Exercising Caution in Reducing Operating Leverage - Term Paper Example

Exercising Caution in Reducing Operating Leverage Introduction Companies employ various strategies to be competitive and survive in this fiercely competitive world. Cost management is one of the most important strategies that the companies often employ invariably to bring down the production cost so as to get an edge over competitors. Keeping fixed cost at the minimal through downsizing and resorting to outsourcing are the important strategic considerations that the companies usually make. The paper explores some of the important cost management strategies in the ensuing paragraphs. Fixed Cost versus Long Term Survival Ciccotello and Green (1995) argue that there are many similarities in private restructuring and those undertaken by the government, especially in the Defense Establishments. Defense organization of the US government manages many production facilities that operate similar to industries. The chief strategies employed by Defense Department are to reduce permanent positions for staff and workers, outsource some of the jobs and depend more on temporary workers. Authors argue that the organizations have to strike a balance while reducing fixed costs permanently. Elaborating further, they argue that Honda Motor Company reduced permanent engineering staff, which was dedicated to the design functions during 1980s; however, that went against the company when its competitors came out with new designs in automobiles. This eventually resulted into the reduced market share for Honda impacting its profitability. Honda had a great difficulty to catch up with new innovative features that competitors released time to time in the market place. Thus, a strategy to reduce fixed cost may appear lucrative in the beginning but could be detrimental to the future growth. Currently, similar situation exists in the Defense Department of the government. In case of a sudden need as that observed during Cold War era, Defense Departments with reduced staff in research and development would find a great difficulty to cope up with the situation. At that time, any addition to fixed staff would not bring any immediate results in terms of adequate defense or deterrence. It always takes time to build innovative technologies to defend in the most appropriate way (Ciccotello & Green 1995). Such situation can better be answered by taking a cue from operating leverage as observed in any private enterprise. The impact of fixed cost is huge in any organization. Higher fixed cost compels firms to operate at higher levels of operations and sales volume to meet those fixed costs. That is why in difficult market conditions, the firms with higher fixed costs are often found in trouble. The firms with higher operating leverages are always at risk during unpredictable sales environment. Moreover, sales volatility is rampant in the industries where technology has been changing rapidly. In these kinds of industries, it becomes important to assess fixed-cost involvement and possible sales volume that are achievable. No wonder that many large sized computer firms reduced their fixed-cost commitment in recent years. IBM reduced their permanent staff by 100,000 between 1990 and 1994. Not only that the company outsourced many of its parts and products in these years; that reduced the requirement on plant and machinery to a great extent. This further reduced fixed-cost burden on the company. That is how IBM could adapt to changing market environment and survive. That surely is a good strategy in unpredictable and difficult market situation (Ciccotello & Green 1995). Exercising Caution in Reducing Operating Leverage Contrary to this, many private firms have been operating in the industries where market demand of their products is quite steady and predictable. With the predictable sales volume, fixed-cost commitment is easy to make and it makes absolutely no sense to reduce permanent staff compromising the future business prospects and efficiency factors. Authors further emphasize that reducing permanent employees is an expensive preposition and once removed they are very costly to replace. Hence, prudence must be exercised while reducing operating leverage (Ciccotello & Green 1995). Fixed Cost and Strategic Need Authors are of the opinion that the Defense Department’s endeavor to eliminate permanent staff as an attempt to enhance the operating leverage is not justified. The department has reduced permanent staff up to 30 percent between 1985 and 1997 and its roles and applications are now changing to a great extent. Not only this but reduced operation of the defense establishments has lowered its requirement for production and maintenance jobs – bringing down the expenses on fixed costs considerably. The DoD outsources many of its operations with private firms keeping fewer permanent staff in its payroll. Authors have justly compared and contrasted the ability of private firms and the DoD reducing operating leverage for diverse needs. It could be a prudent decision for many of the private firms necessary for survival but for the DoD the major objective is to meet the defense needs of the nation and certainly not to achieve cost reductions (Ciccotello & Green 1995). Switching Fuel to Save on Cost Smith (2012) argues that the companies constantly evolve strategies to reduce their fixed and variable cost to remain competitive in the market. Rising crude oil costs increase the diesel cost which is an important component to decide about the cost of servicing to the customers. Waste Management Inc. is one such company that is in the business of garbage management across many part of the US. The company runs its trucks on diesel and it had to spend $169 million more last year toward the increased cost of diesel. To save on the ever increasing burden toward the fuel cost, the company decided to buy new trucks that operates on cheaper natural gas. The extra burden on fixed-cost is $30,000 when compared with diesel models of trucks yet it is worth considering because the company envisages a saving of $27,000 or more in a year on fuel per vehicle. The company has plans to replace almost 80 percent of the trucks in next five years. It is worth realizing the cost-economics of natural gas that has changed the market dynamics recently. Gas production has increased due to shale gas revolution – a new technology to get gas at lower rates in recent years. The cost of gas to the consumer has reduced by 45 percent. That has caused many utility companies to shift in favor of natural gas from other fossil fuels. In the history, there has never been so much price difference between gas and diesel. It has been most lucrative to operate on gas where diesel consumption is huge (Smith, 2012). Smith (2012) emphasizes that gas in lieu of diesel has tremendous potential to change the scenario for the transportation industries where diesel constitute substantial operating (variable) cost. A prudent cost management always looks forward for a saving in the variable cost as it enhances the competitiveness of a producer or service provider in its business. Trucking is a business where fuel constitutes major cost. No wonder then that the truckers would think of replacing their fleet of trucks operating on diesel with the one that operates on natural gas. It is a most prudent decision in the sense that any extra investment made on new trucks – the cost difference between two kinds of trucks can be recovered in a single year of operations by the savings on fuel cost. No surprise that hosts of manufacturers such as General Motors, Cummins, and Navistar are gearing up to offer natural-gas based trucks. Illinois is ready to introduce its delivery trucks based on natural gas. The market is moving toward gas-powered trucks on its own without any subsidy component into it. Not only truckers but many large companies such as AT&T, UPS are out to reduce its cost of operations by running their operations on gas-based vehicles. Another industry that is out to take advantage of cost difference between diesel and natural gas is Ferryboats operating in the US and Canada. Runaway fare increases in ferry services has made their businesses without any growth in the recent years. As argued by the author, in case of Washington State Ferries, diesel constitutes almost 29 percent of their total operating costs, which was only 12 percent in 2000. Switching to natural gas as fuel will provide substantial savings to them and that savings could be up to $7.6 million a year with only fraction of boats switched to natural gas. In case of Staten Island Ferry, which carries passengers between Manhattan and New York would have its fuel costs reduced to half. The logic is simple any saving in operating cost would finally reflect in the lower cost to the consumers. That will attract more customers to avail the services. Thus, cost management is crucial in ferry business not only for survival but to expand the business (Smith, 2012). Reducing Power Production Cost Is a Necessity Power is the most essential of the utilities with inputs in most of the manufacturing industries apart its consumption in domestic and service sectors. In the most competitive arena, it makes sense to save on operating and fixed cost to bring down the cost of production of an important utility such as power. According to Smith (2012), no wonder then that more and more power producing companies are migrating to the gas-based power plants. As per EIA, 52,000 megawatts of new power generation capacity will be added by 2015 in the US and almost 50 percent of that will be natural gas-fired plants. However, gas based power plants have several obstacles. Existing infrastructures to bring gas at power plants are not adequate; that will add up to the cost on creating necessary piping networks. The cost of producing power based on gas must take into account this infrastructure investment to reflect the true cost of power. Curwin (2012) argues that natural gas has now become a low-cost option for power generation. The gas based revolution has been possible due to gas recovery from shale formations that are spread in Ohio, Pennsylvania, West Virginia, and New York. The estimates from the US Energy Information Administration (EIA) indicate that almost 500 trillion cubic feet of natural gas can be recovered from shale. This gas discovery has fueled a new cost dynamics in power generation. The companies are closing down old coal-based power plants in favor of gas-based power generation due to huge savings in fixed costs. The EIA report of 2010 informs that a coal-based power plant costs between $2,800 and $3,200/kilowatt of power produced. Compared to this, the natural gas-based plant costs nearly $1,000/kilowatt. For a plant with the size of 500 megawatts, the fixed-cost savings can be huge making an economical sense to go for gas-based power plants. The report further states that lower cost of gas brings down the operating cost of power produced. For a comparison, the cost of electricity from coal-based plants has been found to be 9.5 cents against just 6.6 cents per kilowatt hour of the power produced (Curwin, 2012). Saving Every Single Cent Important for Survival and Growth Bannon (2001) argues that financial discipline and cost management functions are equally important in an organization particularly, when marketing activities alone cannot bring desired results. The case of Mattel is an eye opener when previously all efforts were directed toward increasing revenue of the company by simply focusing on marketing functions. The interesting aspect was that supply chain management was not functioning efficiently and retailers were complaining that they were being supplied only half of their requirements during peak seasons. Thus, the efforts that were made to increase revenue were not fructifying. Nothing was done to organize production schedule that could have brought substantial savings. If started sufficiently in advance, one or two molds were enough to produce required copies of a popular toy at Mattel but surprisingly, more molds – up to four and five were used to produce a particular type of toys. That simply enhanced the cost of production manifold as each mold used to cost $100,000. Similarly, each product had multiple packaging in 14 different languages costing enormously to the company – at times, as high as $280,000 per product. Many such production inefficiencies were observed in Mattel and no proper measures were ever taken in last 30 years. Robert Eckert, a new CEO, focused more on production scheduling and savings on packaging costs. He reduced packaging for each toy to maximum three versions with each package giving details in multiple languages. This has caused substantial savings to the company. Product flow was streamlined to effect faster delivery and increase efficiency in the operations. For that he revamped supply chain reducing the actual time from designer's table to the retailer's shop. Eckert introduced cost control methods in the Mattel rigorously taking a cue from his previous learning in Kraft. His current focus is not on revenue growth but simply to align the demand and supply dynamics so as to smoothen the operations of the Mattel. His success is evident from the fact that the company has achieved service levels of 90 percent. Conclusion From the above study, it is amply clear that the cost management is an important concept that when properly applied and implemented can not only help survive the company from the impending doom but also can put the company on fast track of growth. Cost management does not always mean cutting the cost but, at times, absorbing the cost keeping a long term perspective. Cost management is certainly an important management tool in overall functioning of the company that cannot be ignored. References Bannon, L. (2001). New playbook: Taking cues from GE, Mattel’s CEO wants toy maker to grow up. The Wall Street Journal, New York, N.Y. Nov. 14. Print. Ciccotello, C. S, & Green, S. G. (1995). Industry's downsizing lessons. govexec.com. Retrieved from http://www.govexec.com/magazine/1995/07/industrys-downsizing-lessons/7456/ Curwin, T. (2012). Natural gas a raging bull in its battle with coal. cnbc.com. Retrieved from http://www.cnbc.com/id/47279731/Natural_Gas_a_Raging_Bull_in_Its_Battle_With_Coal Smith, R. (2012). Will truckers ditch diesel? wsj.com. Retrieved from http://online.wsj.com/article/SB10001424052702304707604577422192910235090.html Read More