The Fallacy of Directly Pursuing Low Cost In Manufacturing
November 1 1987 by Thomas G. Gunn
There is much confusion about being a low cost manufacturer today. This often leads to actions which insure that companies will never attain their low cost (LC) goal.
The problem initially surfaces when senior managers are asked to articulate manufacturing strategy objectives, or when manufacturing executives are asked what they need to become more competitive in their global industries. “Lower cost” or “being the LC manufacturer” is often their first response. Then, they build a list of manufacturing, strategy objectives or crucial goals which contain, at a minimum, the following: lowest cost manufacturer; higher quality; increased flexibility; reduced cumulative manufacturing lead time; reduced new product development lead time; increased customer service; increased return on manufacturing assets; and elimination of waste.
The management team spends countless hours trying to establish whether LC is first, second, fourth or last on the above list. Seldom can the group reach consensus on the priority of LC as an objective. Moreover, factoring this ranking into strategic decision making is not a straightforward task. Even when LC is thought to be ranked properly, confusion and conflict over its real meaning remains.
Then too, we occasionally find manufacturing people whose goal is to be the low selling-price producers. Selling price is a marketing (function) decision that is largely influenced by the price the market will pay for the value of a product as perceived by its customers. Usually, this is a factor over which any one manufacturer has little control.
Manufacturing’s job is to pursue LC, not low selling price. Marketing should have enough knowledge of the global marketplace to be able to say to manufacturing: “You must be able to produce this product at this cost today for us to generate a margin required by our business strategy or shareholders. Moreover, you must be able to meet this significantly lower cost five years from now for the same product.” Thus, technology changes-both product and process-experience curve effects, and scope and scale advantages must all contribute to a continually decreasing manufacturing cost over time.
Directly and vigorously pursuing LC as a primary manufacturing goal reduces the work force-with an emphasis on reducing direct labor cost; the most readily identified portion of labor costs. Capital investment in new plant and equipment (including information systems) is also reduced or curtailed-existing assets are “milked” and cash cows are decapitalized. Accounting policies are changed to bill early, pay late, thus maximizing the float at the expense of customers and suppliers.
Other results of directly pursuing LC manufacturing are that preventive maintenance on plant and equipment is reduced or curtailed, often leading to reduced product quality and reduced capability to meet ship schedules with minimum inventories; basic R&D funding is cut or “postponed”-for both product and process design; investment in new product development is reduced or curtailed-existing products are “stretched” with superficial changes, if any, and investment in new product/process or information systems technology is reduced or curtailed.
When a company pursues LC as a primary manufacturing goal, the company’s suppliers are squeezed for lower prices, which encourages them to reduce the quality of their products and to batch their shipments in even larger lot sizes to gain the benefits of long production runs. In turn, suppliers often de-emphasize their design function to further reduce their overhead, relying on their customers to more fully design and/or specify their products. Purchasing buyers are rewarded for buying the lowest cost (only) products-with little or no regard for quality or delivery (lead time or schedule compliance) considerations.
Company salaries and wages oftentimes fail to keep pace with market rates. The motivation of existing workers goes down. The best and brightest people leave. Good employees become harder to attract. In many cases, operations end up being moved offshore in pursuit of lower labor costs. Corporate staff is reduced or eliminated entirely. Thus, planning and other important management functions often cease.
Production rates are usually kept high (regardless of demand), in an effort to keep factory/machine utilization up and absorb existing overhead.
A focus on short-term LC objectives is often accomplished at the expense of developing, communicating, and implementing a vision of the future.
The result of this misguided approach to LC manufacturing is that for the majority of U.S. manufacturers, their annual cost due to poor quality exceeds their return on sales by a factor of two to four times. And strategically, they are easy prey for effectively managed manufacturers, based either domestically or internationally.
Sometimes companies whose management has tried most of the approaches above are restructured in a vain attempt to buy (their current management?) time. Sadly, this painful approach seldom gets at the underlying reasons for the company’s manufacturing impotence.
These are the very actions that have driven U.S. manufacturing capability and global competitiveness to its current nadir over the past twenty-five years. They directly counteract actions that are critically needed to support the company’s business strategy, all because we have forgotten the basics about cost. They are a result of a control-oriented “cut, cut, cut” mentality that leads to significant erosion in competitive advantage.
RE-THINKING LOW COST
The fact that lower or lowest cost often shows up at the top of the manufacturing strategy objective list suggests a fundamental misunderstanding of costs’ relationship to the remaining strategic objectives. We’ve lost sight of the fact that in manufacturing (as well as in most other activities), LC is a result of doing other things well, or effectively. In mathematical parlance, LC is the dependent variable, not an independent variable.
We must also break old habits of thinking about cost and quality. As the Japanese (primarily) have repeatedly shown us, cost and quality do not lie at opposite ends of the same spectrum. The only way we can be the LC manufacturer is to be the high quality manufacturer. The relationship between cost and quality is one way; a LC approach will not lead (as we have seen) to high quality, but a high quality approach will lead to LC.
The guiding business philosophy or strategy-written or unwritten-is to always pursue the goal of being the lowest total cost manufacturer. Manufacturing cost is the prime element of total cost in most manufacturing companies. In addition, selling and general and administrative costs (SG&A) and R&D costs typically are added to manufacturing cost (cost of goods sold) to arrive at total cost. It is total cost subtracted from selling price that determines profit margin. One could be the lowest cost manufacturer, but still not be the lowest total cost manufacturer due to high SG&A costs. On the other hand, having the lowest manufacturing cost may provide room in the total cost structure to invest more heavily in sales and marketing, compared to other competitors for a given total cost ceiling.
The LC dilemma can be clarified by removing LC from the strategic objective list at the beginning of this article and elevating it to a superordinate goal. Manufacturing’s superordinate goal always is to be the LC manufacturer. Now, the company’s manufacturing strategy focuses only on achieving the independent variables; our pursuit of LC has changed so that it is indirect.
REVISED MANUFACTURING STRATEGY OBJECTIVES
Prioritization of the right combination of strategic objectives will vary by product line, strategic business unit, or company. These objectives include: higher quality; increased inventory and increased flexibility; reduced cumulative and new product development lead time; increased customer service and return on manufacturing assets; and elimination of waste.
With the removal of LC from the strategic objective list, a whole new perspective emerges. Now, by excelling in pursuit of the remaining manufacturing strategy objectives, we will be contributing to the accomplishment of our superordinate goals -increased competitiveness for the company and lower manufacturing cost.
While lower cost is not guaranteed as a result of pursuing the remaining strategic objectives, experience has repeatedly shown that intelligent pursuit of them by educated people, who are motivated by a theme of continual improvement and who use proven ideas and technology, substantially reduces costs over time.
Here are a few of the benefits of pursuing the remaining strategic objectives: higher quality; increased inventory and flexibility; reduced new product development; and increased customer service.
Higher quality means a focus on doing it right the first time, eliminating the wasted dollars and manufacturing capacity of scrap and rework. It also means lower warranty costs.
Increased inventory turns reduces required working capital, reduces inventory carrying costs (now at the rate of about 30 percent per year), and reduces plant floor space required, thereby achieving a higher return on assets. Increased flexibility can also allow inventory and plant floor space to be reduced. Increased flexibility of the work force (workers trained to be multifunctional) can reduce overall direct or indirect labor costs.
Reduced new product development lead time means quicker time to market-increasingly a key basis of competition in many industries. Each month of development time saved means a month at mature sales levels of sales revenue. Increased customer service often means more repeat business resulting in either a smaller (i.e., lower cost) marketing and sales effort for a given amount of business (capacity), or in additional sales growth. As an additional benefit, management confusion and conflict over the ranking of cost versus the other objectives is eliminated.
What are some real world examples of how companies are recognizing this new way of thinking about cost?
A New England manufacturer had its industrial and manufacturing engineers continually redesigning warehouses and factory layouts in an effort to store inventory more cost effectively. When they changed their thinking and focused on production process (quality) improvements and the elimination of waste (inventory reduction), they found there was no need for about 50 percent of the warehouse equipment and plant floor space they had been using to store material.
Xerox, in a dramatic turnaround vividly described in Xerox: American Samurai, focused on benchmarking their global competitors and studying best industry practices. Then, they established new manufacturing strategy objectives geared to beating these benchmark figures in areas such as inventory turns, quality levels, supplier reduction, and the like. Similar changes oriented to gaining competitiveness advantage at Harley Davidson and Omark Industries, have been well publicized. Indeed, Omark Industries shut down its Puerto Rican manufacturing operations when improvements in their U.S. factories enabled them to become more than cost competitive with their low labor cost Puerto Rico facility.
Allen Bradley radically changed its design and production priorities for manufacturing its new world-class starter motor contactor factory. Its well publicized factory now is one of the lowest cost producers of these kinds of products. IBM has accomplished similar results in their Lexington, KY; Charlotte, NC; and Austin, TX plants.
These are but a few well documented examples of how U.S. manufacturers are changing their strategic thinking about how to achieve high- quality/low- cost strategy objectives and global competitive advantage.
In doing so, these companies’ executives shifted the emphasis from a control/cut mentality to the proper strategic focus: which of these remaining objectives do we invest in, and, in what priority, to best accomplish our superordinate business goal of always being the lowest total cost manufacturer? Prudent investments in technology as well as human resources should be prioritized according to their greatest leverage to attain lasting strategic benefits and financial goals. Indeed, with the right strategic vision, little investment beyond education and training is needed to change attitudes and implement Total Quality Control (TQC) and Just-In-Time (JIT) programs that deliver rapid proven benefits both financial and strategic-to any company.
More important, such a change in emphasis may encourage us to look outside our company for the benchmarks by which we measure our success against our global competitors, rather than continually focusing on how much we have reduced our costs compared to our cost last year or the year before. In a competitive sense, how well our company did compared to its performance last year is of interest, but is strategically irrelevant. Strategically, the base of our performance measurements must be our global competitor’s capabilities-now and in the future-not in the past.
We have found that by executing the simple suggestions outlined here-removing the low cost roadblock to strategic thinking-people’s attention shifts quickly and effectively to the real solution of planning, investing, and implementing to attain greater competitive advantage in manufacturing.
Thomas G. Gunn is a partner and national director of Arthur Young’s manufacturing consulting group. Previously, he was vice president of Arthur D. Little’s CIM group. He has conducted more than 150 seminars and conferences worldwide on world-class manufacturing and is the author of Computer Applications in Manufacturing and Manufacturing for Competitive Advantage.