Efficiency is an interesting concept. It is one of those ideas that people believe they understand, but when talking to them about efficiency, there doesn’t seem to be a clear and agreed upon understanding of what it really is. There are common beliefs about efficiency, however. One common belief is that by increasing efficiency you will lower costs. Many programs focus on improving efficiency in the name of reducing costs. This is actually a driving factor behind the famed Toyota Production System, the precursor to well known concepts such as lean.1 The question is: Does it really work? The answer is: Yes and no.
To begin, let’s define efficiency in a way that will be used throughout the book. Efficiency is simply output divided by input as seen in Equation 7.1:
Consider fuel efficiency with your vehicle, miles per gallon. The gallon you start with is the input, and the distance you can travel on the gallon becomes your output. The car that can go 30 miles on a single gallon of gas is considered more efficient than the car that can go only 10. When you try to increase fuel efficiency, the objective is either to see if you can go farther, increase your output, on a gallon of gas or to see if you can go the same distance with less gas—outputs and inputs.
The same notion applies to work and your company. If you have two people who do the same thing for an hour, the one who creates the most output in that hour is more efficient. For example, if you have two people handling customer service calls, the one who answers the most calls in an hour is mathematically and technically more efficient. It doesn’t mean they are better at doing their job, as one possible reason one is more efficient could be they avoid difficult situations that take more time to resolve. This may lead to a negative experience for the customer. However, according to the math definition, they are still more efficient.
To increase efficiency, you improve the ratio of output to input. As with the gas example, a few paragraphs earlier, if you have someone handling 10 customer service calls per hour, increasing the output to 11 per hour increases their efficiency. Doing 10 calls in less than an hour will also improve your efficiency. The question is: Where does the cost-reduction come from?
Let’s assume you wanted to calculate the cost per call in this scenario. If the reps are paid by the hour and not by the call, you are back to the situation in Chapter 6, where you have to create a financial relationship between what you pay them and what they do. If the rep makes $20 per hour, let’s assume an average cost per call can be calculated by dividing the $20 for the hour by the number of calls made during the hour. This is, of course, costNC. At 10 calls, the cost per call is calculated to be $2. At 11 calls, cost per call is calculated to be $1.82, $0.18 cheaper per call.
The costNC goes down, but what does this imply? You still pay the agent $20, whether they make 10 calls, 11 calls, no calls, or 1,000 calls. The cash you spend to get the 11 calls versus the 10 is exactly the same. There are no cash implications associated with the number of calls you make. This further demonstrates the independence of the cost of buying capacity, costC, and what it does.
This should tell you three things. First, the cost per call is not a cash-based value as discussed in Chapter 6. It is costNC. What you spent to get 11 calls is the same as what you spend to get 10. Second, efficiency is the math inverse of average cost per call (Equation 7.2).2 If the hour is input, then the $20 you paid, too, is input. Eleven calls are more efficient than 10 because you got more calls, output, for the same input, $20. Now, consider cost per call. Mathematically, the average cost per call is input divided by output, which is the opposite of efficiency (Equation 7.3)
Third, since changes in efficiency have no direct effect on cash, they are meaningless when used as a cash flow basis for justifying improvements. Many may try to argue that by being more efficient, getting 11 calls versus 10, there is a cost savings of, in this case, $0.18 cents per call. If so, how is the savings manifested as cash?
The conclusion is, being efficient does not improve your cash flow situation directly. Being more efficient only means you get more output from a given level of input. This is still a good thing. Many also reply to this statement saying, “Well, it may not be a cost reduction but if I’m more efficient, I can sell more!” Well, not so fast. First, most capacity in an organization has nothing to do with improved revenue. An efficient accounts payable clerk does not increase revenue, just as efficient HR data entry clerk doesn’t affect revenue. From a manufacturing perspective, let’s say more efficient production allows you to make more salable products. By being more efficient, you can make 20 products in the same time it used to take you to make 15. What if there were demand only for 15? What is the benefit of making more than there is demand for?
There’s a disconnect between what accounting tells you is happening with efficiency and what is happening from a cash flow perspective. Efficiency does not lower your costC, but it does do something else for you. The keen reader will notice I have repeatedly suggested these have no direct cash implications. There are indirect ones however. I will demonstrate, in Chapter 17, the idea that efficiency alone does not lower your costs, but it does enable you to increase costs more slowly when expanding and to reduce them more quickly when reducing the size of your organization.
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1Taiichi Ohno, the primary architect of the Toyota Product System, suggested that the goal of the TPS is cost reduction. This is highlighted in Taiichi Ohno, Toyota Production System: Beyond Large Scale Production (Cambridge MA: Productivity Press, 1988), 62.
2There is a deeper dive into this relationship in Appendix A.