Nestlé’s Cost Reduction in the Coffee Business

Nestle is the world-wide leader in the coffee business. They offer coffees at virtually all price points. They invented instant coffee in the 1930s. After the buffets of the commodity markets over the last few years, the company has created a global push to reduce its costs and to increase the quantity and quality of the coffee it buys.




We have found four generic approaches to reducing costs.



• First, reduce the rate of cost of a cost input.

• Second, reduce the cost inputs that do not produce output.

• Third, reduce unique activities and components in processes and the product

• Fourth, spread fixed cost activities over additional product output



Nestle is using the first three of these approaches in its world-wide investment in cost management.



First, Nestle redesigned part of the process. Its scientists developed a new generation of Robusta and Arabica coffee plants for Mexico. The Robusta beans are relatively inexpensive and make up the bulk of the beans in instant coffee. The Arabica beans are more expensive, harder to grow and go to the higher end coffees. Today, Nestle has planted 100 thousand coffee trees in Mexico using its newly designed coffee trees. Once this experiment is complete, the company plans to distribute 220 million plants to coffee growers world-wide over the next ten years.



The use of these new plants will enable Nestle to reduce its rate of cost for the beans it buys. The new plant design increases yields so it eliminates some inputs that do not produce the output of coffee beans. Many long-term coffee farmers are using older trees, which yield fewer beans and lower quality beans. Many of these farmers are leaving the industry since they cannot compete. This magnifies the commodity price problem Nestle faces. Nestle’s new trees fit the region’s climate. They resist disease and allow for larger and easier harvests. These trees will make coffee beans more consistently and predictably available. Nestle will give these trees to the farmers without asking for a firm long-term contract or ownership of any part of the farm. But it should be obvious that Nestle will engender a great deal of farmer loyalty with this program.



Nestle also expects to reduce the rate of cost it pays for its beans with two other cost reduction initiatives. It will offer farming and investing advice to up to ten thousand farmers world-wide. As these farmers become more efficient, Nestle’s costs will drop. In addition, Nestle will also increase the amount of coffee it buys directly from the nearly 170 thousand growers who produce its coffees.



This kind of foresight and innovation suggests why Nestle commands its market leadership.

Sometimes Smaller is Better

Retailers suffered through the last two years with low or declining sales as typical consumers struggled with an economy in the doldrums. Some of these retailers experimented with cost cutting and discovered an innovation for customers.

As retail demand fell, some retailers decided to reduce the size of their stores and cut their inventories to fit the smaller market they were facing. One company, Anchor Blue, put in temporary walls and cut its selling space in half. This certainly saved them money. It also provided a big surprise. Anchor Blue found that its foot traffic rose by 7% and sales increased by 23% after the remodel.

As other stores had the same experience, bigger chains began their own small-is-beautiful experiments. Bloomingdales and Nike are both trying smaller stores. Retailers are reducing their inventories by removing the slower moving items. These changes enable their customers to find, choose and pay for their products faster. In other words, the smaller stores are a Convenience innovation that customers seem to like.

We seem to be reaching a limit in the retail world. For the last generation, retailers grew by increasing Functions in ever-larger stores. (See the Perspective, “When to Compete on Features” on StrategyStreet.com.) They added categories and assortments to increase customer choices. These Function innovations demanded more space. More choices and space added to the time customers had to spend at a store. The Convenience innovation of the smaller stores suggests that customers have reached saturation points with the larger stores offering more choices. Sometimes smaller is better. (See the Perspective, “Is Bigger Really Better?” on StrategyStreet.com.)

Costs - The Problem with Weak Constraints

Here are two random observations of the results that any manager can expect to face when there is little to no constraint on the level of costs in an organization.

The first comes from the Heritage Foundation. This foundation analyzed the percentage of jobs gained or lost since January of 2008 through July 2010, a time of recession. The foundation measured job growth in the federal government, state government, local government and the private sector. The private sector was under extreme constraints as revenues flattened or shrank. This sector lost 6.8% of its jobs. Local government was under pressure from the fall-off in property tax receipts. This sector lost a little less than 1% of its jobs. State governments suffered from falling income tax revenues as the recession flattened consumers and commercial tax payers. It lost one tenth of one percent of its jobs. Then there is the federal government, who operated without constraints by creating debt. In just the two and a half year period, total federal government employment increased by 10%. Shocking.

The second observation is also a great source of concern. This data tracks the performance of public schools, K through 12, from 1970 to 2010, forty difficult years. Voters of all kinds have tended to support public education. This support shows up in both spending on the public school sector and in its employment. Since 1970, the real spending, that is after adjusting for inflation, on public K through 12 education has increased by 150%. (See “Audio Tip 195: Economies of Scale and Their Measurement” on StrategyStreet.com.) The total employment has increased by about 100%.

Did we get any more for that additional spending? Enrollment increased by about 5%, after having fallen for the first twenty years of the measures. So, productivity, as measured by employment divided by enrollment, declined a great deal. But perhaps there was more benefit in the quality of the education? It turns out that hasn’t happened either. The scores for science, math and reading have not moved at all, despite the increase in spending.

In both of these examples, we seem to be spending without accountability. (See “Audio Tip 198: Diseconomies of Scale” on StrategyStreet.com.) As much as you can criticize the budgeting system of most businesses, results like these are highly unlikely to occur over a period of time in business systems because there would be quick accountability with this kind of loss in productivity. If that accountability did not come from within the business then, surely, competition would call the profligate business to account.

Green Shoots and Attitudes and Jobs

Here is something that may surprise you. We are now gaining manufacturing jobs in the U.S. Manufacturing employment has fallen every year since 1998, until 2010. Since the beginning of 2010, there has been a 1.6% gain in manufacturing jobs. That’s twice the pace of the growth in other private sector jobs. The unemployment rate for the manufacturing has improved from 13% in December of 2009 to 9.5% in August of 2010. That’s a better performance than that of the overall labor force.

These gains have come primarily in four industries: automobiles, fabricated metals, primary metals and machinery. These industries have all been losing jobs for several years. What is behind the change? Here is a significant indicator. Recently, the United Autoworkers Union has crafted an agreement with General Motors to encourage GM to invest money to assemble a low-priced sub-compact car in the U.S., with unionized labor.

This will be a first. All other domestic and foreign manufacturers have produced their sub-compact cars offshore. GM’s sub-compact, the Aveo, came from South Korea. Ford’s Fiesta came from Mexico. Chrysler and Fiat are planning to manufacture the Fiat 500 in Mexico. The Honda Fit and the Toyota Yaris are imported from outside the United States.

This new agreement is truly ground-breaking. Under the terms of the agreement, GM will pay 60% of the sub-compact plant’s 1550 workers a wage of $28 an hour. The other 40% of the plant’s employees will make $14 an hour. By GM’s calculations, this would enable the company to build a sub-compact at a profit in the U.S.

This new agreement may, in fact, reduce the average wage rate to competitive levels. Before GM’s bankruptcy, the average GM worker earned over $70 an hour in wages and benefits. After bankruptcy, that rate of cost fell to about $57 an hour…good, but not good enough to compete profitably. (See “Audio Tip #163: Introduction to Step 25 of the Basic Strategy Guide” on StrategyStreet.com.) Toyota has average labor costs of about $50 an hour. The Toyota workers are not unionized. This new UAW agreement with GM should make the new sub-compact plant competitive with the cost that Toyota incurs in the U.S.

A change in attitude at the UAW is behind this job-creating agreement. A senior UAW official explained that this agreement was the result of some very difficult decisions the union had to make in order to safeguard jobs. He further explained that the UAW developed a new understanding of the realities of the 21st century global auto industry while living through the GM and Chrysler bankruptcies. (See the Symptom & Implication, “The industry is reducing costs aggressively” on StrategyStreet.com.)

Three cheers for the UAW/GM agreement. Let’s hope that it creates jobs and profits.

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 StrategyStreet.com/Improve/Costs/Directions)

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.

Creating Economies of Scale in the Auto Industry

The German automakers are under some pressure. They need to have a small car in their product line-up in order to respond both to consumers’ growing preferences for smaller cars and to government pressures to reduce fuel consumption and carbon emissions. BMW has answered with its One series. Volkswagen has taken a 20% stake in Japan’s Suzuki Motor Corporation, which is a small car specialist. Mercedes Benz has decided to go an alliance route.

Recently, Daimler, the maker of Mercedes Benz automobiles, announced an alliance with Nissan and Renault to create a common line of small cars. The companies will also share engines and work together to create small commercial vans. To do this, Nissan and Renault will invest about $1.6 billion in Daimler who, in turn, will invest about $1.6 billion in Nissan and Renault. These investments will have a good pay-off. The two sides of the alliance estimate that they will each save about $2.7 billion in costs over the coming five years. This alliance creates new economies of scale for each side by increasing their productivity, as measured by units of input costs over units of output product. (See “Audio Tip #187: The Components of Productivity” on StrategyStreet.com.) In this case, they improve productivity by spreading fixed cost activity such as design of new products over more sales output.

In analyzing several thousand cost reduction approaches, which companies have employed over the last twenty-five years, we have seen two basic approaches to the task of increasing the output over which fixed costs investments are used. First, the company may acquire a similar organization to spread fixed costs over more units of sales. Second, the company may form an alliance of some kind to spread these fixed costs over more sales output. This small car alliance is an example of the second approach. In turn, we have identified three ways that companies pursue this second approach of spreading fixed cost. First, the companies may use their fixed cost with competitors who employ outsourcing. Second, the companies may combine fixed cost with competitors into separate businesses. Third, the company may use its fixed cost with new customer segments by turning some of their cost centers into profit centers. This small car alliance is an example of the second of these techniques, combining fixed costs with competitors into separate businesses.

Other examples where companies have employed this cost management approach include Sony and Sharp partnering in the flat panel TV business two years ago. Sony invested in Sharp’s plant to make LCDs. This gave Sony the option of buying the panels for its TVs while Sharp reduced the investment burden for panel production. In another example, General Mills and Land O’Lakes combined their distribution networks, improving their scale economies. In this later case, the companies were not direct competitors as are the companies in the small auto alliance.

You may find many more cost management concepts and examples in StrategyStreet.com/Improve/Costs.

A Pyrrhic Victory?

Wal-Mart stores and Costco Wholesale are disrupting markets again. The market they are disrupting today is the grocery industry. In truth, they have been disrupting the grocery industry for the last several years, to the point that Wal-Mart is now the largest grocery store company in the country. These two competitors drain their competition of their life blood by using low prices. The recession, along with the pressure applied by Wal-Mart and Costco, has reduced the consumer pricing index for food by nearly 3% over the last year.

So, what is an industry leader to do when faced with the Wal-Mart challenge? Kroger answered right away. The company reduced its prices along with those of Wal-Mart. (See “Audio Tip #180: The Real Low-Cost Competitor” on StrategyStreet.com.) The result is that Kroger expanded its market share. This growth in market share came at the expense of other industry leaders, such as Safeway and Supervalu, who did not cut their prices as deeply. (See the Symptom & Implication “As large competitors match low prices, other competitors face difficulties” on StrategyStreet.com.)

There is a rub, of course. Kroger’s margins declined in the face of the price deflation. Predictably, Wall Street pummeled Kroger’s stock.

Wall Street is wrong here. In the long term, the increase in Kroger’s size will enable it to reduce its cost structure compared to that of its smaller rivals. The easiest way to reduce a cost structure is when the company’s sales aren’t growing and you can find opportunities to improve the productivity of the cost structure by increasing efficiency and effectiveness. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) It is much harder to reduce costs when the business is shrinking. In a shrinking business, company morale tends to be bad and companies almost inevitably cut muscle as well as fat.

A growing business will also allow Kroger to fine tune its value proposition in the face of the Wal-Mart price challenge. The customer buys Function, Reliability and Convenience before Price. Kroger’s ability to tailor its offerings for a broad swath of customers, and its local presence, are powerful advantages, even in the face of a competitor with lower prices. (See “Video #56: Design to Value as an Approach to Cost Management” on StrategyStreet.com.) Kroger is right.

One Up, One Down, One Sideways

Three of the leaders of the automobile industry are presenting some interesting new stories. First, General Motors. The new Chairman of General Motors is Edward Whitacre. He is not a car guy. He came from the telecommunications industry, most recently as Chief Executive at AT&T. The Chairman recently asked the head of engineering at GM to call all the customers who had turned in their new cars under a recent quality program. This program offered customers a 60 day money-back guarantee. It allowed a customer who was unhappy with his automobile to turn it back to GM for a full refund. The head of the engineering group charged with calling the new customers noted that the focus on customer satisfaction was new at GM…and long overdue. This is a hopeful development for GM.

GM, for years, has had a poor reputation for reliability and durability. That problem seems slow to change, as witnessed by the recent quality survey by Consumer Reports. This survey criticized the company’s quality, finding it lower than the models from Ford, Honda and Toyota.

If the new top management attention to quality takes hold of the company, it is bound to improve its fortunes. It should move up with this development.

Fortunately for GM, its main competitor, Toyota, seems to be moving down, at least for now. Toyota became the leader in the automobile industry because of its reliability, but that reputation has begun to falter under the blows of recalls for rust problems and sudden acceleration in several models.

In a surprising upset, Hyundai Motors passed Toyota in J.D. Power & Associates survey measuring how many problems an automobile has in its first three months. A few years ago, Hyundai’s reputation for quality was equivalent to Madonna’s reputation for virginity. However, the Korean company instituted stringent measures to improve its quality, measures that seem to be paying great dividends today with their improved reputation and fast-growing market share. (See our blog on the quality changes at Hyundai HERE)

Ford seems to be moving sideways. On the one hand, its 2009 automobiles are getting good reviews from critics and the marketplace. The company is gaining market share. It also reported its first quarterly profit in four years. So, sideways, you ask? Yes, because Ford has a real problem with its cost structure. In October, the UAW refused to grant Ford the same contract terms that it had previously granted to Chrysler and General Motors. The most important part of the better terms that GM and Chrysler won was relief from the many work rules that restricted the work that an individual employee could do on the production line. These work rules make employees inefficient and idle. They reduce the company’s productivity. Not even Ford can face down a cost structure that is higher than those of its domestic and international competitors. Many of these competitors produce in non-unionized plants in the U.S., where work rules do not hinder productivity.

So, Ford is heading sideways until we see what it does to overcome this cost disadvantage. If the company follows the old GM approach of cheapening its fits, finishes and styling, it will lose market share and plunge into big losses. If, on the other hand, the company maintains the style and quality of its new cars, then it has a chance to address its longer term cost problems in ways that might be somewhat less disruptive to the UAW. (See the Perspective, “Achieving the Low Cost Position” on StrategyStreet.com.)

Ford’s situation is not promising. Many industry leaders, when faced with high and fixed labor costs in their industries, cheapen their products in order to eek out some profitability in the short-term. This always hurts them in the long-term. (See “Video #54: Cost Reduction by Winners vs. Losers in Hostility” on StrategyStreet.com.) The plight of the legacy airlines serves as an ample reminder of this tendency and its results.

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.

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.

Two Pathways to Low Cost

There are two pathways to low cost: Focus on particular customers and their product needs; or create economies of scale. When you combine both, you have a powerful low-cost engine that is also attractive to customers.

Several years ago, I consulted for a high tech company. This company sold components for a much larger technology system. The company’s customers were many times the size of my client. Most of the technology system companies who could have been my client’s customers produced their own component rather than purchasing from a merchant outside supplier like my client.

I asked my client CEO how he expected to out-perform the in-house competitors he faced in the marketplace. He had to be at least as good, if not better, in Function, while being lower in Cost and Price. His answer was focus. His company did nothing else but produce this component. Everyone in his company focused their attention on improving the component and reducing its cost. He argued that his in-house competition did not have the same advantages of focus that he had. His focus would produce lower costs and prices, which would be visible to these larger companies over time. Then his business would grow very rapidly.

I was reminded of this story while reading of a study done by Forrester Research. This study explains some of the changes happening in the outsourcing market.

Several Western companies who had opened centers in India to perform back office work in a cost-saving move have now sold these operations. Several of these companies had decided early-on that they could save the 15 to 20% profit margin that Indian outsourcers typically charge by building their own centers. In many cases, this has proven to be a false economy.

The Forrester Research study estimated that it cost about 25% more for a company to operate a captive center in India rather than to have an outside company provide the same services. In other words, the outsourcing company is able to create a profit for itself that allows it to finance and grow its business, and still charge prices 25% below the costs of the captive center. (See Audio Tip #182: Productivity as a Measure of Physical Costs on StrategyStreet.com.)

How can this be? The answer comes in noting the buyers of these centers. (See Diagnose/Costs/Quantifying Cost Reduction Objectives on StrategyStreet.com.) In virtually every case, the buyer of these centers, which western companies are closing, are large Indian outsourcing firms, such as Wipro Ltd. (See Audio Tip #196: Why Economies of Scale Exist on StrategyStreet.com.) As these Indian outsourcers purchase the centers from the western companies, they gain two important benefits. They acquire experienced employees and guaranteed contracts from the western companies extending for a period of years. These Indian acquiring companies then have the benefit of both focus and economies of scale. This combination will make them an even stronger presence in the market.

Cost Standards Come to the Service Industry

For many years, managers manufacturing have measured activities to a farthing using methods developed over a hundred years ago with the time and motion theories of Frederick Taylor. But throughout most of these last hundred years, the service industries have managed to elude this management approach. That may be changing.

The major consulting firm, Accenture Ltd., has a unit named Operations Workforce Optimization (OWO). This consulting group has created labor standards for several retail chains. These labor standards create the equivalent of standard costs for service employees, such as cashiers and stock people.

These new standard cost measurements, along with ubiquitous electronic technology, enable retailers to measure precisely the productivity of some service employees. A clock on the cash register starts as soon as a cashier rings out the previous customer. The clock continues to run until the current customer has paid and received a receipt. This measure of time compares to standards established by OWO and the company. The company then counsels low-performing cashiers to improve their times. OWO maintains that its methods can cut labor costs by 5 to 15%.

The question is, how do retailers best use this cost innovation? Certainly, they should be able to reduce costs by bringing poor performing employees up to a reasonable standard. At least some of the cost savings originate here. But they also should be able to improve customer service by reducing the time the customer must spend in the check-out line. Of course, reducing a customer’s time and reducing workforce at the same time can quickly work at cross purposes. There is where management must balance conflicting opportunities. In some cases, the cashiers, who are under the measurement system, have told customers they cannot talk to them, or do anything extra, because they are “on the clock.” In other cases, customers have found that they do, in fact, spend less time checking out. It will take an astute management team to make these trade-offs properly so that costs go down and customer service goes up at the same time. If the customer sees no benefit, the cost reduction can become self defeating. (See “Costs: The Last Consideration” in the Perspectives on StrategyStreet.com.)

These cost management innovations by OWO and its client retailers are examples of efforts companies make to reduce the units of input, in this case employees, not producing output, in this case customer transactions. The simple measurement of employee productivity is one major approach to reducing lost or wasted input. There are several other approaches producing the same effect. You can shift demand from high demand to low demand locations or times. You can improve the accuracy of the forecast in order to staff more appropriately. You may use short-term sources of help to shave the peak of demand with stretched capacity. And you can speed the process so employees spend less time waiting. (See the cost reduction ideas in the Improve/Costs/Reduce Units of Input Available but not Producing Output on StrategyStreet.com.)

Each of these approaches improve productivity if the company implements them right. If they are done poorly, however, they can actually reduce margins.