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How Much Does Nthrive Denials Management Solution Cost

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Few truisms apply universally in the business world, but four related ones are valid in every business situation.

1. Over the long term, it is absolutely essential to be a lower cost supplier.

2. To stay competitive, inflation-adjusted costs of producing and supplying any product or service must continuously trend downward.

3. The true cost and profit picture for each product, for each product/market segment, and for all key customers must always be known, and traditional accounting practices must not obscure them.

4. A business must concentrate on cash flow and balance-sheet strengths as much as on profits.

These truths are more important than ever because there is increasingly less margin for error in our increasingly more competitive global business environment.

The Lower Cost Supplier

No company, whether industrial, high-tech, or service, can succeed over the long term unless it is a lower cost supplier than all others providing equivalent products or services. Short-term survival might be possible but not long-term success. Proprietary advantage never lasts. Maturity and decline come to products and businesses as they do to life, and prices and margins inevitably succumb to pressures. As competitive product distinctions fade, price becomes increasingly important in buying decisions. The more effective suppliers will constantly improve productivity and reduce costs. Thus, even when price pressures get intense, margins will at least be maintained. When this is not done, profits and market position almost certainly fall. Summarizing retrospectively, Paul Allaire, president of Xerox, told a reporter in 1988, "Until the mid-1970s, we were the undisputed copier king. (Finally) we realized the Japanese were selling quality products for what it cost us to make them. We learned the hard way how quickly our competition can turn market supremacy into market oblivion."

Being a lower cost supplier doesn't necessarily mean being lowest cost among all competitors. Nor does it mean that you can't or shouldn't have a strategy of producing at a higher cost and selling at a higher price. But it does mean that one's total costs should be well below the average of all competitors offering equivalent products or services to the same customer segments.

Costs don't mean just production costs. Overhead or other costs like designing, selling, delivering, or servicing can throw the total cost structure out of line. These tend to overaccumulate in good times when there's no pressure for tight performance and common sense.

Inflation is another enemy of sense and effectiveness. In the late 1970s and early 1980s, it provided a cushion that allowed companies to avoid addressing their costs properly. It was easy to raise prices when costs went up, because demand was bullish and often exceeded supplier capacity. Situations like this lead to indiscipline. The health care industry is a good example. For 20 years, it was a cost-plus reimbursement industry where prices were allowed to ride up with unmanaged costs. When third-party payers (government and insurance companies) and then employers finally came to their senses, a lot of health care providers that had let costs go uncontrolled got into trouble. Abbott Laboratories escaped that fate. In an interview last year, its longtime Chairman and CEO Robert Schoellhorn, decreed.

"To simply raise prices along with the industry is not the Abbott way. Our overall corporate measure of productivity is sales per employee. Price increases don't get factored in. Paying close attention to such things as head count becomes second nature. You must develop an attitude throughout the company that you can always find a better and lower cost way to do things. Our constant effort to lower unit costs also makes more money available for new products and for price-cutting assaults. They help keep old competitors at bay and new ones away."

Logic suggests that, over time, the real, inflation-adjusted costs of doing business should be downward—because as organizations learn how to do things better, they also get more efficient. This is the underlying principle of the experience curve, and it really works: from 1981 to 1989, the computer hardware cost of processing a million instructions per second dropped 76% for mainframes, 86% for minicomputers, and 93% for PCs. In color-film processing, a 3"x5" print fell from 50 cents for 5-day service in 1970 to 20 cents for 1-day service in 1984. In the manufacturing of power hand tools, the cost fell 29% with each doubling of output between 1965 to 1984. And in the low-value-added category of broken and crushed limestone, costs fell about 25% over the 30-year period ending in 1973.

But these continual cost reductions did not come automatically with experience or the passage of time. They required constant management attentiveness in all matters to continuing productivity gains and cost reductions. Too often products and costs drift out of competitive line, and no one realizes it until it is too late. Managers who claim that they are a lower or even the lowest cost producer rarely know what their true costs are or how they compare with competitors'. Even when there is clear evidence that competitors are selling at a lower price, many managers will deny any kind of a cost disadvantage. Instead they will say that their competitors are "stupid" or "aren't as concerned about profits as we are."

To know exactly what your costs are and to manage them well, you must carefully isolate various costs and assign them to specific products, accounts, or markets. Such assignments are often done badly. The most common mistake is to work on the basis of "average" costs, as if all costs were equally shared by all products and customers. Average costing ignores important differences among products and the fact that different products, different markets, and different customers incur different overhead costs. The broader the product line, the more distortions result from cost averaging, which nearly always leads to "average" price increases or decreases. In average pricing, some products or customers are overcharged while others are subsidized. Across-the-board price changes ignore true product-line cost differences and differences in customer price sensitivities. Average costing that results in average price changes can lead to a loss of profit, reduced volume, declining market share, and the dulling of management spirit.

What All This Means

No company can be successful over time if inflation-adjusted total costs do not follow a steadily declining pattern.

Management must place unrelenting pressure on the entire organization for measurable cost reductions and productivity gains, year after year. The rate of improvement may vary annually but should never fall below inflation. Vigilance is critical because it is so difficult to regain cost competitiveness once it has been lost. Costs should not be allowed to get out of line in the first place.

Companies should add large increments of capacity grudgingly, especially as the business matures, but even in growing businesses. In today's fast-moving world, life cycles are shorter and payback cycles must be shorter. Furthermore, companies should evaluate capital appropriations against profits from the least profitable part of the business, since they can always drop the less profitable parts or not make the contemplated addition or both.

If your costs have become noncompetitive, then probably traditional expense reductions alone—cutting back here and there, reducing overhead, saving on travel—won't do the job. Even deep cuts along the way generally won't do. You need to think in a different way—to eliminate big chunks of structured cost, to design cost out of the product and system, and to greatly improve efficiencies everywhere.

Understanding Costs and Profits

An important reason companies get their costs out of phase with their competitors' is that they don't usually know what their true costs are. To ascertain costs, you must be able to answer accurately the following questions for each important product, market, or account:

1. What are the directly attributable and fully allocated costs for each major product line, from procurement to customer delivery, including postsale service and warranties?

2. What is the present break-even point, how does it relate to capacity, and how much can volume be increased before it will have to move up?

3. What is the incremental cost and profit on each unit that is produced and sold over the current break-even point?

4. How do costs change with changes in volume? What costs are inescapable if volume declines?

5. How do the current cost structure, capacity utilization, and historical cost trends compare with those of competitors? What cost advantages or disadvantages exist?

Most managers, and particularly those in multiproduct-line businesses, routinely make critical decisions without these facts. Managers in rapidly growing businesses are especially uninformed. Both are vulnerable to serious troubles.

Consider a manufacturer of plastic injection-molding machines with a 20-year record of successful growth and profits. The company generated reasonable profits during down cycles by reducing the work force and bringing back into its plant a lot of work that had been subcontracted out in good times. To improve margins, management invested heavily in automated equipment and decided to reduce subcontracting greatly. Projected returns were very attractive. But in the next downturn in capital spending, losses accumulated for the first time in 20 years. The investment in automated equipment had raised the fixed costs and the break-even point significantly. The latitude to reduce costs by eliminating direct labor hours and subcontract work no longer existed. No one had raised this point when the company had evaluated the new equipment.

Revisiting Accounting 101

Most managers agree that it is important to understand the costs and profits of their businesses, though often they don't know what that really means. Those who do know are often frustrated because their information systems do not present the data to develop this understanding, and they don't know what to do about it.

To resolve this problem, let's go back to basic accounting principles. In the table "Common Cost/Profit Ranges," we have added target ranges for the key cost/profit components of one kind of manufacturing operation and created a framework for developing an initial understanding of cost/profit structures and requirements. The ranges would be quite different for a process industry because of the much higher plant and equipment investment with the consequent greater pressure for high-capacity utilization. The opposite is true of most service businesses with lower investments and fixed costs.

Exhibit Common Cost/Profit Ranges

The framework in the table is designed to yield a sustainable 15% to 20% pretax profit on sales, a 30% to 40% pretax return on assets employed, and a somewhat higher return on equity, depending on the amount of debt leverage in the capital structure. These profit returns must be achieved in order to be a truly outstanding profit performer. Operating consistently within this framework requires the following.

1. Manufacturing operations must generate a gross margin (after all manufacturing costs, including variances) of at least 35% to 40% (and in many cases, much higher) to cover research and development and market-development costs.

2. R&D activities for product and process technology obviously vary by industry but can range up to as high as 15% of sales, depending on the nature of the business and the stage in the product's life cycle.

3. Sales expense typically runs in the 5% to 10% range—lower if sales agents or distributors are used, higher in the early stages of market development.

4. General and administrative cost is usually in the 10% to 15% range and should include all the overhead costs of conducting the business, including interest (at least for working capital) and allocated division, group, or corporate overhead.

5. Total assets employed for plant and equipment and working capital should not run more than about 60 cents on each dollar of sales in a manufacturing company, with variations in the split between them, depending on the type of business.

A company can be profitable if its performance does not fall precisely into this framework. In fact, the ranges show that there will probably be significant differences in the percentage for any cost element, depending on the nature of the industry and its business strategy. Two numbers are crucial, however, to meet or exceed the profit targets shown. First is the gross margin, which is the profit-generating fuel for any business. No manufacturing business can continuously generate satisfactory profits if gross margins drop much below 40%. Even this margin rate is questionable unless it is clear that R&D and sales, general, and administrative (SG&A) requirements are near the low end of the ranges shown. There simply aren't enough margin dollars to cover the costs of doing business and still generate a 15% to 20% pretax profit. The business may be able to generate attractive profit margins if it can operate with less R&D and/or SG&A expense. Given the pace of technology, however, most manufacturing businesses cannot sustain product and market position while effectively managing and controlling the business with less cost in expense areas. Pursuing a "copier" or "follower" strategy means R&D expense is probably on the low end of the range, but that doesn't mean that it is zero or that SG&A is necessarily less.

The 60% of sales allowed for total assets employed is also a key number. While this percentage again will vary widely, depending on the nature of the business, it is a reasonably good standard for most manufacturing companies. It is clear that the business must generate higher earnings than indicated in our framework in order to yield the desired return if the percentage of total assets to sales is higher. Conversely, the earnings could be much lower and still yield a satisfactory return if the assets were lower, as they are, for example, in many distributor or service businesses.

None of this should come as a surprise to anyone who has been involved in the business world. But it is surprising to find so many managers who continue to struggle to improve profit results by building volume without focusing on basic problems in their cost/profit structure. The problems become readily apparent in this framework. While it is always nice to have more volume, the bottom line will not be helped much if the cost/profit structure is out of line.

The inescapable fact is that any industrial or high-tech company must have a cost/profit structure that makes sense in order to be an attractive profit contributor over the long term. It is essential to first determine what it should be for each particular business and then to make sure the business actually operates around this structure. For no amount of hard work or management brilliance will lead to outstanding profit returns if the business's basic cost/profit structure is not sound.

The Cycle of Decay

When profits decline or disappear, companies might tighten the belt in the wrong way in the wrong places. This can easily generate a self-feeding cycle of competitive decay. There is a natural tendency for managers to shortchange sales or market development, R&D, or forgo manufacturing improvements for the short term to make the business and profits look better.

The diagram "The Self-Feeding Cycle of Competitive Decay" shows how a viciously deteriorating cycle can work itself out into worsening conditions. The most common (and almost most hidden) thing that sets off such a cycle is management operating with the wrong type of data—that of accounting rather than that of control. Unfortunately, most data management uses are derived from accounting systems designed primarily to meet outside financial reporting requirements.

The Self-Feeding Cycle of Competitive Decay

In addition, these data present aggregate numbers for "large chunks" of business rather than costs or profits for a number of discrete product/market businesses. Even when the data present the cost and profit picture for individual product lines, they are often focused on gross or operating margins, not the true picture after all manufacturing, engineering, sales, and administrative overhead costs are taken into account. Finally, traditional accounting systems typically do not provide a clear picture of how costs and profits behave as unit volume moves up or down. Thus they are not particularly helpful to managers who must evaluate sales, marketing, and manufacturing alternatives that involve different levels of activity.

For these reasons, you should reorganize, reorder, and reformulate these financial data. This may mean extra effort, but it is not as difficult as it sounds. First, you must agree on a few commonsense cost definitions that provide the basis for categorizing all costs associated with each product or product-line business. The following cost categories can provide a definitive framework for any manager.

1. Bedrock Fixed. These costs are related to physical capacity and include plant and equipment costs such as depreciation, taxes, and facility maintenance that cannot be avoided unless the facility is sold or written off the books. These are the only true fixed costs. Typically, they are not as large a factor in the cost strucure of companies as you would think, though they become greater as companies automate.

2. Managed Fixed. These costs are largely related to people and structure—the so-called "overhead" of management, accounting, finance—and even activities like advertising, sales, R&D, or market development. All tend to build up as a business grows. Once in place, managers often treat them as integral and bedrock fixed costs. They are not. You can and should manage them. Understanding their makeup is important to keeping them under control and distinguishing them from the overhead costs that organizations share.

3. Direct Variable Costs. These costs rise or fall directly in proportion to the business volume. They are easily identified and can be traced back to the specific units produced or services rendered where, again, they can be better examined and managed.

4. Shared Costs. These are all the other costs incurred to support the business that are not readily traceable to any one product or line or activity. They normally include overhead of the corporation, division, and/or plant, as well as selling and general and administrative expenses. They can also include operating costs for plant and equipment. All are manageable.

Agreeing on these cost definitions is the first step. The second step is assigning the various operating costs to these classifications. In most businesses, few costs are either absolutely fixed or variable. Most costs lie in the vast area of managed costs shown in the accompanying table "Most Costs Are Manageable."

Exhibit Most Costs are Manageable—Few Are Fixed or Variable

Make no mistake, costs in the managed category are not fixed, even though they are commonly bundled under this label. Generally, as a business expands, costs tend to be far more variable than they should be, and when it contracts, they are far more fixed than they should be.

Once there is agreement on these cost categories and definitions, the next step is getting help from the accounting or controller's department to determine how to divide and assign to specific product/market businesses the costs incurred in each of these categories. This is not easily done. Many accountants are reluctant to divide fixed costs into these categories or to allocate shared costs to specific product areas, because it is impossible to do this with the precision that accounting professionals normally use to develop traditional financial statements. There is a natural aversion to shifting numbers around in any imprecise manner. There is simply no way, however, to know how well or how badly a product or product line is doing without getting these cost data clear—without knowing which are bedrock fixed, managed fixed, direct variable, or shared and without allocating them to their various business units and product lines. At the divisional or business unit level, cross-functional teams of all the department heads and the general manager should be responsible for hammering out the allocations according to the actual activity levels of each cost category.

In many cases, general management must ensure that the data are reordered along the lines necessary for intelligent product/market management. Shared costs are a particularly difficult problem for most companies and difficult to attack as a lump. You must break them down and assign them to discrete business units or product lines, even if it means being "arbitrary" by some standard. Managers with hands-on profit responsibility will argue about the fairness of the allocations. But it is critical to take a stand lest discussions get endless, acrimonious, and fruitless. There is no other way. Allocating all costs is the only way to know what is really going on.

The table "Full Costing Changes the Profit Picture" shows the result of changing to full-cost allocations in the instrumentation division of a large corporation. When done, product groups traditionally regarded as the best profit producers were not as profitable as everyone thought, and some of the worst were actually near the best.

Exhibit Full Costing Changes the Profit Picture (in millions of dollars)

The instrumentation division overall had a reported gross margin of 45.6% and a generated 11% pretax profit of $30.1 million. Sales and gross margins were reported by product line, but pretax profit was reported only for the division overall. Reported gross margins for the product groups varied from a high of 54% to a low of 40%. Fully loading all producing lines with their real costs resulted in adjusted gross margins that varied between 38.1% and 15.9%. Because of their relatively lower reported gross margins, standard products D and E (at 41% and 40% respectively) had often taken a backseat when the company assigned sales, manufacturing, and engineering priorities. When it analyzed and allocated plant, engineering, and SG&A overheads according to actual need or usage, it was clear that the standard products were being penalized by standard formulas that distributed these overheads according to sales volume. Adjusted gross margin percentages for standard products D and E improved their relative pretax profit performance dramatically; gross margins on custom-engineered products A, B, and C declined by several percentage points once appropriate overhead costs were allocated against them.

Looked at in another way, products D and E contributed less than half (48.6%) of reported gross-margin dollars but almost two-thirds (63.1%) of pretax-profit dollars after all costs were allocated. It is obvious that the way that management assigns its sales, manufacturing, and engineering priorities can change drastically once the actual cost-profit pictures become clear.

Net profitability statements also help bring management pressure on big chunks of overhead or shared costs (for example, SG&A, engineering, manufacturing, and corporate overheads) that are otherwise difficult to evaluate and control. When companies allocate these costs to specific products or profit centers, they show up as a charge against earnings, and managers responsible for profits carefully scrutinize and challenge them. This can be a powerful force toward reducing and getting large chunks of overhead costs under control that would otherwise never be scrutinized by someone with a direct profit responsibility.

Strategic and Daily Considerations

Selecting Product/Market Segments. Knowing the true cost and profit structure for product groups is also an immense help in selecting products, markets, and customers for emphasis. Remarkably few managers consider profit potentials when they assess and select product/market segments. They more often focus on sales potential—with the assumption that profits will follow. Managers can justify this in a company's or a product's early stages but never later. When the fight for share in a stable or slow-growth or declining market intensifies, managers must specialize in what's more profitable rather than in what's bigger.

Companywide Cost-Profit Awareness. Once costs are known and detailed for product lines, markets, and key customers, you should share detailed cost and profit information with many people in the business unit. If top and general management confine the known cost-profit facts to a select few who "need to know" them, fewer people will feel committed to cost management.

William LaMothe, chairman and CEO of Kellogg, the $4 billion ready-to-eat-cereal manufacturer, said in an interview, "At Kellogg's, we all focus on details, and cost details are a big part of that. By being geared to saving pennies on everything we do, that turns into a lot of dollars when you're dealing with the volumes we move. Hand-in-hand with driving unit costs down is the need for leading-edge production technology and an obsession about quality. As a result, we can produce a box of cereal at a lower unit cost than anyone else in the world. We have many teams of production workers that are responsible for keeping quality up and keeping costs down… We have a very disciplined approach to costs across and up and down the organization. We spend a lot of time talking about costs, because cereal is the only business we have. The drumbeat is that we will remain a lower cost supplier. Kellogg's has earned a ten-year average EPS growth of 12.5% and a ten-year average return on capital of 26% and our return on equity for the same period is approximately 40%."

Managing Cash and Liquidity. Finally, there is the matter of cash. Cash returns can be more important than reported profits. Cash returns lead to liquidity, and liquidity is a top priority whenever there are high risks and great uncertainties. Cash and liquidity help withstand surprises, facilitate adaptation to sudden changes, and can help you capitalize on the narrower windows of opportunity that are common in a turbulent environment.

Any entrepreneur who has lived through a startup and built a market position knows the importance of cash and liquidity. A business can go bankrupt while reporting profits. But it will never go bankrupt as long as its cash and liquidity positions are strong. Most senior corporate executives understand this, but many do not make sure it is sufficiently stressed or understood at the operating level.

The results are apparent in most corporations. Capital expenditure proposals tend to be "wish lists" justified on projected volume gains or cost savings without regard to the availability of funds or to cash-carrying costs. Working capital is allowed to build without adequate regard for its carrying costs. Over-investment in plant, equipment, and working capital often disguises sloppy business practices and control. These are practices that inevitably lead to a bloated investment base—too big for the business and too marginal for profits.

Many operating managers are unaware of the costs of excessive capital tie-ups. For example, most of them will acknowledge that it costs money to carry their inventory—these days, usually 8% or 9%. But few know that total carrying costs should include storage, taxes, obsolescence, and shrinkage, and that total costs (including interest) actually run closer to 30%. The reason that so few managers know this is that the costs of working capital are not charged against their earnings, even though they are real costs of doing business.

A manager who makes pricing, capital investment, personnel, and even strategic and/or tactical decisions without this product/market cost information—and then does not create a companywide discipline to manage costs—will face unpleasant surprises and serious questions of survival as the competitive world gets increasingly turbulent.

Cash management deserves far greater attention than it gets in most companies. Management must put more emphasis on, and be held accountable for, managing liquidity. Planning and reporting systems should be modified to highlight actual cash flow and liquidity against objectives. Finally, the reward system should be adjusted to pay those who meet cash objectives and penalize those who don't.

None of these actions are difficult if senior management has the will and as long as the accounting system is set up to do so. They can be impossible, however, if the accounting systems are designed around big divisions of business rather than around discrete product/market segments and if big chunks of structured or managed fixed costs are not divided and allocated to these smaller business units.

Ideally, every manager should think like a small-business entrepreneur whose own money is at risk and who has little of it at hand. If managers did this, we would see fewer companies with bloated balance sheets and marginal returns and see lots more that thrive efficiently.

A version of this article appeared in the January–February 1990 issue of Harvard Business Review.

How Much Does Nthrive Denials Management Solution Cost

Source: https://hbr.org/1990/01/vital-truths-about-managing-your-costs