Thursday, July 29, 2010

Dis-Economies of Scale

McKinsey research has found that only 10% of cost reduction programs sustain their results after three years. The problem seems to be overhead. Companies have exploited manufacturing efficiencies to reduce the cost of goods sold as a percentage of revenues by nearly 3% over the past decade. On the other hand, sales, general and administrative costs have remained about the same. The performance of sales, general and administrative SG&A costs is an example of dis-economies of scale.

A few definitions are in order. Economies of scale is the phenomenon where unit costs decline as the number of units sold increases. (See “Audio Tip #195: Economies of Scale and Their Measurement” on This happens because part of the cost structure is fixed, so it grows at a fraction of the rate of growth of the unit volume the company sells. Dis-economies of scale occur where units of costs increase at a rate that is greater than the increase in the units of output. (See “Audio Tip #198: Dis-Economies of Scale” on In other words, there appear to be no significant fixed costs in the company’s cost structure when dis-economies of scale occur. At the other end of the cost spectrum, you see super-economies of scale. Super-economies occur with costs decline, even as the number of units sold increases. (See “Audio Tip #199: Super-Economies of Scale” on Usually the super-economies occur due to changes in technology, when the company replaces many employees with technology capital investments.

Now let’s return to the problem of SG&A costs. In 1998, the SG&A costs for the S&P 500 companies were roughly 22% of sales. By 2008, SG&A costs still commanded 22% of the sales dollar. During those ten years, the physical units of output the S&P 500 companies produced certainly increased. On the other hand, the SG&A costs remained the same as a percentage of sales. Are none of the SG&A costs fixed? If there were some fixed costs in SG&A, the companies should have been able to increase the units sold without a proportional increase in numbers of people in the SG&A functions, creating economies of sale. But they did not produce economies of scale as measured as a percentage of revenue. What happened then? Either the number of people employed in the SG&A functions grew with unit sales or the companies paid the average SG&A employee at a higher rate than sales grew. In either case, you have dis-economies of scale operating in SG&A.

Over the years, we have been involved in many cost reduction efforts. We have seen that it is hard to sustain the results of a cost reduction effort over a long period of time. The McKinsey study serves as ample testimony to this fact. What may be helpful is to tie physical units of costs, for example numbers of full time equivalent employees, to physical measures of output, such as customer orders. If the ratio of physical units of cost to physical units of output goes down, the company has an excellent chance of creating economies of scale.

Monday, July 26, 2010

What Happens When Giants Rumble

Over the last few years, Allstate Corporation, the big insurer of homes and automobiles, has concentrated its management efforts on producing industry-leading profitability. Profits have increased but the stock price has gone nowhere. And Allstate is losing market share.

Part of this market share loss is due to higher pricing than its key competitors. A look at market share changes suggests this fact. Both Geico and Progressive, who are known for aggressive pricing, have gained market share. (See the Symptom & Implication, “Large competitors are maintaining price levels as smaller competitors discount” on Allstate’s market share has fallen, as have the shares of the smaller property and casualty insurers. The leader in the industry, State Farm, has gained market share.

Allstate is now altering course. The company’s top management has stated a goal to become the number one property and casualty insurer within the next ten years. At a minimum, this means Allstate’s market share must rise from today’s 10.5% in automobile insurance premiums to State Farm’s 18.6% market share, tough to do in a market growing only 3% a year. Allstate’s first priority is to stem the loss of current customers and then to find a way to develop programs that will enable them to gain market share. (See “Audio Tip #40: The Components of Market Share Change” on A substantial part of these initiatives will involve more aggressive pricing.

This new pricing posture has begun to emerge. In Illinois, Allstate’s home state, the company recently offered a 5% discount to Geico customers who would switch to Allstate. In addition, the company is offering a one time bonus to customers who will agree to buy directly from its web site.

These are opening salvos in a price war. Price discounting begun by the second ranked competitor in the industry is going to effect every other competitor. Prices are going down, margins are going down and no one can avoid the battle. (See the Symptom & Implication, “As large competitors match low prices, other competitors face difficulties” on As long as State Farm avoids the Leader’s Trap, the competitors who are likely to suffer most will be the industry’s smaller players. These companies will suffer mightily in a price war. They manage cost structures that do not enjoy the economies of scale of their much larger competitors.

These smaller competitors are likely to begin to fail in the marketplace. As they do, they may become acquisition candidates for Allstate. Acquisitions may, indeed, be a profitable route toward Allstate’s market share goal.

Thursday, July 22, 2010

Finding a Home for Orphaned Products

The pharmaceutical industry has taken steps in the last few years to reduce the cost of bringing a new drug to market. Pfizer has developed a novel approach.

We have analyzed several thousand cost reduction efforts. Each of these efforts, in one way or another, seeks to improve the productivity of costs by improving the amount of Output that a given quantity of Input can produce. We have found four basic approaches to improving this productivity: 1) reduce the rate of cost for the Input; 2) reduce Inputs not producing Output; 3) reduce unique activities in processes and products; and 4) spread fixed cost activities over new Output. (See

The pharmaceutical industry has used these approaches to reduce the cost and risk of developing new medications. For example, some companies have signed agreements with scientists overseas to develop new products (example #1 above). Others have used contract research organizations (example #1 above). Many have established joint ventures with competitors to spread the risk of developing new drugs (example #4 above).

Pfizer has developed a new organizational unit to use the second approach, reduce Inputs not producing Output. The company set this unit up in 2007 and named it Indications Discovery Unit. This organization enlists outsiders for help in finding uses for compounds that Pfizer had in development but that seemed to have no market potential. In a recent iteration, Pfizer agreed to pay $22.5 million over five years to researchers at the medical school of Washington University in St. Louis. Pfizer will give these researchers access to 500 molecules that otherwise would languish. These molecules were approved for a different use, were developed for a separate indication or they failed during testing for another use. This cost management innovation enables Pfizer to find new uses for work-in-process inventory that otherwise might have been written off.

Monday, July 19, 2010

A Win on Both Price and Convenience

A few forward-thinking retailers have adopted predictive analytics in their loyalty programs. Among the few to use this tool today are Sam’s Club, CVS and Kroger. These programs offer both Convenience and Price advantages to individual customers. It is a true break-through innovation.

The Sam’s Club program provides a good illustration. Sam’s named this program eValues. This program offers bargains tailored to each Sam’s Club member. The member must be part of Sam’s Club “Plus” program. These “Plus” members may print out individually tailored eValues offers at a kiosk at the entrance to the store or by email or by visiting the Sam’s Club web site. Sam’s Club prepares these individualized offers by drawing on the purchasing history of the individual “Plus” members. Their purchasing history predicts what bargains and product combinations will attract the individual customer.

This eValues program is both a Convenience and a Price innovation. (See and Services/Customer Cost System) It is a Convenience innovation because it helps the customer find and choose products more quickly within the store. It is a Price innovation because it offers discounts on products the customer typically buys, or might buy. eValues is highly effective. The average coupon brings a response rate of 1% to 2%, but the eValues program results in customers getting the discount on 20% to 30% of the products where discounts are offered.

The stores’ loyalty programs become more relevant to their most important customers and the stores’ sales per customer visit increase. Clearly a win win situation.

Thursday, July 15, 2010

Here We Go Again

The leader of the United Auto Workers is retiring. He is leaving a union under siege. By 2009, UAW membership was about half of the level of 1995. The union has hemorrhaged members as the big three domestic automobile producers have shrunk in market share, lost billions of dollars, and closed plants.

The departing leader of the UAW claims that the industry’s difficulties never rested with the union and its rich contracts. In his view, the crisis that led to the bankruptcies of GM and Chrysler and the near bankruptcy of Ford was strictly the result of an unexpected spike in gas prices and a recession that resulted from the mortgage crisis. He believes that the fault lay not with the union and not with the industry. Following this belief, he is encouraging his successor to begin clawing back the cost-cutting concessions that the union has granted the Detroit big three domestic automobile manufacturers now that these companies are moving toward profitable operations.

The problem is that these concessions did not do enough, at least from the results they seem to have produced. The concessions really got underway in 2003, as the union reduced its wages and benefits and transferred retiree healthcare costs from the automakers to an independent trust. Despite these concessions, union membership fell parabolically from 2003 to 2009, right along with the profits in the big three. In the meantime, German and Asian manufacturers continued to be profitable. These profits included profits in U.S. domestic manufacturing facilities as well. (See the Symptom & Implication, “Some industry leaders have lower returns than the smaller competitors” on

The union is heading back to trouble and will take its unionized facilities with them. In an earlier blog (See Blog HERE), we described the hourly cost differences in wage rates between a unionized and non-unionized domestic facility. These cost differences are unsustainable in the longer term. No one can expect that an automobile plant with $73 dollar an hour labor will be profitable enough to compete with another domestic plant producing similar automobiles at $48 an hour. Despite recent troubles, the Asian manufacturers still command a premium price over their big three competitors for their products. So, Toyota and Honda get a higher price and produce with a lower costs. (See “Video #1: The Two Best Consultants in the World” on Tell me how GM, Chrysler and Ford can produce an equivalent or better car with these economic conditions. The claw-backs will only make things worse.

Monday, July 12, 2010

Defending the Low Cost Position

The last couple of years have been very tough on the hotel industry. Now, some of the mainline hotel companies are starting to recover, but the high-end hotels continue their prolonged suffering. A typical example are the Four Seasons hotels. Last year the occupancy rate at the chain’s hotels was below 60% and revenue per available room, a key measure of sales, fell 26%. There are 82 Four Seasons hotels. At least 12 of them reputedly are near the breaking point.

The Four Seasons Company no longer owns any of its 82 branded hotels. It, like most of the hotel chains, sold off its hotels in the 80s to companies and investors who had more willingness and ability to carry high levels of leverage on the hotel properties. The Four Seasons, and most other hotel chains today, manage their brands but don’t own them.

The hotel brands tightly control the quality of their hotels through their management agreements. The management company receives a management fee of a percentage of the branded hotels’ revenues and also gets a percentage of the hotels’ profits. The hotel investor gets the use of the brand name and must conform to the rules as written in the management agreements. This arrangement allows for a disconnect between the interest of the hotel property owners and the hotel brand owners. The property owners may wish to find cost shortcuts that the brand owners abhor because the cost savings sully the brand name.

The founder of Four Seasons Hotels & Resorts watches carefully over the brand he created. Isadore Sharp is the founder and Chief Executive of Four Seasons Hotels & Resorts. He started with his first hotel in 1961. He built the company into the chain it is today by providing top notch service to its affluent guests. In the past, the company has weathered market downturns as relatively minor bumps in the road. This downturn has proven to be different. In this downturn, several property owners have petitioned the brand management company to reduce costs, sometimes at the guests’ expense. (See the Symptom & Implication, “The industry is reducing costs aggressively” on Mr. Sharp will have little of it.

Mr. Sharp, who remains CEO of the company and 10% owner of Four Seasons Hotels & Resorts, agreed to some cost savings that have relatively little impact on the guest. Hotels may now outsource their laundry. They may simplify menus in the restaurants and even close a restaurant on slow nights on those hotels that have multiple restaurants. Some hotels may discontinue stocking fresh flowers in the lobbies as long as they replace those fresh flowers with sculptures or ornate vases. The property owners may also combine management positions and cross-train employees to work in multiple departments. Mr. Sharp believes that a guest will not see these kinds of cost savings in their visits to a Four Seasons Hotel.

But he refuses to go along with other cuts proposed by some property owners. The property owners may not combine the concierge desk with the check-in duties on the graveyard shift. Mr. Sharp insists that hotel employees continue to turn down guest bed covers each evening. He also refused a request to end room service during the middle of the night. All of these changes a guest would notice. (See “Video #46: The Place of Cost Management in Hostility” on

These decisions by Mr. Sharp tell us a lot about why he has been so successful in his career. He keeps his attention focused on the quality of his guest experience, despite the short-term cost of continuing that form of Reliability. Profits may dip in the near-term, but he believes they will hold up in the long-term as customers return for the consistent quality of high level services they associate with the Four Seasons brand.

Mr. Sharp is protecting the ultimate low-cost position. We have found in our work and research in many industries that the low-cost position in a market is the ownership of a satisfied customer relationship. A company that owns a satisfied customer will not lose that customer to any other competitor unless that competitor can offer a similar product at a discount that begins at 15% and usually is more. We have not seen any market where peer competitors have cost structures that vary from one another by as much as 15%. Hence, the ownership of a satisfied customer relationship is the equivalent of having a 15% of revenue cost advantage on your peer competitors.

Thursday, July 8, 2010

Mobile Hears Big Footsteps

A short while ago, we wrote a blog about Radio Shack’s rebranding itself (See Blog HERE) as primarily a mobile product carrier. At the time, we predicted that Radio Shack would have a difficult time competing on Function with Best Buy. Though, it would be more Convenient than the average Best Buy. (See “Video #26: Example of the Customer Buying Hierarchy at Work” on

Best Buy is ramping up its mobile product investment now. The company has created 80 stand-alone mobile stores from a standing start in 2006. It may add as many as 100 new shops this year. In addition to these stand-alone shops, BestBuy Mobile operates as a separate store within all 1,000 of Best Buy full-sized stores.

The company has set itself up to be able to catch the mobile wave without committing itself to high costs over the long term. The BestBuy Mobile stand-alone stores average 1500 square feet of footprint. The stores within the regular Best Buy stores are only 600 square feet. These stores compare with an average of 40,000 square feet for a regular Best Buy store. (See “Audio Tip #188: The Efficiency of the Input” on The small footprint allows the company to offer fast-growing products in Convenient mall locations near consumers, especially women consumers. In a few years, when growth slows, the company can withdraw from these small locations at relatively little cost and fold the mobile business back into its large regular stores.

BestBuy Mobile looks to be the Function leader in this market. It offers ninety different handsets and service plans from nine carriers. They offer products that work on the networks run by all four major wireless carriers: AT&T, Verizon Wireless, Sprint Nextel and T-Mobile USA.

BestBuy Mobile offers clear advantages over the stores run by the wireless carriers. Their prices are lower. Pricing is also clear and easy, with no mail-in rebates. And the company promises that the customer will leave the store knowing exactly how to use their phone in what the company brands as its “Walk Out Working” product promise. This promise is both a Reliability and Convenience benefit.

Everyone else in the industry must be hearing Best Buy’s big footsteps.

Tuesday, July 6, 2010

How to Fail in a Market You Dominate

The cable T.V. companies are the big dogs in the television industry. So far, no one has been able to unseat them, though they seem to be trying to unseat themselves. The cable industry is losing customers to satellite T.V. and phone companies entering the video market. The rate of these customer losses is significant.

In 2006, the cable T.V. companies controlled nearly 69 million video customers. By 2009, that number had fallen to 63 million. (See the Symptom & Implication, “The industry leaders are losing share” on The problem is both price and service. Many consumers see these cable T.V. companies failing on both Price and Reliability. (See “Video #14: Definition of Reliability” on

The cable T.V. companies have responded to the incursions of satellite and phone companies with discounts. Most of these discounts come in the form of bundles of products, including two or three choices among T.V., internet and telephone. Some of the discounts came in the form of free services during a promotional period. Still, the prices for cable T.V. have gone up every year faster than inflation. The discounts slowed, but did not stop, customer defections. Customers felt gouged.

A more troubling failure has come with customer service. We have all heard that power corrupts. Well, the cable T.V. companies had great market power for a long period of time. That power didn’t corrupt them in the moral sense, but certainly caused them to ignore the common tenets of good customer service. They offered service on their terms. Customers could take it or lump it. And customers became resentful.

Of the two failures, one of high prices and the other of Reliability failures with poor customer service, the most troubling is the Reliability failure. People tend not to forget and forgive Reliability failures for a long period of time. General Motors will be living down its reputation for less than stellar automobile quality for a long time. The same fate awaits the cable T.V. companies. (See “Audio Tip #35: How Does a Company "Fail" in a Market?” on