Cost Subtraction

Last week, a drive-by a 99 Cent Store (see photo) reminded me of my first real job in an industrial marketing department.  In the 1970’s, one function of this department was to set prices, a task simplified in the early going by the market’s acceptance of whatever surcharges we added each year.   In some years prices were increased twice!  My job was to gather cost data on each product family, and multiply costs times our expected profit to determine a new price.

The basic formula was:          Price = Cost + Profit

There were no reviews of costs – didn’t need to be.  Nobody blinked when prices went up.   In fact, each price increase created an opportunity for distributors to stock up just before the increase at a lower price: more sales for us, at least in the short term, and more profit for distributors.  This was sales’ perpetual motion machine.

Sometime in the early ‘80’s the winds changed; customers in our market no longer accepted price increases.  On the contrary, they began asking for price decreases.  Our first instinct was to object.  We were in denial for about five years thereafter, our salespeople forced to haggle with customers just to avoid an increase.  In the process, we lost customers.   A principle referred to by the creators of TPS as “cost subtractionhad put the customer in the driver’s seat:

Profit = Price – Cost

The phrase “new normal” is used to describe a recent sea change in the world economy.   “Cost subtraction” marked a less obvious sea change in the 1980’s, but one that arguably has contributed significantly to our latter day new normal.   Simply put, the cost subtraction formula assumed that the customer determined the price and that profit therefore required effective cost management.  Organizations that had previously been free to pass along cost increases, now had to find ways to reduce costs.

How did US industry respond?  With outsourcing, off-shoring and leveraging of suppliers.  We purchased larger lots from suppliers to avert their price increases, and then rewarded buyers for “cost avoidance”.  We downsized our workforces and reduced employee benefits.  A company president quipped, “we’ll charge employees for parking spaces if we have to.”  Companies large enough to afford it sought to automate their way out of the dilemma, replacing employees with machines.  These superficial improvements created paper savings while weakening productive strength and emptying cash reserves.  Russ Scaffede, a former executive at General Motors, joked as a Shingo Conference speaker, “All our plants made money, only the corporation was losing its shirt.”

My little company did not have the financial resources to exercise many of these superficial options, which fortuitously led us to the discovery of TPS.   We learned the story behind the cost subtraction principle: that the lion’s share of cost reduction could be found through many small improvements.

Forty years after the cost subtraction sea change, many organizations continue to deny it.  Some are “lucky” companies, still able to price their products or services to cover wastes; others revert to superficial improvements to eke out a profit.  Where does your company stand?  Are you a lucky company?   What are your cost subtraction strategies?  Share a story with us.

O.L.D.

5 thoughts on “Cost Subtraction

  1. Bruce,

    Let me offer a personal example of what cost subtraction has done over the years to a product that many of us up here in the northern part of the country find quite indispensable – a snow blower. Since we average 100” of snow a year, these come in kind of handy. I happen to own a 1993 8 HP / 24” cut model from a very well known manufacturer. My son still uses the machine that came before it – handed down from my parents to me to him – a 1963 4HP / 24” cut from the same manufacturer. A good friend of mine has a 3 year old 9 HP / 24” cut from the same manufacturer. So let’s look at the differences that cost subtraction has brought to the three of us.

    The 1963 model has been in the family since it was purchased as a 2 year old used machine. It shows its age with rust on most surfaces. We rebuilt the auger assembly two years ago with all new bearings and seals due to a minor oil leak. We’ve rebuilt the carburetor and replaced the float bowl because it rusted out. We’ve put a couple of new recoil starter ropes in it over the years. The engine has never been tuned up other than a new spark plug every few years and an oil change every year. Here’s the best part. This machine starts on the second pull even after a full summer’s sleep. It goes through snow drifts that spill over the top of the engine. In short, it’s a tank and virtually nothing will stop it. Not bad for a 49 year old machine.

    My machine is only 19 years old and gets very well cared for. It’s definitely made out of lighter / less expensive materials than my son’s machine. This was first evidenced by the steel discharge chute coming off the very first year after all six bolts holding it in place sheared off. (Somebody saved some money on fasteners.) The carburetor needed to be replaced (no rebuilding these new ones) last year and it takes 3-5 pulls to start it. Numerous little things have gone wrong with it, but I’ve been handy enough to fix all of them myself. The likelihood of this one making it another 30 years is pretty low.

    As for my friend’s almost new machine, one doesn’t have to look very far to see dramatic cost cutting. And remember, the basic design of a snow blower hasn’t changed in 50 years. Things that used to be steel (like the discharge chute) are now flimsy plastic. The gearbox that drives the auger self destructed the second year he owned it with the flimsy case literally falling apart. Even though this is the biggest / most powerful machine of the three, it definitely weighs the least. And that works against you when you’re trying to plug through drifts. Compared to the 1963 model, this thing is a toy. The likelihood of this machine making it even 20 years without a lot of care and feeding is next to zero.

    But let’s look at the other end of this cost cutting. I don’t know what my parents paid for the 1963 model, but it’s still worth about $200 today. I paid $1,350 for my machine in 1993. My friend paid just over $800 for his (bigger) machine just 3 years ago. So the price has definitely come down – and more people can afford one. Many of these people won’t hesitate to throw one away after 10 years and buy a new one. Since most of these folks never saw how well built these things used to be, they have no idea what they’re not getting.

    So I’d say cost subtraction isn’t always a bad thing. But, if taking cost out equates to taking quality out, one had better think real carefully about it. Some companies seem to do this pretty well. Some don’t seem to care at all. I wonder which ones will be around in the long run?

  2. Thanks for your examples, Tom. Some folks might call this “Value Engineering,” a technique for optimizing the value to cost ratio. In your examples, however, basic value was degraded as costs were cut, a common and unfortunate outcome of VE. I’m happy to report that I purchased my snowblower (see my post “Snow Happens”) thirty years ago and it still runs great.

    Bruce Hamilton

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