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Published: April 9, 2002

 
 

Reinventing Scale: How to Escape the Size Trap

Step 2: Unbundle and Determine Cost Drivers
Now that you have a useful map of the value chain, it’s time to unbundle. Unbundling entails breaking the value chain down and examining it step by step, looking for exactly where the costs are and what drives them. The ultimate goal is a step-by-step understanding of cost economics and return on assets, to determine where capital is tied up and where costs arise.

Optimizing value across an extended value chain requires understanding the economic profitability of each step along both the horizontal (product flow) and vertical (function) dimensions. Here we are talking about actual economic profitability, not just its accounting treatment. For example, the cost of making a can includes not only direct materials and labor, but also management time, energy, actual wear and tear on machinery (not just depreciation), and opportunity cost (that is, the return on the best alternative use of the capital tied up in the can), among others.

Start with the vertical dimension — the value-adding functions — because these are somewhat more intuitive and traditional for cost analysis. Again, the topic is the real drivers of cost. A useful tool for describing cost drivers is Booz Allen Hamilton’s ISSR framework, named for the four types of costs it describes: Inherent (process technology, product design), Structural (vertical integration, distribution network, complexity, labor and transportation rates, local raw materials costs, duties), Systemic (operating policies/principles, process-/product-oriented floor layout, resources and capacity management, organization infrastructure, information technology), and Realized (efficiency, productivity, utilization).

Try to unbundle the value-adding functions, exploring all individual processes and operations within manufacturing, distribution, selling, etc., at the lowest level possible to determine what each step actually costs. For instance, in our seafood example, we examined the cost of loining down to the level of the individual loining table, determining how many workers could fit safely around a single table in different locations, and how many loining implements were worn out per worker each year.

After charting value-adding functions, move on to the horizontal dimension — product flows. In unbundling individual product flows, look for the cost drivers that could be product-specific, such as process technology, design, complexity, and duties. The aircraft landing-light company ultimately was able to use a product flow map to segment its manufacturing process into three lines: a high-speed line to capture scale, a smaller line for products with some similar components, and a low-volume “job shop” for one-off orders. Vertical and horizontal unbundling is often a circular process that has to be repeated until the emergence of a two-dimensional matrix with clearly identified cost drivers in each cell.

Consider the mapping and unbundling analyses we did for one client, a manufacturer of automotive batteries. Its products fall into three main types: batteries for original equipment manufacturers (OEMs); for specialized non-OEMs, which require relatively complex manufacturing processes; and for standard non-OEMs, which require less complex processes. Because large batteries are relatively heavy, their production must necessarily be localized within the region of sale, or so it was thought. It was assumed that any scale benefits that resulted from centralizing operations in a single location — or even a few locations — would be negated by high distribution costs to truck the batteries to their final destination. The result was a manufacturing footprint characterized by regional plants producing products for regional customers. Moreover, all plants produced batteries of all three types, leading to a relatively high “cost of complexity” due to multiple production lines, frequent changeovers, and intensive production planning.

In the course of unbundling the value chain into horizontal product flows and identifying detailed cost drivers for each flow, the company discovered that its complexity costs for some products exceeded its distribution costs. In other words, the company ended up spending more to maintain its decentralized footprint than it did to distribute its batteries. By segmenting the product base along the lines mentioned above, the company found it could realize considerable value by using a “partially scaled” process.

 
 
 
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Resources

  1. Lawrence M. Fisher, “From Vertical to Virtual: How Nortel’s Supplier Alliances Extend the Enterprise,” s+b, First Quarter 2001 Click here.
  2. Tim Laseter, Pat Houston, Anne Chung, Silas Byrne, Martha Turner, and Anand Devendran, “The Last Mile to Nowhere: Flaws & Fallacies in Internet Home-Delivery Schemes,” s+b, Third Quarter 2000 Click here.
  3. Tim Laseter, Alex Kandybin, and Pat Houston, “Marketing and Operations: Can This Marriage Be Saved,” s+b, First Quarter 2002 Click here.
  4. Alfred D. Chandler Jr., Scale and Scope: The Dynamics of Industrial Capitalism (Harvard University Press, Belknap Press, 1990)
  5. Adam Smith, The Wealth of Nations (The Modern Library, 1994)