In this month's article, we examine an issue that has been, for some of us, a major source of confusion and, in some cases, embarrassment. This is the issue of costs and cost savings.


You Don't Understand Costs
Some time ago, one of the authors of this column was involved in a project dealing with the in-house manufacturing of a component. The group of people that had been assigned to the study of this component had agreed that the manufacture of this item was anything but efficient. The item was fairly large (the rail frames for a line of chassis produced by the firm). This product was measured and cut by hand. This process was not error-prone, and the flow of the product was more like spaghetti than anything else. The group found that the rails were marked, then taken outside for storage. Later on, they were brought in for final preparation. During the winter, this meant having to clean the snow off the rails. This created a very messy and potentially dangerous work environment. The group approached several outside frame manufacturers. What they found was these suppliers could provide rail frames at a lower unit price, in less lead time and at a higher level of quality. Their recommendation: outsource the manufacture of the rail frames.

The group enthusiastically presented its findings to top management. A member of the top management team was the original owner, and a highly opinionated person. This person was also brilliant — a truly "intuitive" manager and engineer. Well, this person sat back listening politely to the group's presentation. After the group was done, he stood up and asked them why the firm should act on their recommendations. The spokesperson replied that by outsourcing the rail frames, the firm could free up the space currently being used by the rail frame department. In addition, the firm would save something like 12 percent per frame, while also being able to reduce the associated warranty costs. Finally, by moving the rail frames out to the suppliers, the firm could save the cost of the four people involved in the rail frame manufacture.

The owner looked at the spokesman and asked if that meant that he would be willing to fire these four people. No, came the answer, these people could be moved to other departments where they could be better used. "Well," the owner retorted, "we don't have the business to absorb these four displaced workers." The spokesman agreed but noted that, if business ever picked up, then they would not have to hire any more workers. "Nonsense," said the owner. "What I want are real cost savings and not potential cost savings. I want money that I can put in my pocket, not the promise of savings."

This story teaches an important lesson — not all cost savings are equal. There are different cost savings, each with its own set of conditions that must be recognized and considered. In general, we can recognize four different categories of cost savings: true cost savings, opportunity cost savings, incremental cost savings and myopic cost savings.


True Cost Savings
This type of cost savings defines for many the ideal type of cost savings. They are immediate, easily quantifiable and, therefore, unlikely to generate disagreement. For example, if the supplier of one of our components were to reduce the price per piece by $50, we would have a true cost savings. This savings is immediate. It is not dependent on the volume of business. It does not have to wait until other benefits are generated so that, in total, there is a significant cost reduction.

True cost savings occur for a number of reasons. They can occur as a result of a pass-through savings. The example of our supplier reducing the cost of production and sharing those savings with us is an example of this type of pass-through savings. It could also occur because of a rethinking of the process. We have changed the production process, with the result that the setup times and the amount of inventory have been reduced. We could also have a true cost saving due to product redesign. With true cost savings, our benefits are there. They are not dependent on other conditions.


Opportunity Cost Savings
This type of cost savings is what we saw in the story told at the beginning of this article, and is highly dependent on other conditions to take place. Often, these "other" conditions are defined in terms of volume. In the example previously presented, the manpower savings noted by the group would have been gained only if the production volume (reflecting, in turn, increased sales volume) had grown enough to absorb them. Without this increased volume, management has one of two options available. The first is to convert the opportunity cost savings into a true cost saving by terminating the affected employees. Alternatively, management could have kept the employees. Under this option, the cost saving is more of a promise than reality.

For an opportunity cost saving to be real, the action must enable management to avoid incurring other costs and expenses.


Incremental Cost Savings
These are cost savings that cannot be realized until they have been accumulated to a sufficient mass. For example, we may have reduced processing time in one area (requiring two operators) by 25 percent. But as the operation still requires two people, the savings do not really mean much to us (we cannot let go of half an operator). These improvements may not have increased overall output, and they may not have affected any other areas. However, this saving is worthwhile. If, over time, we can introduce enough of these changes, the net result may be that we can reduce the staffing requirements for that operation by one operator.


Myopic Cost Savings
This is a cost savings that is not a cost savings. Assessing the impact of this cost savings requires taking a systems perspective. For example, let's assume we are building trucks. The firm is under increased pressure from competition. Every department is encouraged to find and implement any opportunities for savings. One of the departments decides to change a component in the steering mechanism. They decide to replace one component with another one. They are assured that the differences in steering are minimal. The change is introduced and the resulting cost saving attained. However, everyone is not happy. By changing the nature of the steering mechanism, the handling traits of the truck have been affected. The customers notice. They bring their trucks back to the shop for repairs. Warranties increase to the point that increases in warranties are greater than the cost savings initially attained. With this type of savings, the one department is "better" off, but the firm, as a whole, is worse off.

In short, a myopic cost savings is a "good news/bad news" situation. A cost savings in one area has been created by an offsetting increase in costs in another area. The result is chaos.

Knowing the type of cost savings that you have is important so that you can better justify it and explain it to everyone else.

If you have any ideas for this column, please send your ideas to Steven A. Melnyk at [email protected]