Big Cost Differences in an Industry - Part 2

McKinsey and Company has undertaken a detailed examination of Productivity in the pharmaceutical industry. This extensive study offers us an opportunity to see common patterns in cost management and productivity improvement. We described these patterns in Part 1 of this blog. These common patterns of Productivity improvement include four major concepts.

1. Reduce the rate of cost for the Input

2. Reduce the Inputs not producing Output

3. Reduce unique Intermediate Cost Drivers(ICDs) in products and processes

4. Spread fixed cost ICDs over new Output

McKinsey undertook a detailed analysis of 1900 pharmaceutical production lines at 150 plants located all around the world. The Firm measured the Productivity levels among the plants and companies in their study and found dramatic differences in Productivity among these 150 plants. (See the Perspective, “What Makes Returns High?” on StrategyStreet.com.) The top quartile of the companies involved in this study had manufacturing utilization rates that were more than twice those of the bottom quartile companies. McKinsey estimated that, if the average drug-maker would match the total labor productivity of the top players in the industry, it would realize an improvement of 5 to 6 percentage points in operating earnings, quite an improvement

Here are some of the cost management reasons for the superior performance of the best performing companies and how these cost management efforts fall into the four categories of cost reduction above:

* Measure of I/ICD and Concept #2: McKinsey found that the top performers used non-production labor extraordinarily efficiently. For example, the quality control employees for the top performers reviewed an average of 110 batches a year, while those in the bottom quartile did less than 5. This finding is a good example of both an Input, the quality control employee, and an Intermediate Cost Driver, a quality control batch. A company using this measure would reduce Inputs not producing Output through reporting to the employees of this measure of their efficiency. (Concept 2)

* Concepts #2 and #3: The high performers use standardized ways of measuring and controlling equipment, reducing line stoppages and waste. This is an example of two of the patterns. (Concept 2) This approach reduces Inputs not producing Output by eliminating unplanned downtime. It also reduces the unique ICDs in processes by standardizing processes. (Concept 3)

* Concepts #2 and #3: The top performers were more likely to use lean management tools to plan and schedule activities, so they released a higher percentage of their products to market without reworking. This approach reduced Inputs not producing Output by improving the accuracy of production forecasts. (Concept 2) It also reduced unique ICDs in the process by reducing the rework activities through a reduction in errors. (Concept 3)

* Concept #2: The top quartile players reached final delivery in half as much time as the average manufacturer, and more than five times faster than those in the bottom quartile. The top performers reduced Inputs not producing Output by speeding the process.

* Concept #3: The best performers eliminated unnecessary complexity from their production planning activities by using fixed, repeatable, short duration production schedules in order to avoid forced changes in production plans. These companies reduced unique ICDs in their processes by reducing the movements of Inputs.

* Concept #4: McKinsey found that small plants were substantially less productive than larger plants. However, the very largest plants were not the most productive. This illustrates the spreading of fixed cost ICDs over additional product Output. It also warns us of the limit of that concept when there are multiple products emerging from the plant.

Every drug maker that McKinsey studied had launched a lean, or Six Sigma, project in the recent past. Yet relatively few of these companies were effective in reducing their comparative costs.

For further explanation of these cost reduction patterns, and for over 600 cost reduction concepts, illustrated by 2400 examples of these concepts in action, please visit www.strategystreet.com/improve/costs. These concepts will help you improve your company’s productivity.

Big Cost Differences in an Industry - Part 1

The objective of every cost management system is to improve the Productivity of the Input (I) resources used to produce the final Output (O) product. These resources include the Inputs of People, Purchases and Capital. The Output is the unit of product sold. A simple measure of Productivity is Inputs divided by Outputs (P=I/O).

There are several stages in producing a unit of Output, so relatively few employees (one of the key Inputs) actually produce a unit of Output. Instead, most employees produce something else as an intermediate end product on the way to the final product. We call these intermediate end products Intermediate Cost Drivers. So, to increase Productivity, you would like to improve the ratio of Inputs needed to produce Intermediate Cost Drivers (I/ICD).

You would also like to reduce the activities, or Intermediate Cost Drivers, you require to produce a unit of final product Output. In ratio form, this means you want to reduce the ratio of Intermediate Cost Drivers in the Output (ICDs/O).

The measure of Productivity then expands into two factors:

Productivity = Inputs/Output = Inputs/Intermediate Cost Drivers x Intermediate Cost Driver

Or

P = I/ICD x ICD/O = I/O

We have studied several thousand cost reduction efforts from the last 25 years. We believe that you can categorize all cost reduction efforts into one of four major concepts:

1. Reduce the rate of cost for the Input

2. Reduce the Inputs not producing Output

3. Reduce unique Intermediate Cost Drivers(ICDs) in products and processes

4. Spread fixed cost ICDs over new Output

The current issue of The McKinsey Quarterly describes an interesting study that McKinsey has undertaken in the pharmaceutical industry. The study’s conclusions offer us the opportunity to categorize their findings into one of these four cost reduction concepts.

In Part 2, we will describe some of McKinsey’s findings and then tie the findings to the four major productivity improvement concepts above.