Why an Obsession with Cost Is Damaging Your Profitability and Handicapping Growth

Managers of industrial organizations are obsessed with unit cost.

This obsession flavors almost every management decision, damaging organizations’ profitability and competitive strength.

But it turns out that unit cost isn’t the only game in town. It would make much more sense for managers to develop an obsession with speed. All else being equal, an organization with a faster clock speed is more profitable and grows faster. It consumes less capital, holds less inventory, and harvests greater economies of scale.

Managers appreciate the value of speed but they are reluctant to change horses for one simple reason. Increasing the clock speed of an organization will cause unit costs to increase. And nothing strikes fear into the heart of a manager like the prospect of rising unit costs!

Confronting the Demon

A focus on unit costs is better for profitability than no focus at all. This much is true!

However, to invoke the notion of unit cost to make a management decision is to fail to understand basic mathematics (well, calculus, specifically).

The core problem is that the standard formula for profit (profit = revenue - cost) only works when analyzing the past. We cannot use it to make predictions (about the future) because revenue and cost are not independent variables.

If we’re predicting the impact of a management decision, the rate at which we generate profit in the future will be the difference between two rates — the rate at which we generate contribution margin; and the rate at which we accrue operating expenses.

The standard profit formula ignores time. And standard cost accounting is an attempt to shoehorn the standard profit formula into use to make forward-looking decisions. It’s true that cost accountants have developed exotic approaches to costing in an effort to smuggle time back into consideration, but these simply perpetuate the same bad idea.

The thing is, business is primarily a game of speed maximization, not cost minimization.

Changing Horses

Consider Formula One for a moment. The pit crew, in particular.

It’s easy to imagine that a young MBA tasked with improving the profitability of a Formula One team might fixate on the apparent lack of efficiency here. A team has about 22 crew members responsible for as few as four pit stops each race. Each stop takes around 2 seconds. This means that 22 crew members spend most of their time idle.

If the young MBA suggested downsizing the pit crew to increase the efficiency of this department, his suggestion would be treated with the scorn it deserves.

Given that an industrial organization is a complex system with a network of internal dependencies, the Formula One example is more relevant than it might initially appear.

The Formula One pit crew exemplifies an alternative approach – the speed-based approach – to management decisions. The speed-based approach is simply to maximize speed, while exercising reasonable control over costs.

The Speed-Based Operating System

But an obsession with speed doesn’t just change how we make decisions; it also changes how we manage our teams (all our resources, in fact).

The pit crew members stand idle until one of the team’s cars is headed for the pit. Then, they spring into action and work frantically to turn the car around as quickly as possible.

If you want to maximize the clock speed of your organization, this is exactly how all work should be structured. It’s important to note that this mode of operation will cause a decrease in local efficiencies at the same time that it boosts global profitability.

Counterintuitively, this means that it’s likely that both unit costs and global profitability will increase, something that the standard formula would predict is impossible!

The problem is that a focus on unit cost is so firmly entrenched in most organizations that a change in focus requires more than a book or an engaging lecture. A new operating system is required. A new management framework, with new metrics, a new lexicon, and a whole new calculus.

Barbarians at the Gate

If you’re running the cost-based operating system, the good news is that most of your competitors are, too.

The bad news is that, in most markets, fast-growing upstarts are running the speed-based operating system. This might be because they are venture-funded, emerging from Silicon Valley, the land of the quick and the dead. Or it might be because they have repurposed an operating model from another industry to compete in your space.

Either way, now might be the time to ask whether your organization’s obsession with unit cost is actually in its long-term best interests.

Justin Roff-Marsh is the founder of sales management and marketing consultancy Ballistix.