budgets, headcount, cycle time, safety, technology and so on. A SWOT analysis is also performed in order to prioritize the selected options.
In the example, if one were to take an option like "type of media used" the formulation of that option into a precise strategy would read something like: Change from the current 200 sheet printed manual to an 8 page summary, by installing all information, other than the quick-start section, on the hard drive in the form of an on-line help menu. You will notice that this reads almost like a mission statement, where you have to take a deep breath before reading it aloud. This is because the strategy should be as precise as possible in order to avoid misunderstandings during implementation. The risk analysis would include the cost of development, the time before the next generation laptop is released, the space/memory requirements on the hard drive, the cost of software licensing agreements, customer perception and so on. Benefits include cost savings on paper, packaging and freight savings, the manual is more customer friendly, enhanced aesthetics through better graphics and color, and so on. None of the risks warrant a need to abort the strategy, so it would be fine to proceed to the implementation stage.
6. Implementing an Action Plan. Developing an implementation plan is as critical to the cost management process as writing a strategy. While strategies are ideas, implementation plans are a means of converting those ideas into action. This stage involves listing the action required for each selected strategic option. The action plan consists of determining who will do what, and by when. Yes, even executives in industry need to be "organized" in order to successfully achieve the benefits of cost management. Why? Because it's so easy to abandon a project at this stage and go on to fight other fires.
Implementation plans obviously aim at successfully implementing a given strategy. It is the height of optimism to expect that all strategies will be implemented without a hitch. Murphy tends to pay a visit from time to time and put a spoke in your wheel. It makes sense, therefore, to add another dimension to your implementation plan. This requires the creation of contingency plans: alternative strategies you will implement if your goals cannot be achieved by the proposed strategy.
Think seriously about how you will "market" your plan. Develop your "sales pitch". Then bounce it off your fellow team members or someone you know will be a fair critic. Think about the people who will participate in the implementation process. What makes them tick, what doesn't? Remember, if you rub a key player the wrong way, a carefully developed cost management strategy is likely to end up in a dust covered file folder.
7. Verifying the Plan with Cost Monitors. All too often, good strategies do not realize their true potential. Why not? you may ask. Perhaps a better idea came along. Not likely. In my experience, plans that fail, do so because no one bothered to verify and monitor the process. There are those who believe the world of manufacturing can be superimposed onto the world of strategy building. "Do it right the first time", these folks say. "If you spent a little more time on developing your strategy, you wouldn't have to worry about not achieving your goal." Since many cost management teams include members from manufacturing or quality, it may seem embarrassing to verify or monitor the strategy. What a pity. One's ego can wreck years of planning and improvement.
Verifying the cost management process implicitly assumes that change is inevitable. A team needs to recognize that strategies have to be changed or modified when conditions change. Changes in government or corporate policy, the environment or market conditions, supply base or technology have to be accounted for and adapted to. A flexible strategy is, therefore, essential to the successful and continued implementation of a cost management plan. Failure to recognize change is the hallmark of a static, reactive company that is unlikely to be in existence in the year 2000.
Verifying the process involves:
Verifying the plan includes establishing performance measures. These Measures need to be quantifiable, even if the team uses a subjective approach to quantify improvement. Shell Oil Company has developed a marvelous process called "Performance Indexing". IBM monitors the performance of its procurement teams using measures like PPCA (Product Procurement Competitive Advantage) and GPCA (General Procurement Competitive Advantage). At the cost of repetition, remember that "what gets measured, gets done". Accept criticism gracefully. No one is perfect--nor are plans, for that matter.
8. Eternally Improving and Modifying the Process. Cost management is a journey, not a destination. And the journey, like that of Total Quality Management, never ends. If the process of cost management, spelled out in the seven preceding steps, works successfully on a set of primary, secondary or tertiary costs, then it is time to start again on other costs in the supply chain. Perhaps it's time to expand the supply chain and bring in the supplier's key suppliers and/or your key customer/s. There is no time to stop and smell the roses. Remember, there's no patent on improvement. If you are successful, your competitors will be on your heels, putting the same strategies into practice. So, there's no time to lose... keep the wheels of cost management moving faster than that of your competitor.
Conclusion. The purpose of this article is to provide you and your company with a winning methodology to managing and reducing costs through the supply chain. Working through the AIM & DRIVE (may be logical, but it is not easy. There will have to be major sacrifices and compromises, shifts in paradigms and changes in policy. The good news is that a few proactive companies have already embarked on the journey of cost management by developing written strategies using the process. For these companies, taking the first step was half the battle. No one likes change except a wet baby. But change you must if you want to stay competitive. There is a saying that goes "If we don't change our direction, we're likely to end up where we're headed." How very true. If only the automobile industry had followed this advice more than a decade ago. If only!!
1 AIM & DRIVE (R) is the registered service mark of Jimmy Anklesaria and is used with permission.2 Formula Based Costing (TM) is trademarked by Jimmy Anklesaria and is used with permission.
3 Krause, Donald G., Sun Tzu: The Art of War for Executives, Nicholas Brealey Publishing Limited, 1995
4 Kapoor, Vikas and Gupta, Arnab, "Agressive Sourcing: A Free Market Approach", Sloan Management Review, Fall 1997