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In an interview with Jack Welch's successor at GE, Jeffrey Immelt said that companies must have "ambidextrous" leadership. Geoff Colvin of Fortune Magazine asked the CEO what he meant by "ambidextrous." The response by Immelt was, "Growth and cost control — and sustained excellence at both."
Gregg Sherrill, the recently appointed chairman and CEO of Tenneco, said one of his near term priorities would be a "relentless drive to maintain control of our costs."
Costs and cost controls go hand-in-hand with all departments and responsibilities, including research and development, production, finance and marketing. The list of defunct companies that lost the battle of cost controls — companies of all sizes — is virtually endless.
Perhaps the first lesson to learn is that costs/expenses are moving targets in any company. Costs are constantly changing based on many factors including productivity, yield, tax changes, environmental issues, supply and demand and competition.
Budgeting costs and maintaining historical cost and expense records have evolved considerably over the years. The stereotypical cost accountant wearing a translucent green visor in a remote office has mutated into a managerial accounting department with a host of planning, coordination and investigative responsibilities.
While maintaining historical cost and expense records remains a major task, CFOs, controllers and other financial managers play a greater role in management than ever before. Among the issues dealt with in managerial accounting are the value of incentives (cost/benefit analysis) and the worth of quality output (the process).
It is important to remember that managerial accounting methods need not comply with GAAP (Generally Accepted Accounting Principles). The purpose of managerial accounting is to provide data and other information for evaluation and application inside the organization.
Managerial accounting analyzes the value chain from purchasing and development right through to distribution and customer service. An important function of managerial accountants is to find, report and help eliminate nonvalue-added activities. This is often referred to as ABC (activity based costing). ABC focuses not just on labor, materials and fixed costs but also on the efficiency of the process.
The words "costs" and "expenses" are often used interchangeably, but have slightly different meanings. A graduate school text states that the main difference in application of the two words is timing. For example, if a company spends $2,000 on resale goods in a month, it is referred to as "cost." However, when the goods are sold, the amounts are considered "expenses." Others use the word "cost" in the context of cost of goods sold (COGS), while expenses are often categorized as fixed (as opposed to variable).
Variable costs are those that change as the level of activity increases or decreases. Fixed costs are those that remain static as volume and product mix change. Direct and indirect costs differ depending on whether or not specific costs can be directly traced to a product, department or process.
In our woodworking industries, the two main cost variables are probably productivity and yield. Productivity can be computed in various ways. One method is to simply divide output (sales revenue) by direct labor input (direct payroll costs) for comparable periods. The result is the number of dollars of sales revenue per dollar of direct labor. The CEO of a company in southwest Virginia that produces a broad line of wood products explains annual output per worker is key. He believes that a woodworking company should shoot for a minimum of $125,000 in sales revenue per worker per year. The manager of a profitable Pennsylvania company states his company generates about $130,000 in sales per year per direct employee, validating this target estimate.
Optimum yield is the result of sharp purchasing, the use of skilled workers and the efficiency of machines that employ leading-edge technology. (See "Optimization: Are we there yet?" Wood Digest, March, 2006, p. 32-33.)
A corporate industrial engineer with one of the best-known furniture manufacturers in the United States mentions lean manufacturing and work cells as cost-saving techniques. He stressed the importance of the relentless search for more efficient production methods, especially to match the lower costs of foreign components and finished products (China?).
Wondering if other industries use similar methods of cost controls, I spoke with the CFO of a company that manufactures products for commercial and industrial applications. Coincidentally, the industrial engineer and the CFO related recurring themes in their conversations.
Here are some of the things these companies are doing:
- Making sure there is a strong link between the financial operations of the company and production. The CFO referred to the relationship as a "partnership" of the two departments.
- Cross training of workers so absences due to vacations or illness have little or no effect on production. Workers with skills in several areas can also deal quickly with various order sizes and varying amounts and types of machining and assembly. Other training includes the incessant search for new approaches to lean manufacturing through communications with supervisors and workers.
- Monitoring raw materials, surge (WIP) and finished goods inventory investment. J-I-T (just-in-time) purchasing strategy is an important element in inventory management. Outsourcing is frequently a viable alternative for some parts and components.
- Reduction of lead times. The furniture company has cut work in process time in some departments from 45 to 30 days. Associated with this effort are reduced setup times and the ability to produce order sizes of any quantity without discernible changes in (unit) production efficiency.
- As a part of their strategies, great importance is placed on customer needs as opposed to what the companies can produce. This strategic approach is another key consideration in lean manufacturing. When inventories (especially finished goods) are tied to customer needs, decreased inventory investment and increased turns are almost always the result.
Employee attrition is important to most companies that feel the pressure of domestic and foreign competition. One company mentioned that as its workforce shrinks through attrition, it budgets and buys new, more efficient equipment that has a payback of two years or less.
In addition to being "lean" in all areas of production management, the Pennsylvania company employs some additional methods to hold down costs. One interesting approach of this company is to switch to a lower cost but equivalent wood species when possible. The manager watches lumber markets daily to assure economic purchasing.
Born of many years of leading an integrated company, the manager says he is constantly revising product mix and downplays marginally profitable items to customers. As other operating managers do, he depends to some degree on attrition of the workforce, but also spends time maximizing productivity. Cross training is a constant effort. The company, trolling for further savings, is switching to a work schedule of four nine-hour days and one eight-hour day.
The executive adds that "there are no easy targets for cost-cutting and you can't cut your way to profitability." It's a certainty that you can't assure maximum profitability simply by raising prices or increasing volume.
Profits are produced by the difference between costs and sales, minus expenses. Pricing is governed by either competitive offerings or value (as perceived in the marketplace). In the current market environment, both foreign and domestic products often limit unit prices, placing added importance on cost controls.
The "global marketplace" is exceedingly harsh on those firms that lose control of costs. Whether your company sells products locally, regionally, nationally or worldwide, it is clear you need to know your costs on a continuous basis. If your profit is the result of a broad gap between costs and sales prices, your company should thrive. However, if your costs are excessive and your prices are limited by market factors, you may echo the words of the cabinetmaker. When asked his reporting status by the revenue agent, he responded, "I started out as a profit-making venture, but now it is a charitable nonprofit company."
The pursuit of lower costs is an endless task, but never a thankless one.
Ed. note: Former cabinetmaker and past director of the National Kitchen and Bath Association, Dick Baynton is currently an industry consultant. He can be reached by e-mail at rbaynton@rbnet.com.
author: By Dick Baynton