Succeeding with 80/20

Author: Lakshmi U. Takikonda; Dan O'Brien; Rao J. Takikonda

Title: Succeeding with 80/20

Source: Management Accounting (New York, NY) 80 no8 40-4 F '99

Summary

The authors of this article discuss how a manufacturing company (XYZ) succeeded in cutting costs and increasing customer satisfaction by focusing on process reengineering, total quality management, and using the 80/20 rule extensively to: flatten their organizational structure, modify its plants to fit just-in-time (JIT) production, and empower their employees.

Instead of using activity based costing (ABC), their approach to controlling costs focused on: elimination of waste (e.g. non-value added activities), reduction in cycle time, elimination of defects or disconnects in the process, employee involvement, continuous improvement, and by focusing on the 20% of their key business and products that account for 80% of their revenues. As a result, XYZ was able to improve quality, productivity, delivery of products, product design, communication among all levels of employees, and customer satisfaction. For XYZ, this translated into the doubling of operating income, the recognition of being a low cost provider, and being the supplier of choice for its products.

Issues the company faced & how they addressed them

Like many companies, XYZ had trouble managing their growth and overhead costs. Support areas of the company were growing and it became difficult for the company to determine which products were contributing to the growth. With large amounts of overhead costs in the support departments, a large portion of the costs associated with products were not direct costs. That made it difficult for the company to see the true profitability of products.

In an attempt to control costs, XYZ initially decided to implement the ABC methodology. After a lengthy and costly analysis, XYZ discovered that low-volume products were causing more overhead than high-volume products. As we have learned during this course, this shift in costs is typical when using an ABC system, since costs are assigned to the products that cause the costs instead of spreading them over all products based on some predetermined rate often based on direct labor hours or machine hours.

Prior to fully implementing ABC however, Illinois Tool Works (ITW) acquired XYZ. With that, came a change in philosophy on dealing with overhead costs. The focus shifted to process reengineering (the elimination of non-value added activities), and the use of the 80/20 rule. XYZ chose this approach over ABC because they felt ABC did not provide tools for cutting costs and therefore, would add no value to their operations. Instead, they decided to focus on reducing the complexity in their processes and systems. The authors of the article do not provide specific metrics XYZ used to: identify which overhead costs to focus on, which processes for process reengineering, or which 20% of products/tasks contributed to 80% of their revenues.

XYZ focused on several areas as it simplified operations. One key area was product line simplification. Using the 80/20 rule, the company focused on the products that generated the most revenues and dropped or outsourced other products. Another area of focus was on organizational structure. In order to improve quality and communication among all levels of employees, the company decentralized by aligning their products by business units and placing support staff within the business unit. Departments or employees no longer needed in one area were either eliminated or transferred to other areas where they could add value. Next, the company modified plant layout based on product line and instituted JIT production and inventory systems. This move allowed many overhead costs previously untraceable, traceable to a specific product line. Finally, XYZ changed its performance measurement system to use variable costing. The company also began evaluating business units by return on sales - which compares after tax profit to sales, instead of by return on investment.

Analysis of the issues addressed and the approach taken

Process reengineering has several advantages and disadvantages. XYZ's 80/20 strategy worked because the company did not try to focus its attention on all its products. The advantage of taking this approach is that it allowed them to concentrate on the 20% of the products that contributed to 80% of their revenues. The company did not simply