Cost Drivers and Where to Look to Lower Cost

Every customer is price sensitive. Price is a key characteristic of your offering, whether your business strategy is to offer value through low prices or superior quality at a premium price. If you price your goods too high, the customer may purchase elsewhere.

For this reason, every business is under immense pressure to lower prices, especially during economic downturns when every company is competing harder to win fewer orders. Struggling companies may even be willing to accept business at break-even prices - just to cover fixed overhead.

The only way to survive and profit is to continually lower the cost that it takes you to produce and deliver each unit. The marketplace largely dictates the price that buyers will accept. The only thing we control, besides our product or service itself, is our own cost structure. And we have much more control over our own costs than most business owners realize.

This article presents key drivers of cost. Each "driver" describes an area in which costs arise and can be reduced. Costs are described in terms of "value activities," which are the many discrete activities a business performs in designing, producing, marketing, delivering and supporting its product or services. Take time to understand each cost driver, and then consider how each may be contributing to costs incurred within your business. Better yet, find ways to lower costs associated with each driver.

Economies of Scale

Economies of scale arise from the ability to perform activities differently and more efficiently at larger volume, or the ability to amortize the cost of things over a greater sales volume. An example of the former might be a roofing contractor that focuses on obtaining a higher concentration of jobs in a small geographic area to allow for reduced drive times and more efficient sharing of personnel and equipment between jobs.

Economies of scale can be found to some extent in almost any part of a business' operation, including purchasing, processing, advertising, sales, marketing, billing and collection. Scale economies can be achieved by increasing total sales or by restructuring a product line to offer fewer choices and therefore more volume per product offered.

Given the economies that volume or scale can provide, businesses should organize themselves in a way that allows for volume processing. The first place to look is where natural advantage over competitors may be. For example, a printing company that has a piece of equipment that allows for more efficient processing of a certain type of job might attempt to increase the amount of business it does of this type. It is naturally positioned to win this type of business over its competitors, and higher volumes will allow the cost of the machine to be amortized over larger volumes, thereby enabling higher profit per job.

Learning

The cost of an activity can decline over time due to learning that increases efficiency. Learning can provide ideas for reducing costs through such changes as floor layout, improved scheduling, labor efficiency improvement, product design modifications, yield improvements, or improvements in installation and shipping procedures. Performance improvements derived from learning typically accrue gradually and incrementally over time.

The rate of learning in an organization tends to depend on the degree to which management emphasizes its importance and empowers workers to conceive, investigate and implement process improvements that reduce cost, improve efficiency or add value to products or services. The rate of learning can be greater during times of light workload because it is during these times that additional time and energy may be focused on process improvement and idea generation.

Learning also can occur from one firm to another through the movement of employees or through facilitators such as trade organizations or schools. But because a sustainable cost advantage results only from proprietary learning (learning that is not possessed by your competitors), some care should be taken to protect your proprietary learning from being transferred to your competitors. This can be done by limiting turnover of personnel and taking steps to protect the dissemination of information that is proprietary to your company.

Capacity Utilization

Where a value activity has a large fixed cost associated with it, the cost of the activity will be affected by capacity utilization. For example, a school supply retailer has high fixed costs associated with its physical "store" but can handle a very large volume with minimal increases in cost. As sales rise, the fixed cost of the space and staff are amortizing over a larger sales volume, thereby enabling higher profit.

Fixed costs also create a penalty for underutilization, and the ratio of fixed costs to variable costs determines the sensitivity of a value activity to utilization. For example, a firm that uses independent reps to sell its goods reduces sensitivity to capacity utilization compared to an in-house sales force. This is because when reps are paid only when they sell (commission), they don't contribute to fixed overhead as a salaried salesperson would. Of course, the incremental profit on sales of reps is typically lower, but fixed overhead is less.

The pattern of utilization is also a key factor. It is smooth volume at optimal utilization that is desired. We all know that operating at low capacity is inefficient, but operating at or near capacity can cause inefficiencies and higher costs as well. Company policies and practices should be designed to produce smooth demand and work flow. For example, heat and air conditioning contractors often provide incentives to entice customers to contract for repairs and maintenance at times of the year that tend to have lower service call volumes.

Linkages

The cost of a value activity is frequently affected by how other activities are performed. These are called linkages. Some of the most common linkages are between direct and indirect activities (e.g., machining and maintenance), quality assurance and other activities (e.g., inspection and after-sale service), activities that must be coordinated (e.g., inbound logistics and operations), and between activities that are alternative ways of achieving the result (e.g., advertising and direct sale).

Identifying linkages requires that we ask, "What are all the other activities elsewhere that have or might have an impact on the cost of performing this activity?" Important linkages exist within a company and between a firm and its suppliers and channels (sales reps, distributors, delivery systems). A firm can identify linkage costs or inefficiencies by examining how the behavior of suppliers or channels affects the cost of each of its other activities and vice versa.

Linkages with suppliers tend to center on suppliers' product design characteristics, service, quality assurance procedures, packaging, delivery procedures and order processing. For example, a supplier may be delivering items that are packaged in a way that require too much time to unpack and ready for processing, thus hurting your productivity.

Channel linkages, such as those related to how you sell or distribute the goods you sell, mirror those of supplier linkages and include such items as the mode of transportation, location of distribution hubs, manner of delivery and services provided.

Vertical Integration

Vertical integration is the expansion of the value activities that a firm provides in-house as opposed to outsourcing to a third party. For example, a company has the choice of making parts in-house or having a vendor make them. Or a firm could choose to handle its deliveries with its own trucks and drivers, or it could outsource this value activity to third-party carriers. Every value activity should be evaluated periodically to assess what method will reduce costs and best meet the value-added process adopted by the company. The goal is always expense reduction, improving the delivery to the client of your particular value-add, and solidifying your uniqueness compared to your competition.

Timing

Timing itself can drive cost. When you begin in business, or enter a new business or add a new product or service, can greatly affect the cost required to establish operations and educate the marketplace that you exist and why they should choose you. Often, the first company to offer a service enjoys easier and less costly penetration/customer awareness. Established competitors might also enjoy lower cost because they have already paid for all or a part of their physical assets and they may be able to operate more efficiently because of their experience.

Later entrants might also be able to enjoy cost advantages over their competitors that have been in business longer. For example, older firms may be stuck with older technology that is much less efficient and may not have the capabilities offered by newer machinery. Older firms may also be stuck in a location that is now less than ideal.

Almost any firm can use timing to reduce costs over competitors by simply buying during times of lower prices. This skill alone could produce a powerful cost advantage over competitors. Businesses that depend on the purchase of capital equipment can significantly reduce costs by buying used equipment or during time when prices are depressed. Inventory purchase costs can sometimes be influences as well.

Interrelationships

Interrelationships are how businesses or business units share the cost of a value activity. Sharing a value activity serves the purpose of increasing volume and therefore reducing per-unit costs and improving efficiency. The sharing of a costly technology or piece of equipment might be a way of reducing the cost of delivering a value activity, such as the sharing of prepress equipment and personnel by several print shop locations. Additionally, the pursuit of knowledge and learning can be considered a value activity in itself, indirectly. As such, a franchiser may help franchisees move down the learning curve faster by becoming a storehouse of knowledge and best practices, and disseminating this information to all franchisees. Trade associations play the same valuable role.

Discretionary Policies

Ways of doing things, such as policies and procedures, often reflect a firm's strategy and involve deliberate trade-offs between cost and differentiation. Some of the choices that tend to have the biggest impact on costs include:

• product configuration
• performance and feature
• mix and variety of products offered
• level of services provided
• spending rate on marketing
• delivery time
• buyers served
• channels employed
• technology chosen
• scale, timing or other cost drivers
• specification of raw materials
• wages paid and amenities provided to employees
• human resource policies such as training, hiring and employee motivation
• procedures for scheduling production, maintenance, sales calls and other activities

Location

Geographic location of a value activity can affect cost, as can its location relative to other value activities. Though location frequently reflects a policy choice, it can also stem from history, the location of inputs and other factors. Hence, location should be treated as a separate cost driver. Location affects costs in a number of ways. Locations differ in the prevailing cost of labor; talent pool; raw material quality, cost and availability; energy costs; tax rates; climate; cultural norms, tastes; and other factors. Location relative to suppliers is an important factor in inbound logistical cost, while location relative to buyers affects outbound logistical cost. The effect that location can have on the various parts of a business should be considered when a site is selected.

The basis of this article is the work of Michael E. Porter as described in his two books, Competitive Strategy and Competitive Advantage.