Waging War on Complexity Costs: What the CEO Needs to Know

Does a 15 to 30 percent reduction in operating cost interest you? Thought so.

February 18 2010 by Stephen A. Wilson & Andrei Perumal


For the past two decades the pursuit of growth has created massive complexity in companies, and with it, massive complexity costs. The only good news about this weakness is that your competitors may be carrying as much or more complexity cost as you are—and hence the opportunity: Learn how to effectively remove complexity, and you can regain competitive footing by creating a cost advantage over your competitors. In fact, we’ve found that it’s possible for companies to reduce costs by 15 percent to 30 percent  in significant portions of their business by waging war on complexity costs.

However, while many CEOs will intuitively grasp the magnitude of the issue and the opportunity, what to do about it has been a different story. Companies have generally been thwarted by the sheer scope and size of the issue. Moreover, traditional approaches to tackling complexity have generally fallen short. In our recent book, Waging War on Complexity Costs (McGraw-Hill), we therefore provide new insights on the nature of the issue and innovative and effective battle strategies that the CEO can leverage to finally grapple with the issue.

As a primer, here is our memo to the CEO – five key points that every executive needs to heed in order to win the war on complexity:

  • Key Point #1: Complexity reduction is (for most) one of the biggest opportunities for 2010
  • Key Point #2: ‘Substitutability’ is your friend; cut complexity while keeping revenues
  • Key Point #3: The biggest problem areas may be process and organizational complexity
  • Key Point #4: This is as much about growth as it is about cost reduction
  • Key Point #5: Don’t make this a long academic exercise

We discuss each in detail below:

Key Point #1: Complexity reduction is (for most) one of the biggest opportunities for 2010

For those that have failed thus far to grapple with complexity successfully, it remains a giant nugget of opportunity – likely one of the best in 2010. 

In our recent book, we cite a situation (not uncommon) in which the most profitable 20 percent to 30 percent of products generate more than 300 percent of the profits in a company – what we call the island of profit in a sea of costs. Because actual profits can’t exceed 100 percent of the total, the remaining 70 percent to 80 percent lose 200 percent of the profits: they are tied to assets, processes, products, and customer groups that are disproportionate drivers of cost in your organization.

To us, this type of situation mandates a response: to understand and strip away the vast areas of the business that are destroying profits – eliminate the bad complexity in your business, in your products, your processes, your functions and assets. 

Of course, such a notion frequently faces resistance at the outset. In his book The 80/20 Principle, Richard Koch reports, “Routinely, executives who commission product-line profitability exercises often do refuse to believe the results when first presented with them.” And even if they believe that 80 percent of their products are “profit losers,” they often shy away from dealing with that portion of the product line. The executives’ rationale, Koch maintains, is that it is impossible to remove the 80 percent of corresponding overhead in any sensible time frame. Therefore, only the most horribly unprofitable business is removed.

But this is wrong-headed. The fact is, often it’s complexity that requires overheads to be so large, and that these unprofitable businesses are so unprofitable simply because the increased complexity has led to step-change increases in non-value-added costs. 

So how can companies move past this?  In our experience there are 2 necessary conditions required to galvanize the organization to deal with the “sea of cost”.

  • The first is quantification of the opportunity. Without a “size of the prize” it is very difficult to get support for the changes required, let alone make it a priority. (We describe the approach for assessing the cost opportunity in our book.) 
  • The second is the right set of approaches for eliminating the product, process and organizational complexity. We heard one senior executive accurately describe it as like “trying to untangle the Christmas lights.” This is the reason that many companies fail to tackle complexity – no good battle strategies for attacking the systemic nature of the issue. The fact is, complexity is an issue which requires concurrent actions to unlock the benefits – e.g. a product line rationalization can be more powerful when combined with an asset or footprint consolidation.

If your company has high levels of profit concentration – the rule, rather than the exception, for most companies — it begs a provocative question: What would your organization look like if you could somehow shed the 60 percent, 70 percent, 80 percent of products – and associated overheads – that are sapping profit?  (And moreover, what if your competitor did and you did not?)  What if you were to re-imagine your business, absent its non-value-add complexity in products, processes and organizational constructs?  

Key Point #2: ‘Substitutability’ is your friend:  cut complexity while keeping revenues

One of the most common internal barriers to taking on complexity reduction, specifically SKU rationalization, is fear of losing revenues. That is why many SKU reduction initiatives start off with big goals but quickly lose steam. The focus moves to eliminating the lowest 5 percent of sales by volume, but even then there’s nervousness: who wants to lose 5 percent of sales? Revenue risk becomes an impediment to getting to the heart of the issue: reviving the product and service portfolio for growth, profitability and customer delight.

What most firms overlook is the notion of substitutability – in essence the opposite of cannibalization. It is the CEO’s best friend in attacking portfolio complexity. Revenue substitutability means the likelihood that customers will shift their purchase dollars to other products or services in your portfolio if a particular product or service is cut. Obviously, finding a product with high revenue substitutability makes it a likely target for elimination, because in doing so you can simplify your portfolio (and lose the associated complexity costs) without losing the revenue it generates. 

 Figure 1: Looking deeper into the portfolio – it’s not just about pruning the tail

 

When a company trims just the tail – i.e. the lowest selling items by volume – it will lower the overall SKU count. But because these items are low in volume, while  the net effect on overall costs can be meaningful, it is limited and leaves much opportunity on the table. However, by eliminating complexity costs associated with high-volume high-substitutability items (while initially counter-intuitive) you can bring dramatic savings, while maintaining revenues, as well as clarify the portfolio for customers.  Importantly, by shifting volume and revenue to remaining products, eliminating high-volume, highly-substitutable items will make your remaining products even more profitable—what we call making your ‘good’ even ‘better’—and the results can be dramatic.

If this sounds risky, consider a simple example. If you walk into an Apple store, you will see a crisp display of Apple’s latest technology. This is the result of the efforts the company undertakes to strategically prune its portfolio. It continually eliminates older versions of the iPod, for example, as newer versions are introduced. No one suggests that customers are walking away from Apple because they can no longer acquire an iPod model from 3 years ago. And as it continues to consolidate variant products, there is very little revenue risk. The same is true for most customer demographics. The opportunity exists for many companies to simplify their portfolios in this manner, migrating customers from a number of similar and overlapping items to simpler choice of 1 or 2.

For a division of an industrial products company, substitutability was the key to trimming 16 percent of its SKUs, while remaining essentially revenue neutral. The benefits of this were clear: the SKU reduction meant a 3 percentage point  lift in operating profit and 30 percent reduction in inventories.  Figure 2 below shows where the selected SKUs came from – many from the tail, but it was the higher volume SKUs that enabled the bigger results in working capital and margin lift.

Figure 2: Example – Substitutability was critical to keeping revenues while slashing the SKU-count

The message is clear: companies need to look beyond the tail and leverage the notion of substitutability. And while it may seem quite a challenge at first to determine precisely substitutability, an informed estimate of substitutability can take you far. If you are reluctant to estimate, consider that making SKU rationalization selections without considering substituability is the same as assuming substitutability, which is likely your biggest lever, to be zero, which in most situations is clearly false. Even a rough estimate is a great improvement. 

Key Point #3: The biggest problem areas may be process and organizational complexity

Traditionally complexity reduction efforts have centered on product complexity; but in our experience, process and organizational complexity are often where the biggest opportunities reside for companies. Moreover, understanding how the three types of complexity interact to trap costs is key to making substantial gains. 

For example, consider the pharmaceutical company that was looking to reduce its factory footprint and distribution network. As it examined the various factors involved, such as geography, channels, portfolio, and volumes, the focus soon became how to best rationalize the footprint assuming the same or near same portfolio of products. This is a decision trap: assuming an element is fixed and designing around it. For the pharmaceutical company, this was – initially – a missed opportunity to assess how the product line had defined the footprint and to rethink where it wants to be.

A global industrial goods company had a different dilemma: it knew its product range was hopelessly bloated. As the executive considered what it would mean to make big cuts in its offerings, the team quickly got nervous at the prospect of many of its factories sitting idle with lower capacity utilization but the same overhead.

Both teams discovered that looking at the factory footprint and product portfolio in concert leads to whole new vistas of opportunity, as they would be putting in play the very factors that tend to limit impact. The big savings come from unlocking these interdependencies, which is why we assess complexity in terms of interactions between products, the processes that deliver those products, and the organizational structures (work practices, capabilities, staffing levels, etc.) needed to operate the process.

The confectioner Cadbury’s, recently targeted for acquisition by Kraft Foods, is another very good example of this done well.   

“Given the way the business has developed,” said CEO Todd Stitzer at the outset of its complexity initiative, “Cadbury’s is more complex than it needs to be: the way we’re organized, our factory footprint, and the number of different product formats we produce.”

The company’s response to this state of affairs was a multi-pronged effort to simultaneously consolidate assets, cut SKUs, and eliminate organizational layers and process duplication – attacking product, process and organizational complexity. The company needed to take action. In the UK that meant:

  1. Footprint reconfiguration – reducing the number of distribution depots from 18 to 5.
  2. Organizational simplification – moving from a deeply functional organizational structure where brands and categories were managed on a market by market basis to one with fewer layers, managed along category lines (chocolate, candy and gum). The company reported that because “each category team includes sales, marketing, production and finance,” decisions were made more quickly, and thinking was more “joined-up” with a subsequently more coordinated focus on revenue and margin growth. The company claimed that this allowed it to reduce G&A headcount by 15%. Further, Stizter claimed that the “joined-up approach” resulting from the organizational simplification was critical to successful execution of SKU reduction, which they undertook with seriousness.
  3. SKU reduction – in one particular category, they cut SKUs by 75 percent to 26, raising margins in line with the rest of the seasonal portfolio. Overall across Cadbury, the company cut about 10 percent of SKUs in 2008.

Key Point #4: This is as much about growth as it is about cost reduction

At this moment in time, when many companies are dealing with thoughts about how to grow, while simultaneously trying to sort out the stranded costs tied to products that no one is buying, it’s worth pointing out that in our experience, when you cut complexity, you grow.

The reason: complexity erodes performance levels, both directly and indirectly, so a complexity reduction can see tremendous gains in customer satisfaction. When Motorola Computer Group (MCG) considered massively reducing its portfolio as part of a turnaround, the objections did not emanate from customers but from employees worried about customers. In fact the customers were fine with the changes, as it enabled MCG to improve quality and ratchet up on-time delivery from 70 percent to 78 percent. The result: Customer satisfaction leaped from 27 percent to 55 percent in just a year and top-line revenues increased by 25 percent despite reducing the product portfolio by 40 percent over the same time period.

Another reason that complexity reduction leads to growth is focus. Companies that reduce complexity are better equipped to focus on where value is created and enhance and nurture those elements. Take the situation we cited earlier in the article – 25 percent of a portfolio driving 300 percent of the profits. That might prompt two concerns: the first is – why are we tolerating the 75 percent of the portfolio that is destroying profits? The second is – are we appropriately nurturing and exploiting the 25 percent that is creating profit? Often-times, good complexity, the variety customers care about, gets lost in the noise.

Key Point #5: Don’t make this a long academic exercise

Another way that complexity reduction efforts can break down is through analysis-paralysis. Ensure that you are not embarking on months and months of analysis that is short on insight. It is important to get a more grounded view of the drivers of complexity cost, but a broader view with less detail is more important than deep-diving into any one area. Do enough to develop a battle strategy, and constantly ask yourself, What do I need to know to move forward on this? In our experience, it is possible to quickly develop hypotheses as to the drivers of complexity cost, which can then be validated, and this is a much faster approach than an exhaustive, bottom-up approach.

As an example of what we mean by 80/20 thinking, consider how companies approach the issue of accurate costing. For many companies, getting an accurate view of complexity costs often gets lost between two extremes: launching an all-out activity-based costing effort or doing nothing. We’d recommend a different path: make the 20 percent of adjustments that provide 80 percent of the answer. Understand where the big chunks of cost are and how they should be allocated to get you to a more accurate view of costing without being bound to a full activity-based costing (ABC) effort. Also leverage key rules of thumb. For example, consider how, all else being equal, the ratio of inventory costs between two products is proportional to the square root of the ratio of their demand. This rule of thumb is nearly as easy to apply as the peanut butter approach (where inventory costs are spread evenly across products on a per-unit or percentage-of-cost basis) but provides a significantly better estimate of actual cost by product.

It is our assertion that tackling complexity remains one of the biggest opportunities for the CEO in 2010. We do not suggest that complexity can and should be tackled only through huge, transformation-like efforts. But neither do you want to fritter your time, energy, and resources on attacking individual symptoms. In Waging War on Complexity Costs, we describe how it’s possible to take targeted actions to achieve both financial and performance benefits and create virtuous cycles of improvement. The key is to structure the effort in a way that will allow you to make substantive improvements at a rapid pace while avoiding the trap of diluting your efforts. Behind this is the philosophical acknowledgement that waging the war on complexity costs (as we describe it) can be difficult but will be ultimately rewarding, and that this is vastly superior to a path that is easy but futile. There are no silver bullets, but there are actions of high leverage. 


Stephen A. Wilson and Andrei Perumal are managing directors of management consultancy Wilson Perumal & Co. and are co-authors of “Waging War on Complexity Costs” (McGraw-Hill).Wilson is also coauthor of “Conquering Complexity in Your Business” and Perumal is a former officer in the U.S. Navy’s nuclear power program.