Finding Common Ground Between CFO and COO–Part 6

[Continuation]

Now that we have laid the groundwork, let us begin our turn now to some specific strategies for uniting the CFO and the COO in common and practical actions. First, let us consider the proper priorities for action.

Priorities for Action

The CFO and COO should agree on the following general priorities for actions to be considered:

1. Efforts to Increase Throughput, including efforts to increase revenues and/or efforts to reduce Truly Variable Costs (TVCs)
   
2. Efforts to Reduce Inventories (or investments) or demands for new investments
   
3. Efforts to reduce Operating Expenses

“Why this order?” I hear you ask.

The Detrimental Effects Cost-World Thinking

Let me begin by saying that this order is based on the solid assumption that most companies—especially at this present time—have already trimmed away obvious waste in operating expenses. And, while most CFOs and COOs are focused on the “cost-cutting” as the road to higher profits, this is almost never the long-term result.

A study done some years ago regarding Fortune 500 companies found a trend: Among companies self-assessed themselves as being “cost-cutters,” nearly 40 percent of such companies were no longer in the Fortune 500 a decade or so later. Clearly, the focus on “cost-cutting” is wrong on the face of it.

Consider this: Any company can successfully reduce its “costs” and “operating expenses” to zero. It the easiest and simplest of maneuvers to be carried out jointly by the CFO and COO. All they have to do is close the doors to the business, fire everybody, liquidate everything, and go home. It’s done!

But, if you think I am being overly dramatic, consider the fact that cost-cutting is—by it’s very nature—an action driven inexorably by the law of diminishing returns. If the CFO and COO successfully collaborate to reduce costs and expenses by, say, ten percent in year one; then it will be very difficult to reduce costs and expenses by even five percent in year two while staying healthy. In year three it may be difficult to eek out a two-and-a-half percent reduction in costs and expenses. Each successive year, increasing profits through cost-cutting becomes more and more difficult.

Too soon, despite their very best efforts, the COO and CFO focused on cost-cutting are soon cutting away protective capacity and damaging the ability of the organization to recover from the occasional attacks of “Murphy” (Murphy’s Law). This, in turn, leads to reduced revenues and higher marketing costs as customer retention becomes that much more difficult over time.

For all of these reasons, we must agree to put efforts to reduce operating expenses at the bottom of the list. And because increasing throughput has no theoretical upper limit and is not affected by the law of diminishing returns, efforts to increase throughput should remain foremost in the thoughts of the CFO and COO seeking unified actions for ongoing improvement.

Clarifying Throughput

As a reminder, our working definition of Throughput is not some generic concept of increases in volume or output. It is carefully focused on a financial formula that the strategic CFO should readily accept:

Throughput = Revenue – Truly Variable Costs

Where Truly Variable Costs (TVCs) are restricted to those costs that vary directly (not through allocations or some estimated factors) with changes incremental revenues. Typically, TVCs would be found in raw materials, subcontract or other outside services paid for on a batch or per-unit basis, commissions, piece-rate pay for employees, and little else.

[To be continued…]

[Cross-posted at the Kinaxis Supply Chain Expert Community]

(c)2008, 2009, 2010, 2011 Richard D. Cushing