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July 28, 2005

Why performance evaluation must precede cost reduction

"Vision" and "Mission" intend to continuously guide organizations to a position and stance that is considered "optimal" for the business.

As defined by Princeton's Wordnet, optimal means "the most desirable possible under a restriction expressed or implied".

Certainly, companies consider "excessive costs" to be an expressed restriction -- but worse a restriction that actually represses desirable outcomes.

To understand how costs amount to a repression, cost must be seen in a variety of contexts.

Investments that create resources build capacity; capacity creates opportunity to respond, and response creates the differentiating impact measured as "value".

- But expenses that deplete resources or capacity or responsiveness risk altering the potential impact and can therefore erode or prevent value. (This might be expansions or alterations of property or systems that increase use by some but provoke inhibiting problems for most other users.)

- And excess capacity carries costs that are therefore unavailable as investments in other uses. (For example, consider funds that are allocated to maintaining systems that are not being used.)

- Likewise, expenses that intend yet fail to create capacity hold potential alternative investment hostage, decreasing opportunity to respond. (Here, think of projects that fail, or purchases that acquire the wrong thing.)

Since value is defined both by type and by level of impact, the question brought up by those circumstances above is this:

- Given the demonstrable use of current capacity, does the organization consider the value actually currently expected, which is the real value at stake, to be "the best possible position" ?

If the answer to that question is no, then what is the proper correction?
- Should managers concentrate on removing the risks to higher levels of that expected value?
- Or instead is there some other type of value (that is, some other differentiating impact) that should be installed as the target?

Although we can see that one of those choices should be taken, neither decision necessarily lowers costs!

Meanwhile, the only way to rationally answer either question requires that first we validate the currently targeted type of value as the correct type.

This brings up the issue of mission. A mission is simply a definition of an intent to produce a certain differentiating impact. If current capacity does not support a likelihood of succeeding at the mission, then the value promised by the mission is clearly at risk and potentially impossible.

When capacity mismatches mission, the only two corrective choices are to change the mission to fit the capacity or to increase the capacity.

The chief obstacle to those correctives is a contract or other formally binding agreement that does not allow adjustments without an additional expense that outweighs the related cost-benefit of making the adjustment.

Whether literal or metaphorical, the oneous "switching cost" can raise the cost of a capacity correction beyond practical acceptance, while leaving the capacity imbalance unresolved.

Further, in that way, the consumed-to-date portion of investment in the mismatched capacity becomes "sunk" cost, and the prevention of capacity reorganization increases the effective cost of some potential alternative opportunity (i.e., "opportunity cost").

Overall, what this means is that cutting costs is an action that actually needs to generate a return on investment greater than or equal to the amount of costs cut. Oversimplified, this says that a ten-dollar cost-cut needs to target a twenty-dollar gross benefit. Why? Because if the saved ten dollars is needed at all, it should become an investment working to earn its own way.

This "ROI of cost-reduction" will not materialize except through renegotiation of the agreements underlying the switching costs. Wherever the renegotiations don't offer stakeholders equivalent-or-better benefits compared to what they already have, the mission of the organization remains potentially compromised by stakeholder resistance.

This illustrates that change management is a prerequisite to the success of cost-reduction.

Then, to understand what must be changed and thereafter derive a cost strategy, stakeholder roles in the proposed new configuration of capacity must be mapped out such that their performance under the new agreements will logically produce a mission success suitable to replace the old (mismatched) mission results.

By comparing the proposed performance logic against the bases of current performance, change requirements emerge, and costs related to the changes surface, which allows adjustments of current costs to be made more rationally. Punchline: cost reduction is not an action: it is an effect.

Posted by Malcolm Ryder at July 28, 2005 11:34 AM

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