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Weekly UpdatesEXECUTIVE SUMMARY
Improving operating margins and cash flow is on the minds of most managers, yet the tools and language used to meet these goals are constraining, resulting in billions of dollars spent without promised returns. Capacity mapping allows companies to see exactly how processes perform and provides much more precise margin-related data, The impact? Dramatically increased ability improves margins resulting from a clear understanding of capacity and cost dynamics.
Cost reduction and margin improvement are simple notions that for many companies are difficult to execute.
Consider Oracle, which in 1999, announced that it would use its own software solutions to save $1 billion. Saving a billion dollars is non-specific. What does it mean? A quick review of Oracle's financial statements shows that its operating expenses increased each year from 1999 to 2001. By its own admission, "Excluding the effect of currency rate fluctuations, total operating expenses increased 4 percent and 3 percent in fiscal 2001 and 2000 over the corresponding prior year periods, respectively." The company stated in its 10-K report to the U.S. Securities and Exchange Commission that "Operating expenses were favorably affected during fiscal 2001, 2000, and 1999 as a result of the U.S. dollar strengthening against certain major international currencies." It also mentions that costs for services (its largest operating expense item) were managed via "controls over headcount and headcount-related expenditures in the support, consulting, and education lines of business." In 1999, the sales, general, and administrative (SGA) cost was $426 million; in 2000, it was $481 million. So not only was there not $1 billion to save in SGA, but those costs increased by $55 million. Although Oracle's operating income increased annually, it was not a result of the IT project.
There are three problems the typical manager often runs into when trying to reduce costs, increase cash flow, improve margins, or save money:
* The relationship between cost reduction and cash flow is not as it should be.
* Techniques used to calculate the improvement are often flawed.
* The rhetoric used is ambiguous. Let's look at these in some detail.
Cost reduction vs. cash flow.
The relationship between cost reduction, profit, and cash flow is not simple to understand when looking only at income statements. For individuals, the cash that they have at the end of a given month is determined by the cash at the beginning of the month with income added and expenses subtracted. This is not the case with income statements. A manufacturing company spends cash to build inventory that often ends up on the balance sheet. Only when the inventory is sold does it hit the income statement as the cost of sales. The cash spent to create inventory may be long gone by the time the company calculates its profit.
Flawed techniques and assumptions. The techniques used are sometimes incorrect because of flawed math or assumptions. Oracle identified a sales force productivity savings of between 10 percent and 20 percent. Sales increased from SOB billion to $10.1 billion, which falls within the identified range, but what is not clear is how the savings value was calculated. Sales increases are not savings. Sales and marketing costs decreased from $2.622 billion to $2.617 billion for a savings of $5 million. The net impact when combined with SGA costs was an increase of $50 million. It is easy to suggest that increasing the productivity of $3 billion of resources by 10 percent would yield savings of $300 million, but is it correct to say so? And what relevance does the number have?
Confusing rhetoric. When Oracle spoke of savings, what exactly did it mean? The chairman of the board suggested that "These initiatives have translated ... into hundreds of millions of dollars of lower annual cost ... ." The numbers on the 10-K report clearly show that costs increased.
Some suggest that there are hard and soft savings, but what relevance and impact does softly saving $1 billion have? The term cost is so ambiguous that it is used almost indiscriminately to mean expense, a calculated value based on expense, or even as revenue. One manager of a manufacturing facility pointed out a productivity increase as a cost saving. When pressed, he agreed that his expenses had not gone down and that the result was increased output. He somehow concluded that the increased sales potential was a cost savings. Worse is the tact that the company was in a demand-constrained market so there was no demand for the increased output. However, because the improved area was not a process constraint, there would be no increased output anyway.
The numbers and supporting statements suggest that Oracle did not reduce operating expenses by $1 billion in areas affected by its solutions. However, it was able to improve operating margins by more than $1 billion from 1999 to 2000 by increasing sales at a faster rate than operating expenses and by realizing the benefit of positive currency fluctuations. In other words, its operating profits increased because it achieved more output (sales) given the input (costs) on a relative basis by decreasing the slope of its cost curve. This is the source of its "savings," and some of this could have been enabled (but not caused) by its solutions.
The same phenomenon exists with Delta Airlines' discount subsidiary, Song. Delta claimed when it announced Song that its costs would go down due to increased flight frequency But how is Delta spending less money making more flights? The improvements lead to generating revenue at a faster rate than costs increase. If Song can make six trips ill one day rather than flour, the labor costs for the day are going to be similar and the fuel costs increase, suggesting an overall cost increase. The benefit comes from the revenues created by the two extra flights in a day and not from cost reductions.
Many of the costs that most companies address when looking to improve profit and cash flow are capacity costs: space, labor, equipment, information technology,, and materials. Oracle merged data centers, which likely meant that it could reduce space, Labor, and IT capacity costs. It merged databases, which suggests that perhaps there was excess IT capacity that could be targeted for elimination. It claims to have reduced the cost of expense transactions and the cost for each Web support request. Such improvements, although incorrectly considered cost reductions, often result from the automation of operations and processes, which suggest one or both of two things: First, there is less labor capacity being consumed by the process (which is often believed to be a cost saving); second, the time required to process a report is less if controls are built into the software.
Capacity enables companies to perform work, and the cost of capacity represents a large percent of a company's operating expenses. Companies buy capacity, and the onus is on employees to get the desired output from the capacity. The lease price of an idle factory is no different than the same factory being used. The used factory has the ability to generate revenues to offset the cost of having the factory. This is an important distraction because when seeking to improve profits and cash flow, the proper aspects of capacity need to be understood and quantified. This is where capacity mapping becomes a valuable tool.
Capacity mapping
Capacity mapping helps identify the specific source of capacity-related improvements--whether operational or financial--by modeling operations and processes and then identifying the source and amount of capacity to provide a foundation of what can or should change. It also provides the capability to begin documenting the impact of changes to operations and processes so that it is clear what is to be changed, the impact of the change, and why the change was made. Unlike other tools, the approach is very simple, the language is unambiguous, and the impact created by changes is clear.
Two issues are important when using capacity mapping. First, there must be operating definitions of static capacity and dynamic capacity; which are the foundation for capacity mapping. Second, there needs to be a clear understanding of capacity costs. The flawed tools and assumptions about capacity costs take us away from what we instinctually understand, so we will go back to first principles to create a common level of understanding regarding capacity cost dynamics.
Static capacity is the input component of capacity: what the company buys, square feet of office space, hours of a person's time, or units of materials in inventory. Static capacity is the source of capacity costs and is therefore the target for cost reduction. Dynamic capacity is the output component of static capacity The work that a person hired for an eight-hour day can perform represents that individual's dynamic capacity. Note that what people are able to perform and what they do perform can and likely will be different and that the dynamic capacity of an individual may be different at different times. Finally, activities such as improving work methods, task automation, and job training may increase a person's dynamic capacity but will not automatically reduce static capacity or operating expenses.
Capacity costs are very simple to understand in the context of static and dynamic capacity. First, define a cost as money that leaves the organization. Budget transfers cost the company nothing: They affect the departments evolved. This is an important distinction. If a company provides a product or service only internally at a cost to a department that is higher than the department can purchase from the outside, it may be inclined to go outside the company for the service. This increases the company's costs because the company still must pay for the infrastructure that provides the product or service and will also pay the vendor. Second, consider the fundamental unit of static capacity that the company is purchasing. If a company pays an employee a salary of $50,000 per year, it is not paying the person $25 per hour: It is purchasing one year of work Because a salary can be divided by 2,000 working hours to calculate an hourly rate equivalent does not mean that it should be or that the resulting quotient has mathematical, operational, or even financial validity Working an extra two hours does not cost $50. if a company spends $250,000 on a warehouse with 10,000 square feet, the price is not $25 per square foot. Without such controls, it is easy to become confused when trying to document the cost impact of improvements. A process that consumes 5,000 of the 10,000 square feet will not save $03,500 by reducing its floor space by 50 percent. Similarly, attending a two-hour meeting is covered by the time purchased for the $50,000 salary. The time or space may be more efficiently used, but the static capacity is what it is--time and space. It is the responsibility of company managers to get the desired output given the purchase of the capacity, which has a fixed cost.
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