The Economics of Improvement: Creating and Keeping Customers

I wrote earlier this month in Quality Digest about the economics of Lean-based improvement – the fact that Lean lower’s a firm’s average cost of production, thereby allowing it to reduce its cost structure and drive greater profitability.

What I also mentioned in that article was that for firms operating in imperfect competition, there is a profit maximization point where marginal revenue equals marginal cost. Firms should strive to maximize their profits by producing an output quantity where this occurs.

Firms that are price takers in the marketplace – those that have little or no market power to set or influence prices – must accept the market price as given and choose an ouptut quantity which maximizes profitability. In contrast, firms that are price setters – those can set and influence market prices – can choose the market price they wish to charge and then set output quantities where marginal revenues equal marginal costs.

Too much improvement effort is focused on cost reduction. This requires a firm to have a mindset focused on gaining efficiencies in production by eliminating non-value adding activity. The problem with a cost-reduction only approach is that it always has a threshold beyond which it not possible to go further before a firm seriously impairs its viability as a going concern. In addition, many firms talk a good talk, but refuse to make difficult decisions when it becomes apparent that their single largest cost is usually labour and that improvement initiatives have resulted in an over-supply of labour within the firm which cannot be reassigned or absorbed in other ways.

Of course, cost reduction is important but so, too, is revenue generation. Improving revenues requires a different mindset. It requires a firm to ask itself how it is going to create and keep customers. For many firms this is more difficult question to answer than going down the cost reduction route. However, if that question cannot be answered, the firm is likely to die a slow death, no matter how successful cost reduction initiatives are.

What is needed is a balanced approach. In my estimation it is better to focus first on understanding deeply what value must be provided to create and keep customers, and then to set about designing and improving the business system to create and deliver that value. Then, at the same time, focus on reducing or eliminating the costs that are not directly related to providing that value. A value-first approach makes so much more sense than mindlessly cutting costs and forces a firm to think about how it will sustain itself by creating and keeping customers.

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