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Margin improvement: more than a notion.

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EXECUTIVE SUMMARY

Improving operating margins and cash flow is on the minds of most managers, yet the tools and language used to meet these goals are constraining, resulting in billions of dollars spent without promised returns. Capacity mapping allows companies to see exactly how processes perform and provides much more precise margin-related data, The impact? Dramatically increased ability improves margins resulting from a clear understanding of capacity and cost dynamics.

Cost reduction and margin improvement are simple notions that for many companies are difficult to execute.

Consider Oracle, which in 1999, announced that it would use its own software solutions to save $1 billion. Saving a billion dollars is non-specific. What does it mean? A quick review of Oracle's financial statements shows that its operating expenses increased each year from 1999 to 2001. By its own admission, "Excluding the effect of currency rate fluctuations, total operating expenses increased 4 percent and 3 percent in fiscal 2001 and 2000 over the corresponding prior year periods, respectively." The company stated in its 10-K report to the U.S. Securities and Exchange Commission that "Operating expenses were favorably affected during fiscal 2001, 2000, and 1999 as a result of the U.S. dollar strengthening against certain major international currencies." It also mentions that costs for services (its largest operating expense item) were managed via "controls over headcount and headcount-related expenditures in the support, consulting, and education lines of business." In 1999, the sales, general, and administrative (SGA) cost was $426 million; in 2000, it was $481 million. So not only was there not $1 billion to save in SGA, but those costs increased by $55 million. Although Oracle's operating income increased annually, it was not a result of the IT project.

There are three problems the typical manager often runs into when trying to reduce costs, increase cash flow, improve margins, or save money:

* The relationship between cost reduction and cash flow is not as it should be.

* Techniques used to calculate the improvement are often flawed.

* The rhetoric used is ambiguous. Let's look at these in some detail.

Cost reduction vs. cash flow.

The relationship between cost reduction, profit, and cash flow is not simple to understand when looking only at income statements. For individuals, the cash that they have at the end of a given month is determined by the cash at the beginning of the month with income added and expenses subtracted. This is not the case with income statements. A manufacturing company spends cash to build inventory that often ends up on the balance sheet. Only when the inventory is sold does it hit the income statement as the cost of sales. The cash spent to create inventory may be long gone by the time the company calculates its profit.

Flawed techniques and assumptions. The techniques used are sometimes incorrect because of flawed math or assumptions. Oracle identified a sales force productivity savings of between 10 percent and 20 percent. Sales increased from SOB billion to $10.1 billion, which falls within the identified range, but what is not clear is how the savings value was calculated. Sales increases are not savings. Sales and marketing costs decreased from $2.622 billion to $2.617 billion for a savings of $5 million. The net impact when combined with SGA costs was an increase of $50 million. It is easy to suggest that increasing the productivity of $3 billion of resources by 10 percent would yield savings of $300 million, but is it correct to say so? And what relevance does the number have?

Confusing rhetoric. When Oracle spoke of savings, what exactly did it mean? The chairman of the board suggested that "These initiatives have translated ... into hundreds of millions of dollars of lower annual cost ... ." The numbers on the 10-K report clearly show that costs increased.

Some suggest that there are hard and soft savings, but what relevance and impact does softly saving $1 billion have? The term cost is so ambiguous that it is used almost indiscriminately to mean expense, a calculated value based on expense, or even as revenue. One manager of a manufacturing facility pointed out a productivity increase as a cost saving. When pressed,...

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