Innovation: The large and small of it

This is Part 1 of a two-part series. The second part will appear in the March issue. The concept of innovation has been around for a long time. Webster's dictionary defines innovation as "the introduction of something new; a new idea, method, or device." For most people today, innovation, more often than not, conjures up images of the latest gizmo or some advanced "gee-whiz" technology.


This is Part 1 of a two-part series. The second part will appear in the March issue.

The concept of innovation has been around for a long time. Webster's dictionary defines innovation as "the introduction of something new; a new idea, method, or device." For most people today, innovation, more often than not, conjures up images of the latest gizmo or some advanced "gee-whiz" technology.

One of the clarion calls in all businesses today is to innovate: they must develop or access the latest advance in technology, products, or processes, in order to gain a competitive advantage. And yet, many companies are managing what they have already with only mediocre results. How can you achieve advances through innovation in a climate of mediocrity? In manufacturing companies, working to create innovative products without having your basic practices in order is problematic at best, and nearly impossible at worst. You might, by some accident or happenstance, but innovation and the attitude and culture that go with an innovative company must permeate the organization from the CEO to the shop floor.

Consider the following:

Three companies are represented in this "market survivor profile." Each has a certain market share, and each produces its product for a certain unit cost. Each is likely to have a very different operating environment. "C" is compelled to change to survive , "A" is driven to change to sustain and improve its position, and "B" is typically relatively complacent with its position. After all, B is making money, and it's working on its problems, but its sense of urgency is not like that of A or C. Unfortunately, it's likely to become a "C" before too long.

The gap between unit cost of production and market price represents gross profit. How do we spend our gross profit? It finances our marketing, sales, and development of our distribution channels, R&D and new product and process development, general and administrative expenses, and of course, operating profits. These profits, in turn, finance additional capital investment, and ultimately, growth. Gross profit can be summed in one word: future of the company.

Without gross profit for investing in the innovative efforts associated with marketing, R&D, and new product/process development, or what I'll call "big innovation," the company has little future. Of course, "A" has the brightest prospective future in this simple model. It has the greater ability to finance the "big innovation" required for assuring its future success.

Financing big innovation

How do we increasingly improve our gross profit, and finance our "big innovation" in an intensely competitive world? We must reduce our production unit costs, particularly when market price is declining with time, as they always do over the long term. How do we do that? By cost cutting? By process improvement? Both? As we'll discuss later, it's through "little innovation" at the plant or operating level, and constantly seeking to improve our processes so that the costs are constantly driven lower that we can finance our "big innovation" and create a virtual circle for improvement. Before we do that though, let's consider a few other issues.

Looking at Fig. 1 again, let's consider the unit cost equation. It basically answers the following questions: "How much did we make? How much did it cost?" Thus, it provides a simple way of calculating our unit cost of production. At this point, however, let's make a modest adjustment in our thinking about this equation, and view capacity as the maximum amount of product that could possibly be made with the current assets: no downtime, no rate losses, no quality losses, zero losses from ideal. With that in mind, it's been my experience that the best companies focus on the denominator of the unit-cost equation. That is, they focus on doing the things that will maximize the production capacity of their physical assets, and then they use that capacity to go after more market share, without having to make additional capital investments.

Alternatively, with the capacity created (their hidden plant), they rationalize their worst performing assets. Or, they reduce their staffing levels for a given production capacity; e.g., reducing a 6-day, 3-shift operation to a 6-day, 2-shift operation. Think about it. If things aren't "falling over" because their processes are reliable and capable, they also have lower costs, not just because of potential volume, but also because costs just aren't being incurred unnecessarily. And, they don't make product for the sake of making it. Indeed, they are much more capable of running a lean manufacturing operation — their assets are reliable and capable of running when needed to meet market demand. They don't carry extra inventory, just in case, because they don't need to. Their assets don't fail when they're needed, and all their costs are lower as a consequence of their business system design and capability.

Cost cutting and innovative environment

Is cost cutting effective as a means for achieving lower costs? The data suggest not, that it has a low probability for success. Ask yourself how motivated to innovate you think you would be in a cost-cutting environment, where "Theory X" typically prevails: employees are lazy and need to be managed. This contrasts to a "Theory Y" environment: employees want to make a difference and to be led. I'm of the belief that most employees (95% or so) would much prefer to be led into making a difference. We should not let the 5% who don't want to be led hinder the potential of the rest.

Of nine major studies on cost cutting reviewed, all provided similar results. Three of these are summarized below.

In a study of several hundred companies that had gone through major cost-cutting efforts, and published by The Wall Street Journal on July 5, 1995, it was found that:

a. Only half improved productivity

b. Only a third improved profits

c. Only an eighth improved morale.

In a study of 50 Fortune -500 companies, Gary Hamel reported on the concept of "Corporate Liposuction," wherein earnings growth is more than five times sales growth (through cost cutting or other constraints).

Of the 50 companies engaged in a cost-cutting strategy, 43 suffered a significant downturn in earnings after three years of applying this approach.

Growing profits through cost cutting is not sustainable, and must be balanced with sales growth through innovation, new product development, etc.

In a study of 3628 companies reviewed over a 15-yr period, Morris, Cascio and Young reported:

"Employment downsizers do not improve financial performance. ... Those with the largest layoffs exhibited the largest decreases in ROA."

"One striking aspect of downsizing is that the impact on profitability is negligible relative to the magnitude of the layoffs."

"Not only did they fail to increase their return on assets, but they experienced a continued decline on their return."

Why do cost cutting?

All these data suggest that, at best, cost cutting provides a 50/50 chance of improving company performance. Why then is cost cutting viewed as one of the primary means of improving financial performance, even if it doesn't have a high probability for success? It may be necessary, as will be discussed below, but it could also be because "Everybody does it." It's a generally accepted practice that is often warmly received on Wall Street with its focus on quarterly results. At the very least it provides competitive parity.

Management doesn't view layoffs as a possible admission of failure. Why did we have all those people on the payroll in the first place if we didn't need them?

Perhaps most importantly, they often don't fully appreciate that costs are a consequence of your business system design. If you don't change your fundamental business system design, but you remove resources from the system, performance will likely decline.

In a merger that's part of an industry consolidation, having layoffs is not necessarily a management failure. In that situation, it's common and proper to have layoffs to eliminate redundant functions, hopefully gaining economies from the consolidation. After all, you only need one CEO, one COO, one CFO, and so on. These benefits may be slight however, and may be overwhelmed, particularly if you have difficulty in effectively integrating the cultures of the two organizations and aligning the new organization to a common strategy and set of goals.

Most importantly, however, many senior managers don't fully appreciate the last point. As Deming said, "Your system is perfectly designed to give you the results that you get." Hence, removing resources from your business system without changing its fundamental design will likely result in a decline of the performance of the system. Granted, just removing the resources will force people to think a little differently, and they will automatically work to compensate for the reduced resources. And, perhaps more importantly, if the restructuring is done so that the business system is in fact redesigned to eliminate the poorest performing assets, and leverage the best performing assets, then layoffs and cost cutting may work.

When does cost cutting work?

From the above data, cost cutting is not likely to lead to prosperity. But, it may work some of the time. Perhaps under the following circumstances: