| Building a Profit Culture
Introduction By Cynthea Kinnaman, Connect Press Editor
Enterprise Cost Management is a new category of enterprise-class software designed to help manufacturing organizations increase profit by driving costs out of their products prior to production, reducing Cost of Goods Sold.
According to aPriori founder and Chief Product Officer Eric Hiller, aPriori's Enterprise Cost Management software platform enables manufacturers to reduce product costs earlier in the development process with real-time cost assessments, significantly lowering the Cost of Goods Sold (COGS) and measurably improving overall financial results.
In the discrete product manufacturing industries, aPrior reports, COGS is always the largest expense on a company’s income statement (typically between 70% to 90% of revenue). With a COGS percentage this high and typical net profit margins being 3% to 8%, even a slight reduction in COGS provides a tremendous opportunity to improve the financial results of an organization. If aPriori is able to help companies reduce COGS by 1%, they can add 10% to 30% to the bottom line. There is no driver of net profit margins as powerful as Cost of Goods Sold, Hiller says.
Creating a Profit-Centric Business Culture looks at how an organization can grow and strengthen a profit-based culture, in which senior management sets the direction and priorities and C-level executives move from asking “Why is profit more important than all the other fires I am fighting?” to:
“I know that I am responsible for increasing profit by reducing product cost; what is the easiest and best way to meet this goal?”
Creating a Profit-Centric Business Culture
An aPrior Whitepaper
By Eric Hiller, Founder and Chief Product Officer, aPriori
Enterprise Cost Management is a new category of enterprise-class software designed to help manufacturing organizations increase profit by driving costs out of their products prior to production (reducing Cost of Goods Sold). With Enterprise Cost Management, companies can significantly improve quality and timeliness of their product cost assessments. Although many companies today lack adequate Enterprise Cost Management capabilities (which determines a firm's potential to generate more profit), a bigger problem is that firms do not have a corporate-wide focus on increasing overall profit. Without a strong profit 'culture' (the will and skill to generate more profit), organizations will fail to reach the potential that Enterprise Cost Management creates. This paper will discuss the foundations for creating a corporate-wide culture of profit.
Quality of Cost and a Profit-Centric Business Culture
As discussed in a previous whitepaper (download available at www.apriori.com), Quality of Cost is a measure of the quality of an organization's product cost numbers. It is also a measure of an organization's ability to generate precise, repeatable and relevant product cost assessments in real-time from design to production. Quality of Cost encompasses many ideas including accuracy, precision, reliability and understandability of the cost number generated by a cost system.
Figure 1 details the three primary drivers of Quality of Cost:
1. The quality of the data provided (for both the product being cost and the environment in which it is manufactured);
2. The fidelity and sophistication of process and cost models being used; and
3. The strength of the profit culture in a company.
The first two drivers (data quality and cost models) are functions of the sophistication of the Enterprise Cost Management (ECM) capabilities in place at the firm, which determines the potential the firm has to generate a quality cost number. The strength of firm's profit culture determines its ability (will and skill) to realize that potential - both in being able to generate a quality cost number and to use it to increase profit through reducing product costs. Let us define profit culture as:
Profit Culture - the relative importance of cost reduction efforts in a company versus other priorities, the level of awareness and focus of the organization on product cost, and the extent to which Enterprise Cost Management is built into the business process of the firm.
Figure 1. The Elements of Quality of Cost
The Theory of Profit Constraints
When implementing profit-increasing initiatives that are based on reducing product costs (in large part Cost of Goods Sold), many companies begin by trying to maximize their potential to improve profit. This is accomplished by improving the overall quality of their cost numbers, usually through Enterprise Cost Management capabilities. But even if an organization has the potential to generate a quality cost number, the overall culture of the organization will ultimately determine if the potential can be achieved. In most companies today, the sophistication of the profit culture lags behind the capabilities of creating a quality number. The possibilities for the combination of Enterprise Cost Management sophistication and profit culture are depicted in Figure 2.
Figure 2. Constrained versus free profit flow
The ability of the firm to generate more profit can be thought of as a pipe, in which the profit flow is restricted either by the potential to generate quality cost numbers for product cost reduction activities or by the will and skill of the firm to generate these numbers and to use them. With an Enterprise Cost Management system in place, the potential for the firm to generate profit is greatly increased. However, because the firm has not made profit an enterprise-wide priority, it cannot take full advantage of this increased potential. As a result, new profit realized is minimal. For every dollar the firm puts into cost reduction, it only realizes a small amount of additional profit.
The second scenario is less common, but can occur when a firm has everyone focused on reducing product costs to generate more profit, but does not have adequate capability to generate cost numbers that help them make the right decisions. Once again, for every dollar put into cost reduction efforts, only a small amount of profit is produced.
The third scenario is obviously the desirable situation, where a firm's desire and ability to generate more profit are grown simultaneously. In this case, for every dollar of effort invested to reduce product cost, multiple dollars of new profit are generated.
Figure 3 examines the potential and the ability to improve profit from another point of view. When a firm has little cost-generation sophistication and a weak profit culture, it will not generate much new profit, (and no one is really that concerned about the problem!). Not having the potential sounds plausible, but not caring about profit sounds absurd. Obviously, it is rare to find a firm that doesn't care about profit, at least the executive level. However, this situation is not uncommon within firms; there are often specific functions and many individuals in the firm that do not believe increasing profit is important or, at least, as important as other competing priorities. Other times, these functions believe profit is important, but to them, it is "somebody else's" responsibility.
Figure 3. The potential and ability to generate new profit
Companies in the bottom-right quadrant also suffer from weak profit culture, but in this case, the firm has invested in some level of Enterprise Cost Management capability. Therefore, some people in the firm who do realize how important profit is do have the potential to generate some level of improvement. However, with most of the organization not participating, the returns are isolated. The upper-left quadrant depicts organizations that are mobilized behind improving profit, but lack a modern cost management system in place make new profits a reality. In this case, efforts to identify cost reductions are manual and therefore tedious, inefficient and expensive to come by.
Finally, the upper right quadrant combines a capability cost management system with a strong profit culture where every person and function believes generating profit through product cost reduction is paramount. In this environment, new profit flows because every effort is multiplied by the cost management system, and there is a lot of effort throughout the company.
Creating a Strong Profit Culture
As discussed, Profit Culture is often the bottleneck that limits the amount of product cost reductions even with superior Enterprise Cost Management capabilities in place. So, how does a company grow and strengthen a profit-based culture? Organizations should consider the following questions:
How high and broad is executive championship of increasing profit?
It is natural for firms to look to their executive leadership for prioritization (unless firms are dysfunctional). Every year, in the Management Discussion & Analysis section of the firm's annual report, many CEOs discuss the subject of growing profit and increasing cash flow. In other words, firms are messaging externally to Wall Street about the importance of profit. Unfortunately, most employees (including many managers) do not read the annual report, and even if they do, they are not sure how to tactically execute the executives' directives to increase profit. The C-level leaders of the organization need to outline tangible initiatives in which the rest of the organization can participate to affect the goal.
One of the best ways to do this, and to signal leadership's seriousness behind generating profit, is for the highest levels of the organization to personally champion the cost management implementation and efforts of the firm. When an initiative is allowed to bounce down the ladder to lower-level executives, mid-level management, and/or the IT organization to champion, the organization perceives that the initiative is not really important. When the C-level is involved, the organization takes note.
In addition, because cost management touches so many functions - purchasing, finance, and engineering, etc. - the sponsorship should not only be high, but broad, so profit is not viewed as a single function's initiative. The best people to own profit initiatives are the CEO, because of his/her broad scope, or the CFO because of financial impact of cost management. With one of these two individuals as the primary champion and the chiefs of manufacturing, purchasing and engineering serving in supporting roles, the organization will fall in line.
Is profit maximization officially a top priority of the organization and a metric employees are required to maximize?
Another phenomenon of management is that most people really can only focus on a few (one to three) initiatives or assignments at once and make meaningful progress. Wall Street and every business school in the world have taught us that the primary goal of the firm is to maximize free cash flow (primarily driven by profit) to investors. If this is clearly the top goal to everyone outside of the firm, shouldn't this also be the top goal (or at least one of the top three) of every employee in the company? For example:
This is not to say that there are not other valid goals for the organization and the products that it produces. Many people may argue that safety, product performance, and delivery should be the organization's top goals. No doubt these are important goals. However, these are simply important requirements that must be met. Profit should be the goal to maximize.. Figure 4 provides a specific example of a typical company's problems.
Figure 4. Maximizing profit while meeting other constraints
The market is a complex multidimensional space. Safety, product performance, delivery, and other product attributes are constraints that must be met to some target level in order for the product to be viable in the market. Because the market is a nonlinear complex space, there are multiple regions of localized maxima for profit (shown as the tops of the contour diagrams "hills"). Some of these hills are blocked by the constraints. The goal of the firm is to maximize profit (i.e. minimize product cost) within the remaining viable solution space, which is shown as a triangular region.
The natural question is, "How does the company know which design, manufacturing, and sourcing choices to make to move toward the maximum profit point?" This is where the power of an Enterprise Cost Management system comes into play. The purpose of the Enterprise Cost Management platform is to provide cost visibility - the ability to know the cost of every potential alternative, so the best decisions will be made.
Is Enterprise Cost Management part of key business processes?
One of the best ways to grow a profit culture is to build Enterprise Cost Management into the business processes of the organization. Most well-run businesses adhere to standard processes and gateways. The official sourcing, new product development, and manufacturing planning processes need to have cost management gateways and goals built into them. These include, but are not limited to:
How deep and how early are cost targets set?
One of the most critical Enterprise Cost Management processes to implement is to set cost targets for the product. As discussed in the aPriori white paper on Quality of Cost, cost targets are usually only set at the product or system level. However, individual engineers and buyers don't own products or large systems. They own parts or sub-systems. If a company wants line-level employees to care about increasing profit in their own work, cost targets need to be set so that individual people can be measured and be held accountable for their work.
Are ECM deliverables on management's and employees' performance reviews?
Closely related to setting cost targets is the incentive structure of the organization, shown in figure 4. The higher up the corporate ladder one goes, the more people are incentivized by hard-dollar savings (reduced Cost of Goods Sold). However, as one moves down the ladder, employees tend to be incentivized by soft savings - time to market, earlier changes, "productivity," etc. While some of these soft savings can and do increase profit, they are very difficult to measure. Furthermore, soft savings fall within the Sales, General and Administrative (SG&A) line of the income statement. In most product companies, SG&A is only five to 15 percent of revenue, whereas hard savings (product cost or COGS) is between 70 and 90 percent of revenue.
Figure 4. Incentive Structure of Most Firms Today
So, why do executives have the majority of the organization focused on soft savings when hard savings have a much larger effect on profit? As previously discussed, one reason is because cost targets are often set and measured at the product levels only. Secondly, without predictive visibility into what the cost of a part or sub-system will be when it is finally manufactured, it is difficult to hold individual line-level employees accountable for product cost.
However, if the firm can provide every employee with the real-time and predictive cost visibility that an Enterprise Cost Management system can provide, an it can both set targets and assign specific people to own them. Enterprise Cost Management systems make it possible for management to make meeting product cost targets and delivering cost reductions a realizable part of every employee's performance goals. As shown in Error! Reference source not found., this has the effect of making hard savings and profit increases relevant to even line-level employees.
Figure 5. Effect of Giving Cost Visibility
Is everyone who impacts or manages product cost (design, manufacturing, sourcing, suppliers, management, etc.) involved directly in cost management efforts on a daily basis, or is it a sporadic focus or the responsibility of only one group of experts?
Increasing profit is not a once a year or quarterly activity. It should be part of every employees' daily activities. This is especially important for the employees that directly impact the cost of the product. However, most organizations have relegated cost management to small groups of cost experts who have no ownership over the parts in the product. One reason that this has occurred is that before Enterprise Cost Management systems, getting a quality cost assessment was a time-consuming process that required expert skill. Enterprise Cost Management can provide a real-time, predictive, precise cost assessment to anyone in the organization. Therefore, everyone who impacts or manages product cost needs to be using and contributing to the cost management system every day.
How experienced is the organization with Enterprise Cost Management (length of practice and sophistication)?
As with any initiative, Enterprise Cost Management and growing a Profit Culture takes effort and time. However, one of the greatest advantages of Enterprise Cost Management is that the organization will typically begin to identify significant product cost reductions and profit increases within days or a couple weeks of beginning to use the system.
Assessing the Strength of Your Profit Culture
Measuring the exact strength of an organization's Profit Culture is hard to do. However, there are indicators that a firm can use to assess the Profit Culture. Figure 7 outlines the attributes of the various levels for Profit Culture from weak to strong. If the executive would like independent help assessing the strength of his firm's profit culture or how to build profit culture, most Enterprise Cost Management software solution providers can offer professional services to do this.
Figure 6. Assessing an organization's Profit Culture
Figure 7 looks at Profit Culture by functional group, both in what defines weak and strong culture in each function.
Figure 7. Profit Culture by Function
The level of quality in a cost number is driven by the quality of the data provided on the object being cost, the data about the environment in which it is costed, the fidelity and sophistication of process and cost models used, and the strength of the profit culture in a company. To arrive at high quality of a cost number in an efficient way, the firm must simultaneously build the quality of its data and its models, as well as build its profit culture.
Quality data and quality models provide only the potential to generate a high quality of cost number. However, like any system, the firm must have the will and skill to use it and realize the potential. The strength of the organization's will and skill to do this is called Profit Culture. If a company uses a sophisticated Enterprise Cost Management platform, it will generate a good cost number. But a cost number alone is not good enough. The profit culture must be built and maintained. Often the biggest problem with profit culture is that no one below a profit and loss owner is properly incentivized to care about cost reductions and profit maximization.
Profit Culture starts at the top with the direction and priorities set by senior management. It is the responsibility of the C-level executives to "change the question" the rest of the organization is asking from:
"Why is profit more important than all the other fires that I am fighting?"
Wall Street has already answered the first question; an Enterprise Cost Management solution can answer the second.
About aPriori & the aPriori Enterprise Cost Management Platform
The aPriori Enterprise Cost Management Platform is the first software solution to provide discrete manufacturers and product companies with real-time, predictive and precise product cost assessments throughout the entire development and production process. aPriori's revolutionary cost management capabilities empower organizations to identify quantifiable savings in material, tooling, labor and overhead while evaluating alternative designs, processes and sources. By generating cost assessments early in the product development process, aPriori customers drive significant costs out of their products prior to production, reducing Cost of Goods Sold (COGS) by whole percentage points and improving the overall financial results of the company.
Through an innovative, patented understanding of how product design, materials and manufacturing processes translate into product costs, aPriori replaces traditional, inefficient cost-estimation techniques with precise cost assessments that update in real-time as parameters change. aPriori provides true cost visibility to everyone in the organization that impacts cost -- designers, manufacturing engineers and planners, purchasing and sourcing professionals, cost managers, program management and executives.
To learn more about aPriori or to view a demonstration of the aPriori Enterprise Cost Management Platform, visit www.apriori.com.
Learn more about the aPriori Enterprise Cost Management Platform and how leading manufacturing organizations are reducing product costs through real-time, predictive and precise cost estimates. Download an aPriori customer case study at www.apriori.com.
About the Author
Eric Hiller is the Founder & Chief Product Officer of aPriori. At aPriori, Eric leads product strategy and is part of many operational aspects of the business, both internal and customer facing. Prior to his current position, Eric was the founding CEO of aPriori in 2003 and led the company from its founding to its first round of funding. Eric architected the aPriori software in 1996 during the early work with aPriori's first customer, and his business plan for aPriori won the 2003 Harvard Business Plan Contest. Prior to aPriori, Eric was Product Manager/Systems Engineer for five years at Ford Motor Company where he was involved in the new product introduction cycle in advanced engineering, design, manufacturing launch and product management, as well as completing tours in corporate strategy and treasury. Eric's previous experience also includes roles at Procter & Gamble in manufacturing, John Deere in design, and 3i, PLC in venture capital. Eric holds an MBA from Harvard Business School with second year honors and summa cum laude masters and bachelors degrees in Mechanical Engineering from the University of Illinois Urbana-Champaign.