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Product Costing is Key to Unlocking Growth Potential: How ‘Resource Use’ and ‘Access Costs’ Provide a More Insightful View

Profit Segmentation

Nearly 40 percent of every company is unprofitable by any measure–a harsh conclusion drawn in an extensive study of corporate finances. The study also found that roughly 20 to 30 percent of the products are so profitable that they provide all reported earnings and cross-subsidize the losses. The rest of the company is only marginally profitable. The dilemma is that executives often don't know which products belong to which segments.

In order to improve financial performance, it is imperative to gather factual costing information about each product. Are the products, which are believed to be unprofitable, truly unprofitable and, if so, then to what extent? What can be done about them? Inadequate segmentation of resources cleanly along product lines contributes to ineffective investment decisions whether focused on bottom line improvements or growing the top line.

Cost Pressures

Most companies use normal costing to estimate cost of manufacturing and distributing products. Such an approach typically uses standard costing where costs are divided into three categories: direct material, direct labor, and factory overhead, which is allocated to various products based on machine hours, labor hours or some other similar metric. This approach is adequate to estimate costs of individual products when the product volume, product batch size, product and processing technologies, and labor use do not vary significantly by product, and the overall overhead is significantly smaller than direct costs.

However, in recent years, with increases in productivity and advanced technologies the share of overhead has increased dramatically such that it no longer correlates with machine hours or labor hours. The product portfolios have also changed with diversity of product volumes and dissimilar batch sizes. This change is large enough that analyses based on standard costing are insufficient for directionally correct decisions.

Although standard costing coupled with variance analysis is still suitable for reporting purposes it is no longer acceptable for managerial decision making. It has become imperative to understand the true cost of manufacturing based on requirements for manufacturing for each product within the product portfolio of each fiscal unit. The same product manufactured at two different locations using identical technologies can have dramatically different cost structures depending on its placement in the product portfolio at its location. Restructuring of operations should not be undertaken without clearly understanding the operational requirements of each product and their associated costs—the risks are simply too high.

Accurate Assignment of Resource Consumption to Products Is Key

Menawat & Co.’s ProFIT-MAP™ approach treats the cost of all resources as direct regardless of type. This requires greater visibility into how the manufacturing process for each product relates to various resources and their costs. This is accomplished by segmenting resource costs into two types:

• Resource Use Cost—per use costs (e.g., labor, supplies, material, maintenance, inventory carrying cost).
• Resource Access Cost—costs incurred to have a resource available when it is needed whether or not that resource is used (e.g., assets, supply chain, maintenance, overhead).

This is similar to direct and indirect costs in normal costing but with major differences – direct costs of resources are extended into factory overhead. As expected, if fully extended, it would become activities based costing, which is very expensive and requires a great deal of detail, time and effort that is not justifiable in most cases.

In our experience controlling the degree of extension into overhead has to be dictated by the need of the situation and, therefore, it is a unique solution for each corporate entity. Our approach is a Predictive Operational Analytics methodology of process and financial integration technology to develop a roadmap to solve the problem at hand, hence the name ProFIT-MAP™.

Working with resource use and access costs is a more dynamic perspective over traditional and static terms of direct and indirect (fixed and variable) costs. The dynamic approach allows for greater precision in distributing costs based on the actual level of effort and contribution by each resource towards the stated objective.

Anil Menawat

Is ERP a Dinosaur?

Enterprise Resource Planning (ERP) software has served companies well for storing and retrieving data but has built-in limitations. Do these limitations make it a dinosaur? For instance, ERP:

• Is not designed for operational and business analytics. It is, therefore, a poor planning and execution tool.
• Has inflexible predefined workflows. Users hate ERP systems due to their rigidity.
• Does not facilitate collaboration and perpetuates data silos. Critical facts are hidden from people who need them.
• Is a top-down push strategy out of sync with modern pull production techniques.
• Implementations are often customized beyond plain vanilla designs. This adds complexity and increases costs.

How Does ERP Differentiate Your Business?

ERP sits on a mountain of static data. Where is the rich context for business processes?  Where is the live actionable business insight? ERP is simply not designed to provide holistic and detailed visibility into specific drivers of current and future performance.

ERP is not a differentiator! There is no competitive advantage to having an ERP. Although necessary, it does not set the organization apart from the pack.

Questions for ERP-Centric Organizations

• If your competitors are also using ERP, how do you enhance your competitive advantage?
• How do you drive continuous improvement of business processes supported by ERP?
• How do you automate and mistake proof a business process that spans ERP and other information including manual steps, spreadsheets, and human knowledge?
• Are you drowning in data from ERP and other systems but starving for real-time business insight to increase effectiveness and reduce risk?

Success with ERP has to be about improving end-to-end business performance. It is not just about correctly functioning ERP software. This means that processes that span ERP and other information need to be understood in total and managed to realize true performance improvement.

Operational processes are simply too complex and fluid to live in ERP systems. Enterprises should focus on leveraging the data by bringing it forward into a business process and customer centric approach. Such an approach must be easily reconfigurable without customization while maintaining complete end-to-end process integration to satisfy all operational and business stakeholders.

Adam Garfein and Anil Menawat

Execution Dynamics Beta Software

I have seen a beta version of the new Execution Dynamics program and it is truly inspiring, not something you say about a piece of software every day. It’s going to be a huge hit because it’s a concrete manifestation of the Profit Mapping philosophy.  An idea that was always well received by both practitioner and critic is now packaged in a tangible tool that every business can use.

In my experience one of the problems of modern business is that while the ERP system takes care of the nuts and bolts on the shop floor, there’s nothing to take care of the management side. Most companies have very tight restrictions on hiring indirect labour, so the small group of senior managers are ever squeezed to take on additional responsibilities as businesses get more complex and standards get higher.

In a standards-driven organisation managers are under great pressure to act in conformance with a multitude of policies, procedures and work instructions. Most of the time they have to remember to do the right thing, and then they have to decide to do it, since unlike the shop floor there’s no formal system to guide them. The risk of deviation from standard is a constant problem as individual managers struggle to get parts out on time. You may get over the finish-line in the end, but the price is poor process control and higher costs than necessary. That leads to variable quality, accidents, high energy costs, lack of security and all kinds of waste.

In business nothing continues unchanged for very long.  Whether it’s a customer return, a process change due to problems with material or tooling, a breakdown, scheduled maintenance, contractors on site, near-miss or accident, training a new hire, new product introduction or whatever, the managers responsible go off and do stuff, on a best effort basis. They approve changes and do whatever it takes but frequently the system doesn’t catch up and soon you’ve got more deviations and the process is a little more out of control.

The way it’s set up, Execution Dynamics has the potential to plug that gap because you can teach it your standards. It’s quick and easy to reconfigure things and because it’s intelligent it will error trap and be your safety net. It can guide the manager to make the ad hoc change while tracking the implications, risk assessing and making sure that everybody is in the loop. Actions later either get reversed or universally adopted so that the process integrity is maintained, and the manager doesn’t have to carry it all because he or she has the support of the system. 

Meanwhile the boss has exception reports that could indicate trends before they become a problem and also has the reassurance that a maverick can’t break something important because the system will defend itself.

So hang in there, help is at hand!

James O’Sullivan

We've Been Busy

You may have noticed that we have not posted to our blog in awhile. We’ve been very busy with other writings!

Forthcoming Book in 2012

Execution Dynamics: Align to the Customer Quantum for the Best Possible Business Performance

Let us know if you would like to review an advance copy. We are always appreciative of a few kind words.

Detailed Articles

Achieving Rapid Business Success with Lean Thinking: A Holistic Systems Approach

Lean success, as enjoyed by Toyota Motor Co, has eluded most Western companies. Recent studies have documented and identified various causes for this abject failure. In this e-article, we analyze the situation and propose six attributes necessary to achieve success. We further describe the Profit Mapping methodology that incorporates the six attributes and provides a holistic and systematic way to rapidly achieve success with lean.

Predictive Operational Analytics: A Holistic SystemsApproach to Plan, Manage, and Optimize Business Performance

Predictive Operational Analytics is the convergence of business methods, systems thinking, and business intelligence software for rapid decision making to maximize performance and profit. In this article, we describe the individual elements of Predictive Operational Analytics and present its practical application using Profit Mapping methods and tools.

Adam Garfein

Two Tiers of Continuous Improvement

Part I in a Series of Observations from Biology for Business

Running a business is akin to maintaining health and well-being. In our book "Profit Mapping" we devoted a lot of attention to lean thinking, systems theory, business goals, and integrated financials. Profit Mapping is a set of methods and tools for business analysis and optimization. Fundamentally, Profit Mapping is inspired by cell biology -- the basic unit of life. As the book did not talk as much about biology, we are writing a series of blogs to illustrate parallels between business improvement and what we were taught in high school biology.

Continuous Improvement "Tiers"

Over many years and across varied organizations we have observed that many successful companies use a two-tiered approach to continuous improvement.

The first tier is akin to emergency response fire fighting. Here, managers and workers battle daily operational “fires.” Problems are immediate, often mission critical, and must be resolved quickly or the risks may threaten operations and/or the business. Effective managers are good at this, calling upon their wealth of real-world experiences. In addition, low hanging fruit for change is often targeted in this tier.

Actions taken in Tier I are tactical in nature. The objective is to quickly get operations back on track. Living to fight another day is an ongoing struggle.

The second tier tackles harder and more complex opportunities to maximize process and financial performance simultaneously. A big challenge for managers is to figure out how to optimally configure multiple product, process, resources, supply chain and financial parameters all at once to achieve the best possible performance.

Managers frequently confide in us how difficult this is to do well. On the one hand, we are trained to reduce problems into narrower definitions and improve upon a few variables at a time. Reduce waste in any particular part of the system, we are taught, for instance, and the impact will percolate up to show real business value.

Yet, the reality is that everything is interconnected. Even the smallest operational or policy changes have ripple effects, which are dependent on both the specific and collective changes within the environment. In other words, a business is not the sum of its individual parts, but the collection of its interdependent operational systems.

Thus, managers must both constantly fight fires on demand (Tier I) as well as systematically drive complex change for the purpose of meeting multiple business objectives, including financial performance (Tier II). You can't do just one or the other! You have to do both effectively or the organization will get sick and may perish.

The Biology of Continuous Improvement

A little background on us helps explain our thinking. I am a gerontologist by training -- one who studies adult development and aging. Anil Menawat, who is the creator of Profit Mapping, comes from a cellular metabolism and systems theory background. How we ended up in business together is a story for another day. One might say our interests span from individual cells to entire human beings, with emphasis on facilitating growth and maintaining health and well-being.

You can begin to see the connection to business. Swap the above terms with those such as products, operations, factories, business units, supply chains, people, etc., and the "living" system comparison comes to life in a business context.

The first tier of continuous improvement is analogous to disease and the immune system. For instance, we are all exposed to viruses and bacteria on a daily basis. This is our risk exposure. Sometimes we develop infections. Some are life threatening. Some people may obsess over prevention. We take different actions depending on the severity and our pre-existing conditions and current situation when disease strikes. These symptoms are the "fires" that we all fight sooner or later.

The second tier of continuous improvement is analogous to growth and cell division. Growth relies on the production of new cells through cell division. This biological process is one of the most complex systems in the world, particularly when you extend this to an entire human being. Its parallel in the business world is also complex and dynamic. We've all heard the slogans concerning the "DNA" of business. The analogy seems to be that strategy is the genetic code guiding growth. This raises several business questions. Does the organization have the right strategy and roadmap? Is the cell division carried out properly? What are the risks?

The objectives for growth in both biology and business seem to be to "get it right" and sustain. Yet, the risks are great with plenty of opportunity for "error" in both systems, whether in cell division or implementing the right operational changes.

In the Tier I example of a virus or bacterial threat, our actions are tactical, such as taking a couple of Tylenols or getting a prescription for antibiotics. However, that does not change the larger context of cell growth and life (or death).

In Tier II, disturbances in cell division can also cause problems. Sometimes the implications are benign, but they can also have dire consequences. In addition, uncontrolled cell growth is cancer. In business this might be viewed as irresponsible management. Both of these biological and business situations are unsustainable without swift and appropriate action.

As we know from biology, there are more than two “tiers” to human existence and functioning. Likewise, organizations have many interconnected functions and tiers. We have simply focused on a couple to illustrate the dual approach to business improvement.

Adam Garfein

Future Blogs in this Biology-Inspired Series
   • Planning for Growth and Sustenance
   • Two Tiers of Toyota Production System
   • Systems of the Human Body and Business Management
   • Interdependence of Metabolism in Cells
   • Please share your ideas for others too

Why Progressive Companies Should Embrace Their Complexity

A corporation is like a sponge in the sea of commercial energy which surges around it. Taking in goods and services, it makes a unique conversion, and then sends out something of value to others. Like the biosphere, the output of one part becomes the input of the next.

The memory of this activity is represented by the countless records of every transaction, internal and external, created by the conversion process. To become fully in tune with what’s going on, the organization needs to somehow be mindful of all the data flowing through it, and find a way of metabolizing it. By doing so, the company mediates its functions and remains in harmony both internally with its own constituent parts, and externally with the wider commercial world.

The balancing process, like the sea, is fraught with danger, however. The chaotic energy of the world, like fluctuating markets forces, pull and push against the innate self-organizing ability of the enterprise, and if we can’t react quickly enough, our business becomes inflexible. This eventually results in points of starvation and blockage in the company’s throughput and ultimately to a decline in the commercial health of the enterprise.

The information we need to stay subtle is all there in the transaction dynamics, but interpreting such a rich stream in time to take the right action it is not an easy task, and without the correct analytical tools, most companies struggle. Viewed in isolation the numbers are useless fragments like individual pixels in a giant TV screen. But composed into a grand mosaic, they form a meaningful picture of the corporate metabolism, and once the movie is synchronized, decisions can be taken in the best interest of the company with very low risk of failure.

Learn to read the pulse of the organization and you will benefit from a new source of profit generating energy and risk deflection.

James O’Sullivan
Ireland

Integration of Finance and Operations

Recently, an operations executive expressed his frustration about the management’s inability to manage their company in these hard economic times. He complained about limited integration between Finance and Operations affecting their decision making. The CFO runs business models in Excel spreadsheets, but the models are not tied to the operations systems. The scenarios cannot be validated for being operationally realistic. Nevertheless, they set the expectations for the operations.

Without a “reality check” the decisions become surgical mandates. If the CFO demands a 10% drop in inventories, operations manager cannot evaluate its consequences on the customer service. They don’t know whether they could afford even more cuts. Or, what would be the right level of inventory for the current business environment. Such single dimensional approaches often result in unintended consequences elsewhere. More importantly, managers lose the real opportunities of making a number of smaller changes to achieve strategic business goals.

On the flip side, the value of an operational improvement is not known until the end of the quarter when financials accrue. The lack of integration hampers forward looking projections of financial KPI’s. Impact of the proposed initiative is unknown without implementation. Some initiatives succeed while others don’t. In reality the situation is even more troublesome. With many on-going initiatives it is difficult to isolate the successful ones.

On the surface it sounds like a typical silo mentality that exists in most companies. The CFO office does their model and throws a mandate over to the operations. Operational managers do not know the reason why they are being asked to do so. They have no opportunity to contribute in developing a solution to meet real objectives. It being a mandate they work busily to meet without understanding the full situation.

Fortunately, the situation is usually not this critical. The operations managers do talk to the financial managers to understand the situation. This is, however, a partial solution only. Both are talking with their respective expertise but without real facts and data. Without the integrated analytical capability neither can substantiate their proposals with any real analysis for the expected “future” environment. The product mix, volumes, and a whole lot of other variables change frequently over time. If the goal is to reduce overall cost then probably there are many options available that must be considered along with inventory reduction to make it work. Single variable approach is dangerous and often results in moving costs around the strategic business unit netting little to nothing on the bottom-line. This is a far too frequent occurrence in continuous improvement programs.

There are many who believe that such problems can never be solved with any mathematical analysis. They argue no matter the sophistication of mathematics it cannot capture the complexity of the real situation. In my humble opinion this is an uninformed position. Indeed there is no single formula or software that can solve this problem of integrating process and finance. But, it can be achieved by integrating problem solving and mathematical analysis tools in tandem. Rudimentary mathematical analysis such as OEE calculations or static capacity analyses are inadequate for the job.

Commonly used continuous improvement approaches, and even the mentality, are not sufficient for the required restructuring. It requires holistic thinking, which is different from “divide to conquer” approach of continuous improvement. It demands a systematic approach and expertise to identify the correct set of parameters to change simultaneously. You have to create many such scenarios before finding the most feasible solution with minimum risk. Detailed dynamic process, resource requirements and financials analyses with “appropriate” mathematical rigor provide the basis for comparison among scenarios. It’s an iterative process that results in a collaborative solution to meet the strategic business goals. That’s what the discipline of risk management is all about.

We have been studying this problem for over 20 years and have confronted this problem as senior managers and consultants in many different industries. Our consulting business is solely dedicated to this very single issue of connecting operations and financials to strategic business goals. We have developed a set of methods and tools called Profit Mapping focused for rapid restructuring. We invite you to learn more about them at www.menawat.com.

Anil Menawat

The Winds of Change

A business can be like a hanging mobile. Pull on any part of it, and the whole thing will go into a dance until some kind of equilibrium is restored. That's just what happens when you take one part of a production process and change it. We typically focus on that one part, but all the other parts begin to dance around it, sometimes with unexpected results.





Likewise, if the wind comes along, every part of the mobile starts changing all at once. It’s like that now for businesses everywhere, as shockwaves of the global banking crisis reverberate around the world.

Because we’re powerless over external factors, it’s now vital to optimize the profitability of the processes inside our businesses; and we can’t do that without looking deeply into their dynamic interactions. Tools like Value Stream Maps, and measurements like Overall Equipment Effectiveness served us well as a compass might an explorer or a ship’s captain at sea. But now we’re navigating narrow streets and alleyways for survival itself and we need something with the pinpoint accuracy of a GPS if all’s not to be lost. In short we need a way to put a financial value on the disposition of every workflow, asset, unit of labor, utility, raw material and consumable for every conceivable situation…and be able to quickly what-if the whole thing as each new situation presents. Impossible? Up until recently, yes.

Now, it is possible for a company of any size to embrace this level of complexity. You need Profit Mapping’s analytical engine, PAL and a way to hook it up to your process. That connection is made with a Business Execution Profile from which emerges your Process and Policy Map, (a mechanism we’ll talk a little more about another time). For now the message is this. The technology is here to turn the current situation into an unprecedented opportunity. Thousands of companies are going to fail in the near future, but yours doesn’t have to be one of them. Instead you can position it not just to survive, but to absorb the huge amount of additional business that will become available when the shakeout is over. Business you couldn’t win in any other circumstances. But to do it will take a level of agility few companies currently possess. Profit Mapping can give you that edge. Your time has arrived, seize the day.

James O'Sullivan

Optimize the Value Stream: Closing the Loop Between Continuous Improvement, Execution and Business Objectives

A culture of continuous improvement is vital for success. Leading companies engrain this mindset at all levels of the organization, and provide the necessary resources and management support to sustain initiatives. However, many senior managers are beginning to ask for more. They want to know precisely how any change in the operational environment will specifically impact the financials at the end of the reporting period.

Unless you can demonstrate the bottom line impact of any proposed operational improvement on a financial statement, there is no real improvement! Managers are less willing to sign on for changes with only the “promises of a better tomorrow.” They need something more substantial before they commit valuable time and resources to implementing the best ideas of your domain experts. In addition, they want to leapfrog continuous improvements and proceed directly to the “optimum” process and policy configuration to maximize performance.

Critical Management Questions in a Multi-Product and Multi-Workflow Environment

Managers convey to us several critical questions when it comes to reconfiguring processes and policies for superior performance.

• How do you know that the proposed change will improve the business?
  
• Can you guarantee that it won’t actually make things worse?
  
• How much will it cost and what is the return on investment?
  
• What is the financial performance of each product and workflow in our multi-product and multi-workflow environment?

Until now, it was not easy to obtain clear answers to these questions. Savvy managers can see right through hollow answers. Either show them the data or move on to something else. Fortunately, a benefit to answering the last question is that it also contains the answers to the above management questions. Financial insight at the level of products and workflows tells you your precise costs, and is a starting point for improving performance throughout the value stream.

Optimize the Value Stream Flow

Optimizing the value stream flow creates the best possible operational and financial performance for any given business context. The following figure represents all of the operations in a Strategic Business Unit (SBU). The rows represent different products and the columns represent different operations and activities involved in the production of a product or service. Collectively, the products and workflows represent all of the value steams for an SBU.



Typically, companies take the best advice from their domain experts as they set out to resolve operational challenges. Investing in new technologies and reconfiguring a line is a common solution approach. Yet, senior managers often confide that neither they nor their experts know which one is the best new configuration to adopt out of several reasonable possibilities. They are also not sure whether the new equipment is worth the investment.

The problem is they have been burned in the past. Previous investments in automation may have modernized production processes, but the cost savings never materialized over the years. Moreover, managers often report that previous technology investments have actually reduced their flexibility to quickly respond to market changes.

Drive Effectiveness In and Costs Out of the SBU

We frequently see how technology issues such as the deployment of robots impact business performance. A robot, for instance, is installed to feed parts into three independent grinding or polishing stations. If either the robot fails or any of the stations fail, the whole operation comprised of the four pieces of equipment (1 robot, 3 stations) ceases production.

Unintended consequences of this configuration can include: (a) exacerbated failure time behavior because all three grinding operations come to a halt if any of the four operations fail, (b) reduced flexibility for handling changes in product mix due to constraints imposed by the configuration of the robot and three stations, and (c) increased indirect labor cost for the more expensive technical personnel who are on call to support the technology.

The central management issue is not whether automation is helpful or not, but how well the proposed changes in automation plus all other changes in the SBU collectively roll up to produce measurable financial results. Local improvements may look quite reasonable when viewed in isolation in the SBU, but it is a fact that all such changes exist in the context of multiple products and workflows. The activities required to produce the given product mix coexist and dynamically interact with the other functions in the SBU.

As observed above several factors conspire against achieving true improvement in financial performance. Finicky automation behavior results in a line being run slower than its rated speed. Breakdowns are more severe in terms of their collective reduction in throughput. The particular configuration in a value stream flow is tied to a specific product mix. It isn’t practical to run different product mixes through these operations, resulting in less agility to respond to market conditions. The “visible” reduction in direct labor is offset by a “hidden” increase in indirect expensive technical personnel added to the SBU for support.

These types of management challenges are becoming more problematic for companies as they grapple with how to handle an increasingly complex and fluctuating product mix. Negative past experiences and a difficult economy conspire against committing to needed improvements.

Only when you can “see,” coordinate, and holistically balance improvements for the collective good within the entire SBU will you begin to achieve superior performance. The financial benefits flow when you optimize the interactive value streams in alignment to your business objectives for the entire SBU.

Adam Garfein

Note: The next posting will explore the central role Cost of Goods Manufactured and Unit Cost financial reports play in optimizing value stream flows. Hint: Optimization is easy when you quickly produce these reports at the level of products and workflows.