Paring Down to Spend More

Economy of flow is a management paradox whose time has come

Published: Monday, July 19, 2010 - 07:43

Often when I write articles or have a speaking engagement, I like to polarize things into black and white. Almost every time I do this, I’m challenged about the audacity of the approach. Nothing seems to irritate people more than the statement “A focus on costs always increases them.” Just to stir the pot once again, I’m making that the subject of this offering.

One typical response I get is from those who claim “never” or “always” are absolutes, and should be vanquished from our communications. To these folks I say, “Can’t we always improve?” For the rest, let’s walk through this theory together and discern for ourselves what makes sense.

Let’s begin by challenging existing assumptions linked to economies of scale, which is the bedrock for assumptions about reducing costs. Then we’ll explore and debunk two popular strategies that attempt to exploit this assumption around reducing costs: outsourcing and shared services.

In a recent white paper titled, “Why Do We Believe in Economy of Scale?” written by a Vanguard Consulting team and John Seddon, managing director at Vanguard Consulting , we are provided with a more in-depth argument about economy-of-scale thinking. The paper boils down two broad assumptions. One centers on organizational design, and the other around savings.

• Organizational design: Specialization and standardization will lead to lower costs and greater productivity.
• Savings: Cost savings will be made through common IT systems, fewer buildings, and fewer managers (and workers).

The organizational design argument

This argument stems from its manufacturing origins. It was Frederick Taylor at the beginning of the last century who taught us to break things down by functionally separating the work. This design has perpetuated itself unchallenged for more than a century now.

Once we have separated the work, specialists work according to standards in process and time. This thinking is reinforced by the use of targets and incentives to ensure the design is locked in.

However, the “Japanese industrial miracle” changed this playing field. Following World War II, the United States had all the production, so how is it that a tiny country with few natural resources could compete with such a behemoth? The answer was different and better thinking originally introduced by W. Edwards Deming and fine-tuned by Taiichi Ohno.

Deming started us thinking about the concept that quality was more important than mass production. Ohno discovered many counterintuitive improvements by thinking differently. One was that economies were in flow, not scale. Costs were not reduced in the mass production-designed factories of the West, but in the total cost thinking of smaller units—a counterintuitive—but important—discovery.

Managers have long been preoccupied with costs and how to reduce them. This represents a large part of their activities. The problem is that by managing costs using economy-of-scale thinking, they miss what causes the costs: economies of flow.

Cost savings vs. cost increases

Two popular process approaches are outsourcing and shared services. Both are influenced by economies-of-scale thinking. Too often, when you dig deeper, you find that costs are, in reality, increasing.

Outsourcing is popular by virtue of its lower transaction costs. In contact centers, visible costs are reduced by a lower cost per call. However, the visible and highly-used “per unit” cost is no match for measures of total costs. This demonstrates the flawed design and cost-savings mentality of economies of scale.

Organizations and governments outsource their waste in the form of failure demand (i.e., demand caused by a failure to do something or do something right for a customer). By reducing transaction costs, they overlook the failure demand that is designed into that process. Typically this can be 40 to 60 percent of all contacts, even upward of 90-percent failure demand, such as that experienced in some poorly designed government entities.

Further, with all the standardization that exists in contact centers, more failure demand is created as the scripts and technology doesn’t allow for the unexpected situations unique to service organizations. Interactive voice response (IVR) systems with standard scripts leave customers scratching their heads trying to get their inquiries answered. Instead, customers are forced to call back or, worse, give up and go to a competitor. What are the costs associated with this scenario?

The result is predictable and damaging. Even contracts drive contact centers to more failure demand through incentives for lower handling times that, in turn, create more failure demand calls. Outsourcing vendors many times remain silent about this issue because more phone calls mean more money.

In a Fortune 500 technology company, I observed outsourcing of software developers to reduce the cost of banking software. What the company didn’t see was that the outsourced developers were cheap but not competent about banking. This required more phone calls to negotiate the learning curve. That in turn increased the time to develop and implement projects. Although unit costs were reduced, total costs increased—dramatically.

Government entities, with their need to balance budgets, increase the budgets due to cost-reducing, economies-of-scale thinking.

A shared service is another example that presents the same management paradox. The same problem is with the design. With shared services, management sees several back offices, contact centers, and IT systems, and assumes that combining them will reduce costs. The problem is the work design and demand. Two contact centers with different customer demands will not receive fewer calls. They will receive the same amount of calls, and combining the two in a different location often ruins the continuity or flow.

There is also the combining of back offices in shared services as a way to save money. No one is asking whether the front office/back office design is even the right design. Was a back office needed in the first place?

The right approach for outsourcing or shared services is the insightful study of demand. Customer demand provides us with the information we need to improve work design, structure, technology, and contact centers; it also offers us a huge opportunity to improve.

Ultimately, we have a choice about how we approach reducing costs. One is based on economies of flow and the other more accepted method is economies of scale. “Economies of flow” thinking is not mainstream or intuitive.  It is, however, an idea whose time has come.

About The Author

Tripp Babbitt

Tripp Babbitt the managing partner for The 95 Method - Executive Education and Advisors. The 95 Method is about giving organizations a method to use new theories to grow business.  Babbitt can be reached at tripp@the95method.com. Reach him on LinkedIn at www.linkedin.com/in/trippbabbitt

Tripp also has a podcast and YouTube channel called, The Effective Executive.