Efficiency and cost cutting are not the same thing. The distinction is crucial to creating (vs. diminishing) customer and business value.
I speak with many C-level and senior leadership team members regarding business strategy and many divisional/business unit leadership and management regarding strategy execution.
The concept of “cost cutting” is increasingly a part of these discussions. However, the term “cost cutting” is often misunderstood and often has different meanings across an organization - leading to sub-optimal execution of cost cutting strategies and tactics.
This post discusses 3 key concepts and distinctions.
Key Concepts and Distinctions
- Effectiveness vs. Efficiency.
I refer to Effectiveness as the big “E” and efficiency as the little “e.”
Effectiveness (the big “E”) is about creating value for internal and external customers and creating business value though providing goods and services. Value is defined from a customer’s perspective in terms of, for example, fit-for-use, quality, customer service, etc. at specified service levels.
Efficiency (the little “e”) is about producing/providing products and services at specified levels of effectiveness (aka service levels) – in the lowest cost / most economical manner to achieve the specified service levels without compromising the specified service levels.
Also, see my blog post The Five Essential Business Analysis Questions for BPR.
- Efficiency vs. Cost Cutting: Strategic vs. Tactical Cost reduction.
Efficiency (the little “e”) as described above is about creating effectiveness (the big “E”) in the most economical manner. Strategic and tactical cost reduction/cost cutting (described below) are important components of efficiency.
Strategic cost reduction/cost cutting is considered when an organization provides effectiveness - fit for use, quality, customer service, etc. at services levels that exceed what customers (internal or external) value and are willing to pay.
Accordingly, if this is the case, it often makes sense to reduce the specified levels of effectiveness to reduce costs if the specified levels exceed customer needs and expectations. This is referred to as strategic cost cutting/reduction.
However, it also typically makes sense to increase the specified service levels of effectiveness if the specified levels of effectiveness are below your customer’s needs and expectations.
Strategic cost reduction, as described above, is lowering the levels of effectiveness to the appropriate/optimal levels to reduce cost. However, once we calibrate the levels of effectiveness, we can look at tactical cost reduction. Tactical cost reduction is about maintaining the appropriate/optimal services levels while cutting out non-value adding costs.
Non-value adding costs are costs (e.g., waste, rework redundancy, excess internal movement, etc.) that we can cut/reduce that do negatively impact the specified service levels. For more information of tactical cost reduction see my blog post Lean: Getting Early Wins from BPM.
Strategic and tactical cost cutting / cost reduction are both viable, but different, strategies regarding cost optimization.
However, there is also indiscriminate cost cutting - cutting costs without analyzing the impact on effectiveness and efficiency and not looking at the impact of the cuts upstream and downstream in the process across functional silos. Indiscriminate cost cutting often results in sub-optimization of the end-to-value of goods and services.
- Cost Cutting vs. Cost Optimization.
Cost optimization, as defined by the Gartner Group “is a business-focused, continuous discipline to drive spending and cost reduction, while maximizing business value.”
Cost optimization has two components. First, its essential to “get” effectiveness “right.” Meaning, ensuring that the specified levels of effectiveness are appropriate for customer needs and expectations.
Second, once the specified levels of effectiveness are properly set/calibrated, it’s important to identify and apply strategic and tactical cost cutting strategies per the discussion above.
The key takeaway from this post is for organizations to have a clear understanding of distinctions among effectiveness (the big “E”), efficiency (the little “e”), indiscriminate cost cutting, and cost optimization, and then apply the appropriate cost optimization strategies such as strategic cost reduction and tactical cost reduction, but not indiscriminate cost reduction.
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