Part 2: Measuring Current Economies of Scale
CREATING COUNTABLE MEASURES OF PRODUCTIVITY
Capsule: The Company's functional cost organizations produce parts of the final Output. These parts are the Intermediate Cost Drivers of the final Output. The ideal Productivity cost tracking system would establish a direct relationship between the Building Block costs in each functional cost area through the Intermediate Cost Drivers to the final Output.
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The Company and each of its functional cost organizations exist solely to provide benefits to the customer. Any measurement of countable costs in an organization must start from the basis of the benefits the organization must deliver to the customer. Each functional cost organization contributes something to the final Output for the customers. These contributions are Intermediate Cost Drivers (ICDs), specific outputs produced by the functional cost department in support of the final Output for the customer. The functional cost departments use the units of Input Building Block Costs to produce the Intermediate Cost Drivers.
In the previous section, the Company counted the units of Input Building Block costs (i.e., People, Purchases and Capital) managed by each of the organization’s functional cost departments. This work sets up the creation of a direct relationship between the units of Building Block costs and the Intermediate Cost Drivers of each functional cost department.
Our objective in this section is to create links between physical measures of Inputs, Intermediate Cost Drivers and Outputs. Once we have physical ties between the Outputs for customers and the Intermediate Cost Drivers and their Input Building Block Costs, we can measure and control the rate at which Input Building Block Costs and Intermediate Cost Drivers grow as the Output grows.
Accordingly, this section of the diagnostic has four steps. First, quantify the customer benefits for which the functional cost department has responsibility. Second, count the Intermediate Cost Drivers that the functional cost department produces. Third, establish the quantitative relationships between the department’s Building Block costs and its Intermediate Cost Drivers. Fourth, establish the quantitative relationships between the department’s Intermediate Cost Drivers and the Company’s final Outputs. We discuss each of these steps in turn.
Step One: Quantifying Customer Benefits
The Company should not approach cost management without first considering the benefits that it, through its functional cost departments, must provide the customer. If the Company reduces costs at the customer’s expense, by ignoring what competition offers the customer, the customer will deem the Company to have failed it and leave the Company for a better supplier. This is a self-defeating cost reduction that causes many companies to struggle in Hostile markets.
Every cost department exists to serve the customer. The Company spends money with the department in order to provide the customer with specific benefits. These benefits must be as good as, or better than, those of the competition. The Company uses the work it did in Diagnose/Segments and Diagnose/Products and Services to describe the specific benefit targets planned for the customer. Examples of these targets might include numbers of marketing messages, speed of order entry, days from order to delivery, percent on-time delivery, level of backlogs, mean times-between-failure for products, customer service calls, and so forth.
Each benefit needs a quantified target performance level that the Company has determined it must reach in order to avoid Negative Volatility and to gain share with Positive Volatility. The Company quantifies the targets in order to measure its progress in reaching them. These target performance levels apply throughout the Company’s functional cost organizations.
Each department, then, uses the Company’s specific benefit targets to quantify its own contribution to these targets. For example, If the Company must deliver its products within one week of order, the order entry functional cost organization may need to ensure that all orders received are entered into the Company’s system within four hours of the order. The order entry functional cost department then has a quantified performance target to enter all orders within this specified time.
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Intermediate Cost Driver Questions |
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Step Two: Counting the Intermediate Cost Drivers
Counting the Intermediate Cost Drivers of the functional cost organization names and measures the Intermediate Cost Drivers that deliver the department’s customer benefits.
An Intermediate Cost Driver (ICD), is a countable entity or activity, such as the entry of an order, that adds value to the final Output. Examples of ICDs would include complaints handled by customer service, subassemblies produced in manufacturing, inquiries received and handled by the sales department and customer calls made by salesmen. These ICDs are the activities or products of the functional cost organization. The treasury functional cost organization may produce investments in marketable securities as Intermediate Cost Drivers. The marketing department may produce lines of media purchased to advertise the product as one of its Intermediate Cost Drivers. These activities of the functional cost organization contribute to the value and cost of the final Output of the Company.
Examples of Intermediate Cost Drivers >>
In order for these Intermediate Cost Drivers to be helpful in improving Productivity and Economies of Scale, the Company must be able to count them accurately on an annual basis. Each cost organization names and develops an annual count of the important Intermediate Cost Drivers it produces. An accurate count of the Intermediate Cost Drivers enables the Company to establish baseline measures for a key component of Productivity in each functional cost organization.
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Step Three: Quantifying Ties Between Building Block Costs and Intermediate Cost Drivers
Next, the cost department and its subordinate organizational units create a quantifiable relationship between the Building Block costs and the Intermediate Cost Drivers. For the remainder of this diagnostic section, we will concentrate on the Input People costs of the Building Block costs. In most companies, these are the most important costs to measure and control. The Company may use similar approaches when it extends the measurement project to Purchases and Capital.
Once the Company has a count, in FTEs, of its employees in each department and subordinate organizational unit, it could measure the Productivity of the department quite simply by measuring the Input, that is FTEs, divided by the Output. We discuss this measure more fully in the next section of this diagnostic. However, as we have seen above, the departmental People do not produce the Output directly. Rather, they produce Intermediate Cost Drivers. In turn, the Intermediate Cost Drivers produce the Output.
To quantify the ties between People and Intermediate Cost Drivers, the Company must assign its FTEs to the ICDs. The department assigns each FTE’s annual work time to an Intermediate Cost Driver. For example, an employee might spend 20% of his time on Intermediate Cost Driver 1, 35% on Intermediate Cost Driver 2, and 45% on Intermediate Cost Driver 3. Doing the same analysis for the remainder of the organization will create a Full Time Equivalent (FTE) number of people for each Intermediate Cost Driver.
The Company should extend this analysis to cover the FTE activities of the Think Employees, Supervise Employees and Do Employees as well.
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More Intermediate Cost Driver Questions |
What is the relationship between the FTEs of Think, Supervise and Do employees to the ICDs produced in each functional cost organization? |
Step Four: Establish the Quantitative Relationships Between the Department’s Intermediate Cost Drivers and the Company’s Final Output
The Company may assume that the Intermediate Cost Drivers are unique to a functional cost organization, or its subordinate organizational unit. They need not be counted outside that unit. For example, more than one functional cost department might work on a customer complaint, but the work and ICDs done inside one department is a separate ICD from that done in another department. The final Output counts are the same for all functional cost departments.
In this diagnostic step, the Company calculates the ratio of the number of each unique ICD per unit of Output. There usually are several unique ICDs in each functional cost department. The quantification counts the number of each unique ICD undertaken within that department and divides it by the number of units of final Output.
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At the conclusion of this step, the Company, and each of its functional cost organizational units, has the ability to calculate its current Productivity and the components of Productivity, which we discuss next.
Basic Strategy Guide Users Return to Step 27
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| Summary Points | Next: Components of Productivity |