Fewer Customers? Cut Capacity

For a year now the economy has weighed down passenger airline traffic. The industry expects a 4% reduction in passenger volume for 2009’s Thanksgiving season compared to the previous year. And, as demand has fallen, so have prices. Ticket prices this year are down 13% compared to 2008, so the industry is getting hit twice: by a fall-off in passenger seat miles flown, and by falling prices per seat mile. (See the Symptom & Implication “Demand in the industry is falling” on StrategyStreet.com.)

The airline industry thought it had an answer to this developing problem: cutting capacity. The industry has reduced capacity by 6.9% this year in the expectation that the industry could improve its efficiency and raise prices. (See “Audio Tip #116: The Withdrawal of Capacity to Raise Prices” on StrategyStreet.com.)

So, why haven’t prices risen? There are two possible answers. The first is that the industry has panicked and is offering lower prices to keep demand from falling any further than it already has. This answer is certainly in keeping with the industry’s previous practices. But there is a more subtle and more problematic answer as well, and that is that the smaller industry carriers are adding capacity faster than the industry leaders are reducing it.

Over the years we have witnessed many cases where industry leaders would reduce their capacity in order to constrain supply and force industry prices to rise. Time and again industry followers have stymied these initiatives. These followers insist on adding capacity, even as the industry leaders withdraw it. The result is the same, or more capacity, and continued low or falling prices.

To some extent, this addition of capacity by follower competitors is predictable (see “Audio Tip #106: How do we Predict Competitor Responses to our Price Moves?” on StrategyStreet.com). These smaller competitors already added capacity in the face of low industry pricing. They have even more incentive to add capacity as industry prices rise.

The Wrong Customer

CVS Caremark is struggling. The Caremark side, which is a pharmacy-benefit manager, is bleeding losses and major customers. The company picked the wrong customers.

CVS is one of the country’s premier retail drug store chains. The company has grown through acquisitions over the last several years. On the retail drugstore side, these acquisitions have been a great success. Not so, on the pharmacy benefit side. (See the Perspective, “Buying Share, Not Sand” on StrategyStreet.com.)

A couple of years ago, CVS beat out Express Scripts, a competing pharmacy-benefit manager, to win Caremark. The other competitors in pharmacy-benefit management are independent companies, focused strictly on the wholesaling of drugs to large companies and institutions.

CVS has trodden another path. As a retail druggist at heart, CVS developed innovations aimed at the retail, rather than the wholesale customer. For example, the company offers the Maintenance Choice plan that lets pharmacy-benefit management patients pick up 90 day prescriptions in its drug stores at the same low price they would pay through the mail. Of course, this helps CVS sell more products through its drug store chain. It does not, however, help the wholesale customer who makes the pharmacy-benefit management buying decision. (See “Video #34: Types of Product Innovations That Reduce Customer Costs” on StrategyStreet.com.) But there is even a downside for the retail customer, the employee of the wholesale customers. These retail customers must use a CVS drugstore to fill their prescriptions or see their drug co-pays rise to 50% rather than 25%. Hear loud protests off-stage.

Trouble started early in this acquisition. The wholesale customers have been unhappy for some time. In fact, last year CVS offered lower prices to more than half of its pharmacy-benefit management customers in order to keep them from defecting. A few other clients simply left,
discouraged by the fact that CVS seemed to be focused more on the retail, than on the wholesale, customers.

Of course, the Medco’s and Express Script’s are delighted to be picking up such easy share from the failures of CVS Caremark. (See “Audio Tip #35: How Does a Company “Fail” in a Market?” on StrategyStreet.com.)

Let Someone Else Pay the Freight

Some lucky companies have discovered ways to get other people to carry costs on their behalf. (See “Video #62: How to Improve a Cost Structure” on StrategyStreet.com.)

Twitter is a recent example. Twitter watches what its visitors do with its product and then has its engineers turn these ideas into new features. Twitter is about to release two new features, Lists and ReTweets, that began with users. With Lists, users can create lists of all the tweets written by celebrities or politicians. This innovation helps users save time in deciding whom to follow on Twitter. ReTweet allows a Twitter user to send a posting from another Twitter user to the user’s own set of followers. With these examples, Twitter has off-loaded some of the cost of R&D to its customers.

The shift of a company’s cost to others with no payment is not a new phenomenon. For example, as long ago as 1986, Walgreens decided to reduce its inventory levels by a third. It gave its suppliers the choice to participate in a just-in-time delivery program, or to stop supplying the company. Walgreens shifted the cost of inventory to its suppliers.

Customers can often do more than design new products. The Hilton Hotel chain installed computerized check-in kiosks in lobbies of its larger hotels in 2004. This allowed Hilton to reduce its check-in staffing. (See “Video #55: The Value of Customer Sensitive Cost Structures” on StrategyStreet.com.)

In the right situation, even the general public can help a company reduce its costs. One famous example is NetFlix. It offered a $1 million prize for new software that would predict more accurately whether a NetFlix customer would enjoy a movie based on the ratings of previous movies. A team of software developers won that prize in 2009.

We have found more than 50 examples of companies who shift costs to third parties for little or no payment. You can find them in the Improve/Costs section of StrategyStreet.

Microsoft is Leaving Money on the Table

Every few years, Microsoft introduces a new version of its very popular Office product. The last version was Office 2007. The next will be Office 2010. As often happens with technology upgrade innovations, the new versions sometimes do not offer enough additional benefits to justify all the customers of the old version spending on the upgrade. Office 2003 attracted 60% of the existing Office customers when it came out. Current expectations are for Office 2007 to attract somewhere between 50% and 55% of existing Office users to upgrade. So, somewhere between 40% and 45% of the current Microsoft Office market will not upgrade to the next version.

That is a problem for Microsoft. The company introduces its Office products in a bundled package. The product improvements and upgrades come in packages that contain most of the Office products, with the exception of the Access product. For the most part, Microsoft does not sell the improvements to the Office products as separate, stand-alone products.

Other companies have sensed an opportunity in this Microsoft approach. They have introduced add-on products that give old versions of Office some of the features of current and future Microsoft Office products without the full cost of upgrading. Some of these products include Xobni, DockVerse, Gist and Xiant. Basic versions of some of these products are free, while premium versions come at a modest cost.

These add-on products are low-end competitors. They are examples of Stripper products, one of the four major types of low-end competitors (see the Perspective “Turmoil Below: Confronting Low-End Competition” on StrategyStreet.com). Microsoft is ignoring the success of these small Stripper competitors.

It seems there should be a better path for Microsoft. The company might introduce its own stand-alone version of these products and match their pricing. This move would forestall the growth these Stripper companies enjoy today and provide Microsoft with additional revenues from the 40% of its current customer base who will not upgrade to the new Office 2010 product. If the customers like the Microsoft products as stand-alone add-ons, they may be more likely to upgrade to the new Office 2010 when it comes out.

Aside from the fact that Microsoft is leaving money on the table (see the Perspective “Failure Shifts Shifts More Share than Success” on StrategyStreet.com), it is generally a bad idea to ignore low-end competition that is entering your market.

Fish or Fowl?

The internet has given birth to another retail concept. A new set of retail start-ups specialize in discounted designer apparel. These web site based companies include Gilt.com, RueLaLa.com and HauteLook.com. These companies offer “private sales” to customers on a membership list. Each day the companies send an email offering “members only” sales on expensive designer goods. These goods are discounted heavily and are a year old, but these sites have been very popular. They are growing at a rate of over 20% a year. (See the Symptom & Implication “Small discounting competitors have gained a market toehold” on StrategyStreet.com.)

Now an industry leader is offering a challenge to these web-only discounters. Saks tested an online “private event” in October. This 36 hour sale invited customers, who received emails from Saks, to purchase designer goods at prices 50% below the suggested retail price. The company plans another similar online sale this month. The goods for sale are off season or specially made for the event.

The Saks model needs some significant tweaking before it can really compete with the “private sale” online discounters. First it has to establish a separate brand for this product. Not many designers are going to want to sell products through Saks at such significant discounts when their products sell at full price during the season. Customers can learn to simply wait for the “private sale” online event. As a corollary, Saks will have to do something to protect the brand name of the designer, perhaps by removing labels. A change in name and labeling would then enable Saks to use the “private sale” online events to liquidate excess inventory.

Since the online “private sale” discounters offer additional products daily, it is unlikely that the new Saks “private sale” online product will compete directly with the discounting on-line specialists (see “Audio Tip #17: The Heart of the Market” on StrategyStreet.com). The Saks initiative is much more likely to be an end-of-season service to benefit some of its loyal customers.

Digits Save Lives...and Costs by Improving Effectiveness

Part 2

Some hospitals, along with some health insurance companies, are using video technology to connect patients in outlying areas with specialists in urban centers. This video technology connects local and regional hospitals to large urban medical centers where most medical specialists practice medicine.

These video hook-ups provide information for both the specialist doctor and the patient. The specialist doctor has the benefit of a high definition video, both televisions and cameras, along with internet connected medical equipment and a nurse at the patient’s side to carry out instructions. The patient sees the specialist doctor on a video in the room.

The costs of these video systems have been declining. The typical system costs between $30,000 and $50,000. Thirty-five hundred hospitals now employ the system. These systems have a unit growth rate of 15% a year. They are about to become mainstream.

This innovation for both specialist doctors and patients offer us some good examples of cost reduction techniques.

We have examined several thousand examples of cost reduction efforts. There are four basic approaches to reducing costs:

*Reduce the rate of costs you pay for people, purchases and capital
*Reduce the costs that are not contributing to output because they are wasted or idle
*Redesign the product or the process to reduce components and activities
*Use fixed costs with more customers

The latter two of these four basic approaches to reducing costs improve the effectiveness of a cost structure by reducing the number of activities required for the completion of an Output. We call these activities Intermediate Cost Drivers (ICDs). (See “Audio Tip #189: The Effectiveness of the ICD” on StrategyStreet.com.) Effectiveness measures the ratio of ICDs to Output (ICD ÷ Output = Effectiveness).

A company improves the effectiveness of its cost structure by reducing activities, that is, ICDs. It reduces these activities by redesigning the product, or the process, the company uses to produce the product.

The company may redesign the product by reducing activities or components that make up the current product. The company may do this by reducing:

Performance standards which enables the company to eliminate activities
Components that are part of the current product

There are also several cost reduction alternatives available to the company who wishes to redesign the process to reduce activities. The company may use one of these recurring patterns of process cost reduction techniques:

- Shift the activity to others with no payment for their assistance
- Automate an activity
- Reduce the movement involved in the process
- Reduce errors the process produces
- Standardize activities
- Accept risk of lower revenues or higher costs
- Eliminate activities with low value to the customer

This new video technology improves Effectiveness with a redesign of the product. The video technology allows the patient to use an alternative form of a key component, the attending doctor. Since the specialist is at a distance, the patient does not receive the same quality of experience as he would if the specialist were physically present. The specialist doctor may be at a distance. But the specialist is more qualified than is any doctor at the patient’s location.

The process is more effective as well. The technology reduces the movement of patients. It substitutes the costs of the video technology for the costs of transportation by ambulance from the outlying locations to the urban centers. Perhaps more importantly, the process also reduces errors in the system by allowing an expert to diagnose the ailment and prescribe more immediate and more effective treatment.

The fourth basic approach to reducing cost improves a cost structure’s effectiveness by using fixed costs with more customers. These fixed costs, and their activities, become a lower proportion of the value of the final Output. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) We have found two recurrent patterns to spread fixed costs activities over more customer Output:

- Acquire a similar organization and eliminate overlapping fixed costs
- Use the current fixed costs with new customer groups

The article on video technology did not offer an example of this fourth cost reduction approach. However, we can easily imagine how a hospital might employ this approach. First, the hospital system might acquire additional outlying locations and incorporate the video technology with these newly acquired hospitals as well. Alternatively, the hospital system, who already uses the video technology, might offer its technology to unrelated hospitals in similar locations near the company’s hospitals. The company would then benefit from the revenues these competing hospitals might provide and, in turn, use these revenues to reduce the effective costs it incurs for its video technology.

Of course, these are just a few of the cost reduction concepts we have observed. To date we have found more than 300 of these concepts of cost reduction. You may see more of them in the Improve/Costs section of StrategyStreet.

Digits Save Lives...and Costs by Improving Efficiency

Some hospitals, along with some health insurance companies, are using video technology to connect patients in outlying areas with specialists in urban centers. This video technology connects local and regional hospitals to large urban medical centers where most medical specialists practice medicine.

These video hook-ups provide information for both the specialist doctor and the patient. The specialist doctor has the benefit of a high definition video, both televisions and cameras, along with internet connected medical equipment and a nurse at the patient’s side to carry out instructions. The patient sees the specialist doctor on a video screen in the room.

The costs of these video systems have been declining. The typical system costs between $30,000 and $50,000. Thirty-five hundred hospitals now employ the system. These systems have a unit growth rate of 15% a year. They are about to become mainstream.

This innovation for both specialist doctors and patients offer us some good examples of cost reduction techniques.

We have examined several thousand examples of cost reduction efforts. There are four basic approaches to reducing costs:

* Reduce the rate of costs you pay for people, purchases and capital
* Reduce the costs that are not contributing to output because they are wasted or idle
* Redesign the product or the process to reduce components and activities
* Use fixed costs with more customers

The first two of these four basic cost reduction techniques improve the Efficiency of a cost Input. Efficiency measures the amount of Input required to produce an Output (Input ÷ Output = Efficiency). (See “Audio Tip #188: The Efficiency of the Input” on StrategyStreet.com.) For example, the number of labor hours required to produce a completed customer transaction.

If you reduce the rate of cost you pay for an Input, such as People, you reduce the effective number of people required to produce the Output. An employee making $20 an hour is effectively half of an employee who makes $40 an hour.

In our analyses of cost reduction techniques, we have seen seven major approaches to reducing the rate of cost:

-Purchase in larger quantities
-Reduce the quality of the Input
-Change the components of the rate of cost
-Use subsidies offered by third parties
-Request the supplier to lower its price
-Change the source of supply to a less expensive supplier
-Bring some activities in-house in order to achieve a lower rate of cost

The video technology reduces the rate of cost in the hospital system. It helps the hospital reduce the quality of the Input used in treating the patient without hurting the patient. This reduction in quality is not meant to be pejorative. Rather, it focuses high-cost activities on high-cost people by shifting lower value activities done by high cost people to lower cost people. It reduces the rate of People costs by separating tasks into high and low cost activities. Once the low and high cost activities are separated, lower cost people can do some activities previously done by high cost people. With the urban hospital specialist in charge, a nurse can now do more of the onsite work previously done by higher paid internists. The technology also offers the system the opportunity to lower the rate of cost it pays for square footage at its medical centers. The medical facilities in outlying areas have a lower cost per square foot than do those in urban centers. The outlying location is not as convenient to many patients, so its price per square foot is lower. The video technology overcomes the problem of distance.

The hospital may increase the Efficiency of its Inputs by reducing the proportion of Inputs that are not producing any Outputs. Inputs, such as People, are unproductive when they are sick or idle. If the hospital can find ways to reduce sickness or idle time, the same number of People Inputs will produce more Output. The efficiency of the Input rises as the number of People required per customer transaction falls.

In our research into the techniques that companies use to reduce the costs that are wasted or idle, we have identified several recurring patterns. The company may:

-Assist the Inputs, such as People, in increasing its efficiency
-Shift demand to use otherwise unproductive resources
-Improve the accuracy of the forecast it uses to plan work
-Use short term sources to meet peak demand
-Speed the process to reduce otherwise avoidable wait times

The video technology reduces unproductive or wasted resources. This technology speeds the process for the patient and the local attending physician. Diagnosis occurs more quickly due to the fast access to the distant specialist. All the parties involved at the outlying hospital spend less time waiting for a proper diagnosis.

Of course, these are just a few of the cost reduction concepts we have observed. To date we have found more than 300 of these concepts of cost reduction. You may see more of them in the Improve/Costs section of StrategyStreet.com.

In our next blog, we will discuss how video technology might reduce the hospital’s cost structure by using the latter two of the four basic approaches to reducing costs.