129-Spread Fixed Cost Activities Over More Sales Volume to Reduce Costs

Corporations have just completed the latest quarterly profit reports for publicly traded companies. Two-thirds of the publicly traded companies beat their forecast profits. Many of these companies failed to reach their forecast revenue numbers, but still reached their profit targets, or better, by reducing their costs. Since there is so much focus on the power of cost reduction in today’s margin environment, I thought it would be interesting to review the ways that a company can reduce its unit costs. To make it more interesting, I decided to use stories that I have seen over the last week in order to illustrate these techniques.

In our StrategyStreet system, there are four major approaches to reducing a product’s unit cost:

1. Reduce the rate of cost for an Input used to produce the product (the Output). An Input is an employee, a purchase or a capital outlay.
2. Reduce the Inputs not producing Output.
3. Redesign products or processes to reduce activities, thereby reducing the Inputs the activities require.
4. Use fixed cost activities with more product Output.

Some activities of the company have a fixed cost. A product design, for example, is a fixed cost of producing the final product. If the company can increase the units of product sold using that design, it reduces its effective unit cost.

Google dominates the search business. Its market share is 65% of the market and its share is steady. Microsoft has recently introduced its new search product, called Bing. This product holds 8% of the market and is gaining a bit of share. Its share gains are coming largely at the expense of the second ranked company in the search business, Yahoo. Yahoo has about 20% of the market and its share is declining.

Recently, Microsoft announced that it had reached a deal with Yahoo that would combine the Microsoft and Yahoo search businesses. This deal involves revenue sharing from advertising sales. Neither company will exchange significant upfront payments. Microsoft’s Bing becomes the search engine for Yahoo. This deal allows Microsoft to create powerful new leverage for the fixed cost of its Bing search product. Yahoo has two and a half times its search volume and Microsoft will pick up new sales volume with no addition to its currently fixed costs. There are other revenue and cost benefits from this combination as well, but this is a good example of a company finding new customer volume over which to spread its fixed costs.

The cell phone business is slowing in its growth. The reason: market penetration. Cell phone competitors have penetrated more than 80% of the U.S. market, so most new users coming into the market do so by way of the prepaid plans offered by several companies.

In another recent example, Sprint Nextel announced it will buy Virgin Mobile USA. This acquisition will make Sprint Nextel the number two seller of prepaid cell phone services in the country. The acquisition of Virgin Mobile’s 5.2 million customers will bring Sprint’s total paid prepaid subscriber numbers to 9.5 million customers. The industry leader, TracPhone, has 12.5 million U.S. subscribers.

Over the years of studying various approaches to cost reduction, we have found that a company can increase the product Output over which it spreads its fixed cost of activities:

• Acquiring a similar organization to spread fixed costs. This is an acquisition of another organization with a similar business.

• Using fixed cost activities with more customers. This approach uses fixed costs with competitors who employ outsourcing as well as combining fixed costs with competitors into separate businesses.

Over the years we have gathered these cost-saving techniques in order to use them in brainstorming examples. The examples help you cover all the bases. Over the course of many years of doing cost reduction work, I have failed to look at several techniques that might have been useful in the situation I was studying because I did not have these examples as thought starters and reminders. We have gathered these techniques help you be more comprehensive in your cost reduction efforts. You may see all these cost reduction concepts and their examples by visiting the Improve/Cost/Brainstorming Ideas section of StrategyStreet.

Posted 8/17/09

Update:

Acquisitions can be a very effective low-cost source of new customers. See HERE for an explanation. However, here is an important caveat: size alone will not usually produce a low-cost competitor. See HERE for an explanation. Even cost reduction is a competitive undertaking.
8/22

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