Nobody has saved their way to prosperity! Consequently, cost has meaning only in the context of a value producing initiative. We need to reduce the cost of undertaking this initiative to the least possible
Before we proceed, please note that we did not use the term “revenue,” when referring to the desired outcome of the business initiative. Instead, we used a more meaningful term “value.” Revenue is just one way to produce value. There are many others, equally, if not more, meaningful means of producing and delivering business value.
Cost is more valuable that revenues
Let us say, you had the option of creating one dollar of additional revenue or saving one dollar of cost, which would you prefer?
My recommendation is to go for the latter. Here is the math:
- For every dollar of revenue there is a cost. This varies from company to company and initiative to initiative but the fact remains that it is there.
- Let us assume that our margin is 20%, i.e. for every dollar of revenue we invest 80 cents in costs. For the sake of simplicity, let us also assume that this margin is constant i.e. no matter how much we produce our costs remain the same as a percentage. In other words, in our simple world, economies of scale do not exist.
- Now, let us assume, we were producing $10 of revenues. By definition, our cost is $8 and we are making $2 in profits.
- If we went for an additional dollar in revenues, this 11th dollar added 20 cents to our bottom line. Now, we are making $2.20 in profits on $11 in revenues and $8.80 in costs.
- However, had we chosen to reduce costs by $1 to $7 dollars, our profit would have been $3 ($10 of revenues; $7 of cost). We got $80 cents more to our bottom line.
- For those of you who are wondering what happened to the cost of reducing the cost
- One has to assume that it is going to be less than 80 cents required to increase revenues
- Even if it was 80 cents, it would be a one time cost and the long term impact of cost reduction would still be greater than the revenue increase
The example above is a powerful incentive for companies to reduce cost. However, one has to remember the caveat at the beginning of this section that the context for value from cost savings is the presence of value creating initiative. In other words, you cannot have a cost reduction of $8 dollars – our theoretical maximum in this example – and still produce $10 of revenues! There is a threshold cost that must be expended. As a matter of fact the 80/20 rule or the law of diminishing returns usually kicks in at or around that threshold – every incremental dollar of cost savings will come at an increasingly higher cost!
Factors driving cost
In business, cost – and, consequently cost reduction – lies along three areas:
Process optimization is the key to cost reduction
Process, is perhaps the most important area for cost reduction for it is where the cost is expended! At every step in the process, resources are consumed - the more the steps, the more this consumption.
So, if one wants to reduce costs, one has to optimize processes first. As a matter of fact, this is where 80% of the costs are reduced not in the application of IT to process automation. Consequently, process design must factor in the following:
- Eliminate waste: any step that is unnecessary, must be eliminated
- Reduce duplication: any duplicate step must be eliminated or consolidated
- Reduce rework: do it right the first time is the mantra to dramatically reduce costs.
Resource planning is the key to cost reduction
Resources are consumed by processes and hence are a factor in the cost equation. Often, one focuses on the unit cost of the resource, forgetting the other important factor: resource substitution.
Here are the parameters that drive resource cost:
- Unit cost: price per unit of the resource
- Resource substitution: using lower cost and readily available resources, one can reduce costs.
- Resource standardization: standardization drives economies of scale. It also has an impact on interoperability that lowers the cost of resource implementation and substitution
- Resource planning: this concept is analogous to ordering all your supplies at the same time to get volume discounts. But demand management is more complex and powerful that this simple example. Combined with effective inventory management this can be an even more powerful factor in reducing cost.
- Resource utilization: the goal is to have 100% utilization. However, practical considerations prevent the achievement of this goal. From server consolidation to network optimization, one can employ a variety of tricks to increase resource utilization.
- Resource life: same price but lasts longer is always better! That is why Total Cost of Ownership” or TCO is an important metric when it comes to resource selection.
As some of you might be wondering, isn’t time also a resource? Yes, it is but the reason for separating it is to clearly see its impact on cost.
First, the obvious: the longer a resource is used the most is the cost. To reduce costs, one must not only reduce the steps and optimize resource costs but also reduce the time they are applied.
Then, the not so obvious: the time value of money. By lowering the time to collect payments, one can increase revenues and overall value. Similarly, by reducing project implementation time, one can lower costs and increase revenues because they are realized faster.
If a project costs $8 and delivers $10 revenues, but takes 3 months to complete, it will cost less than $8, and create more than $10 in revenues if it completes in 2 months:
- Certain resource costs, such as labor, are only needed for the 2 months
- $10 in revenues applied to business for one additional month will create value. For your Internal Rate of Return is 12%, you have just made 1% on $10 by reducing implementation time by a month!
IT can help reduce costs
Capital in business is to be applied effectively i.e. to the most profitable things. It has to be applied efficiently. Doesn’t have to mean cost goes away; just means waste has gone away and now that money is available for other more productive uses.
Here are some ways in which IT can help pursue cost reduction for business value:
– Cost elimination: direct cost reduction through process, resource and time optimization
o Process optimization
o Demand management
o Inventory management
– Cost avoidance – not investing in things you would have had to
– Cost redirection – from more expensive transactions to lower cost ones
o Self service for customers
o Self service for employees
o Manual tasks to automated tasks
– Cost reduction
o Reducing inventory on hand
o Reducing paper statements
o Increasing economies of scale
Cost optimization is an important factor in delivering business value. One must remember the golden rules:
- Cost optimization is meaningful only in the context of a value creating initiative!
- Process optimization before technology automation
- Focus on the big picture not the most obvious or the easiest:
- Reducing costs by eliminating positions is both obvious and easy, not to mention fast - but might not be in the long term interests of the organization
- Pursuing outsourcing for cost reasons is both shallow and dangerous in the long term
Follow the Series:
- Part I: A Framework for IT Value
- Part II: A Framework for IT Value
In Part 1, we lay the foundation for a discussion on IT Value. This week, we look at specific areas where IT creates value.
- Part III: A Framework for IT Value
In Part 2, we focused on revenues. This week, we look at the costs in the IT value equation.
- Part IV: A Framework For IT Value
In Part 3, we discussed the cost dimension of IT Value. This week, we will discuss the time to market dimension.
- Part V: A Framework for IT Value
In Part 4, we discussed the time to market dimension of IT Value. This week, we will discuss the quality dimension.
- Part VI: A Framework for IT Value
In Part 5, we focused on quality and its impact on IT Value. This week, we will take a look at productivity and its impact on IT Value
- Part VII: A Framework for IT Value
In Part 6, we focused on productivity and its impact on IT Value. This week, we will take a look at customer satisfaction and its impact on IT Value
- Part VIII: A Framework for IT Value (Risk Dimension)
In Part 7, we discussed customer satisfaction. This week we will look at the risk dimension of IT Value.
Sourabh Hajela is a management consultant and trainer with over 20 years of experience creating shareholder value for his Fortune 50 clients. His consulting practice is focused on IT strategy, alignment and ROI. For more information, please visit http://www.startsmarts.com/.