Volume Obsession: Rising Costs and Falling Margins

By Dr. Jagdish N. Sheth

[An obsession with increasing production volumes means one simple] thing: you're spending too much money to make money. This occurs when prices have crashed due to intense competition or excess industry capacity, but your costs remain the same.

The consequences of volume obsession, like overeating, are incremental. Once we're fat, we know we're fat. We don't need to be told (and often resent it when we are). But the [incremental] process of overeating – a doughnut here, a second helping there – that results in being fat is somehow easier to overlook. The price of staying lean is constant vigilance.

How to Break the Volume Obsession Habit
Breaking the volume obsession habit requires a strategic vision and a time commitment for planning and implementation activities. It can also be a painful process when the remedy involves workforce reduction. However, because volume obsession has a direct negative impact on the financial well-being of a company, it must be dealt with.

Identify where our costs are
This sounds self-evident, but a lot of companies still don't know how to create the appropriate revenue/cost alignment. If revenues are skewed, if 20 percent of customers are generating 80 percent of revenue, profitability is likely to be even more skewed. It may be that 10 percent of your customers are actually making money for you, and 90 are being subsidized. More and more companies are coming to realize that if the customer is the revenue generator, costs should align that way. The new platform is sometimes called customer relationship management (CRM). At its heart is the "customer profitability analysis" – calculating costs and revenues on a per-customer basis.

Convert cost centers into revenue centers or profit centers
As noted, it's not unusual for companies to designate sales as their revenue-generating function and then define other functions as cost centers in support of sales. It doesn't have to be that way. A fresh approach can sometimes turn even strategic functions from cost centers into revenue or profit centers.

Virtually any function – R&D, manufacturing, logistics (like shipping), customer support – can be reorganized into a revenue center. Almost all the cheese at your local supermarket, whatever the brand, is stocked by Kraft, just as most cigarette racks are owned and operated by RJ Reynolds. In this case, these two mega-companies have turned inventory management into a revenue producer. Companies with extra capacity at their call centers can produce revenue from customer support by taking calls for other companies. Now when you read about companies that have reorganized to make individual functions more "entrepreneurial," you know how to translate: they're transforming cost centers into moneymakers.

Decentralize profit and loss to more and smaller business units
If you have centralized P&L at the top, you may have poor oversight over how your individual units are doing. One corrective is to apply the EVA principle described earlier: delegate to each unit the responsibility of justifying its costs, including non-operating costs or hidden costs. Require each unit to pay its own way, to cover even shareholder dividends, income taxes, and the cost of capital – costs that might have been passed up to the corporate level. Let managers know that they will be supported only if they can generate more than enough revenue to cover these costs; otherwise, they will be divested.

Move from vertical integration to "virtual integration"
Throughout the 20th century, vertical integration has been the model. This model doesn't make as much sense as it used to, for a couple of reasons. First, it's difficult to have enough oversight to make sure every unit in a vertically integrated business is running with optimum efficiency. In fact, the system is likely to have some cost inefficiency because, basically, you're buying from yourself; no market mechanism is at work. ... And second, even if your units are efficient, there's still an excellent chance that a specialist company can do it better. The new model is "virtual integration" – concentrating on the one or two things you do best and letting others do the rest.

Outsource non-core functions
If you're not quite ready for virtual integration, you can still increase efficiency and cut costs by outsourcing non-core functionality to outsiders that have appropriate economies of scale. Today more and more firms are beginning to outsource what used to be considered "strategic" functions. For instance, pharmaceutical companies are realizing that even some of their R&D work can be contracted out. While they concentrate on next-generation drugs, they can outsource the job of reformulating and improving older drugs whose patents might be about to expire.

Downsize (or rightsize) the company's management
Most companies, as they grow and prosper, start adding levels of management. It's possible, and often advisable, to compress some of these management layers. Consider professional services companies, which tend to offer the "flattest" paradigm. In law or accounting firms, or in IT consulting, everyone is a revenue producer. The partner who runs the shop is called the managing director or managing partner, but he's not a full-time bureaucrat with a hierarchy of managers under him. He spends half his time as a manager or coordinator and the other half earning money doing the same work the other firm members do.

Reengineer your processes
One key process to examine is what's known as "factory forward." Why "factory forward?" Why not "customer backward" into the factory? This kind of process reengineering wrings out all the costs caused by inefficient inventory management. ... In our increasingly services-oriented economy, services generally are demand-driven, not supply-driven. What's happening now is that the demand-driven model is being recognized as viable for manufacturing operations as well.

Move toward "mass customization"
Demand-driven manufacturing leads naturally to the next phase of reengineering: "mass customization." This seeming oxymoron – also known as "agile production" – essentially means producing customized products with the cost economy of the assembly line. ... The point is not so much "lower volume," but rather volume on demand, or a demand/supply alignment that creates zero inventory. Over the past decade, as consumers have become more demanding and markets have splintered, mass customization has swept through industries as diverse as car-making, consumer electronics, clothing, retailing, and fast food.

Implement target costing
In U.S. business, the standard practice (born during the beginning of the Industrial Age) has been to price our products based on what it costs to make them. We don't really know what a new product will cost until we've finished making it. It was the Japanese who recognized the fallacy in this model and inverted the process. They understood that the manufacturer cannot control the price. The competitive market determines the price. But what the manufacturer can control is costs. In other words, price doesn't come out at the end of the formula; it goes in at the beginning. The real formula is market price minus target return equals target cost.

Become a world-class customer
Remember that for most customers procurement is the biggest cost – often 65 to 70 percent of the total. So pursuing excellence in procurement can be a critical cost-reduction mechanism. How? Not by strong-arming your suppliers into reducing the price, but by nurturing them and making the m emotionally loyal to you. Just as you have your own best customers, those you enjoy doing business with the most, so you need to be that kind of customer for your suppliers. If you treat your suppliers with as much respect as you do your customers, they will want to do business with you.

To "go lean" is a tough request in this world of ours. It runs counter to the archetype of success: spending, consuming, growing "fat and happy." This archetype is deeply ingrained – in society as well as in business. But the story across industries has the same general outline: In the face of increasing competition (often global), prices are falling, but cost structures, full of fat like clogged arteries, remain high, and margins inevitably collapse. Many, at the eleventh hour, are taking measure like those just outlined. Others, more likely to survive, will take these steps as precautions, rather than as desperate remedies.