Why a focus on cost makes organizations weaker, less profitable, and less competitive

A viable alternative based on Goldratt’s Theory of Constraints

Imagine you were to take over the management of a Formula One team, and rather than focusing on the car’s speed, you focused on reducing fuel consumption.

That would be stupid, right? Idiotic, even!

But this is the orthodox approach to business management. Not surprisingly, the result is that almost every business is weaker, less profitable, and less competitive than it could be.

If yours happens to be one of these businesses, your only saving grace is that your competitors have likely adopted the same management approach.

It’s not that managers are unaware of the importance of speed. There are certainly speed-based metrics (on-time delivery performance, inventory turns, and debtors’ days, for example). The problem is that these are exceptions, not the rule. The default focus is cost.

This paper explains why a focus on cost minimization is harmful to both the profitability and the growth of businesses. It then describes how you can (and why you should) shift your focus to the maximization of speed.

Efficiency is another word for cost reduction

Now, you might object to my characterization of cost as the alternative to speed. You might argue that you pursue efficiency, an optimal mix of speed and cost.

In practice, efficiency-improvement initiatives are cost reduction by another name. Economists might measure efficiency at the level of the organization, but managers never do. In practice, efficiency improvement is performed at the level of departments, machines, or even individual contributors.

The goal of efficiency improvement is to ensure that the resource in question is fully activated (always busy). If the resource can’t be fully activated because it lacks work or because of a lack of demand for whatever it produces, then the only viable alternative is to downsize (or eliminate it).

The ideas presented here are derived from Eliyahu Goldratt’s Theory of Constraints. If you’ve ever read his best-selling book (The Goal), much of the reasoning here will be familiar.

An ode to speed

If I were asked to give a single piece of advice to the owner of an industrial business (or any business, for that matter), I would say to increase your organization’s clock speed.

By clock speed,I mean the default rate at which work gets done within your organization—not just some work, but all work.

If unnecessary work is being done in your organization, you should eliminate it; however, if it’s necessary, it should probably be done faster.

Modern businesses are incredibly complex systems, which is to say, massively interconnected. If a department anywhere within your organization performs important but non-urgent activities at a less-than-optimal rate, it’s almost certainly causing drag somewhere that really matters.

And if you have a department anywhere within your organization that is not marching to a time-based metric, that department is definitely operating at a less-than-optimal rate.

But, if your organization is typical, most departments march to cost- rather than time-based metrics, which brings us face to face with the villain in our little story.

Cost accounting

The villain, of course, is Cost Accounting.

It’s widely understood among experienced executives (and accountants) that cost accounting has problems. Most are aware of situations where the cost-based approach to management decision-making yields laughable results.

But the standard response to these problems is basically to shrug. “We need cost accounting. It’s better than the alternative. In most situations, it’s accurate enough.”

The first two of these responses are correct. The third is wrong. So, let’s take a look at each briefly. And then, let’s explore the core problem with cost accounting and an alternative approach to management decision-making.

“We need cost accounting”

It’s true that organizations need cost accounting. It’s critical for reporting the organization’s historical performance to external stakeholders (particularly shareholders and various statutory authorities).

So, where financial accounting is concerned, cost accounting is here to stay. And that’s fine because the problems inherent in cost accounting do not raise their ugly little heads in the generation of (historical) reports.

But we’re not here to talk about reporting. We’re here to talk about management decision-making. And that’s a forward-looking activity. No law dictates that cost accounting be used for management decision-making.

Organizations do this because they lack a practical alternative (and because everyone else does it!).

“It’s better than the alternative”

Remember when you were first exposed to business? Perhaps you were a new hire at a big, scary corporation. I guess there was a point where you suggested that the organization do something because it would make a bunch of money, and you were chided for not considering all the hidden costs associated with your proposition.

Maybe a customer asked to make a bulk purchase at a lower price, and you got excited about the juicy margin that would land in the corporate bank account. Then, a more seasoned executive pointed out that the “real” cost of filling that order was much more than you realized because you needed to allocate a portion of the organization’s operating expenses to calculate the “profit” in the deal.

This hypothetical highlights both the default alternative to cost accounting (which is to ignore operating costs altogether) as well as the solution provided by cost accounting (which is to allocate—via some method—some portion of operating costs) to every “profit” calculation.

Given those two alternatives, cost accounting is certainly the preferable one! But it’s a terrible mistake to assume that these are the only possible approaches to management decision-making.

“In most situations, it’s accurate enough”

It’s true that cost accounting can yield accurate results in some situations. And it’s also true that it can yield laughable results in others.

The distinguishing factor is the predictability of transactional volume.

This is why cost accounting works just fine when reporting on the past. Because the past has already occurred, you have perfect knowledge of the number of transactions in the period under consideration.

But, when considering the future, you’re unlikely to have that same level of confidence. Furthermore, many decisions involve proposals that are likely to cause a change in transaction volume.

So, where transaction volume is concerned, cost accounting works well when the organization is in stasis. It can furnish you with dependable answers if you’re attempting to make decisions that do not impact the rate at which your customers buy things.

However, if you’re contemplating a change that is likely to impact transaction volume, cost accounting is effectively useless as a decision-support system.

It’s worth pausing to consider the implications of this. Cost accounting (as it’s typically used) provides managers with dependable information only when they consider proposals that will result in them making minimal functional changes to their organizations.

But on the occasions when they are bold enough to propose something that might actually change the way their organizations function, their default decision-support tool punishes them with wildly unpredictable information!

The extent of the problem

In a moment, I’ll explain an obvious problem with the math underpinning cost accounting. And we need to acknowledge that problem before we contemplate a solution.

But it’s important to note that lousy math is not the extent of the problem.

The bigger issue is that managers build a mental model of their organizations, and cost accounting is an integral part of this model.

This means that cost-based reasoning is applied by default to day-to-day management decisions, even when no math is involved.

But it gets worse. Because there are frequent situations where cost-based reasoning furnishes managers with obviously false conclusions, managers suffer from regular cognitive dissonance. You might expect this cognitive dissonance would cause managers to challenge their mental model of the organization, but, for the most part, it doesn’t. The more common effect is that managers hunker down and become even more defensive of their belief system and even more insistent that others respect the answers furnished by their cost-based reasoning!

Taiichi Ohno, the father of the Toyota Production System, once said: “It was not enough to chase out the cost accountants from the plants. The problem was to chase cost accounting from my people’s minds”.

Cost accounting’s fatal flaw: bad math

It’s impossible to understand the bad math that underpins cost accounting without first understanding the concept of “profit”.

Profit is probably not what you think it is

If our goal is to have an intelligent conversation about business, it’s critical that we understand that profit is not what you get when you subtract raw material costs from revenue: that’s contribution margin.

Profit is the stuff that a business generates. Profit is an attribute of a business. It is NOT an attribute of a transaction, a customer, a branch office, or even a project. Only businesses generate profits. It makes absolutely no sense to talk about a profitable transaction, a profitable customer, a profitable project, or even a profitable division.

Okay, so what is profit?

In simple terms, profit is cash that is released by a business that can be used by the owners of that business for other things. It’s true that profit can be reinvested in the business, but rational owners only do that when they expect that the investment will cause the business to release even more cash in the future (which can then be used for other things).

Now, profit is not a quantity; it’s a rate. A rate is a relationship between two quantities. Profit is the cash that is released by a business in a given time period. Profit is denominated in units of time. If the period isn’t specified, it’s implied.

It’s helpful to compare the concept of profit with velocity. Velocity is also a rate: the relationship between distance and time. However, there’s a difference. We never use velocity as a synonym for distance. However, the word profit is frequently used to refer to a quantity (cash) as well as a rate (cash/time). This is unfortunate. The former usage leads to confusion and, frequently, poor decisions.

The next obvious question is, how do you calculate profit? Profit is NOT revenue minus cost. Profit is the difference between two rates:

The rate at which a business generates contribution margin
The rate at which that business accrues operating cost

The difference between these two is profit: the rate at which a business generates cash.

I’ll say it one more time for good measure: profit is not a quantity. It’s a rate. (Cash over time.)

The time dimension is critically important to business. The moment we forget about time is the moment our business begins to decay.

The forgetting of time, institutionalized

To use a fancy turn of phrase, cost accounting abstracts away the concept of time.

When a decision is made to allocate some portion of an operating cost to a transaction, a relationship between that cost and transaction volume is assumed and then forgotten!

From that point forward, whenever a manager makes a decision using a fully loaded cost, they inherit someone else’s assumption without question. And they are, in all likelihood, making a decision that will cause a change in transaction volume that renders the initial assumption invalid!

Now, you might wonder how a business benefits from removing time from consideration and focusing only on cost.

There are two benefits. The first is ease of use. The second is cost containment, a byproduct of ease of use.

Ease of use

It should be obvious that nothing good will come from ignoring operating costs when making day-to-day management decisions. So, cost allocation does at least ensure that operating costs are considered when managers make decisions at the transaction level.

And ease of use is a big deal.

Managers need some method to estimate the organization-wide profit implications of the decisions they are asked to make on a day-to-day basis.

It isn’t practical for them to use calculus to reconcile the two different rates that determine profitability. Nor is it practical for them to consult complex mathematical models of the entire organization.

It’s unfortunate that cost accounting has a tendency to generate wrong (often wildly wrong) answers, but ease of use is definitely a benefit!

If we are to provide managers with an alternative approach to management decision-making, ease of use is a critical attribute.

The direction of the solution

The following (fictitious) story illustrates the conflict between a manager whose intuition is furnishing her with a correct answer in conflict with a directive from the organization’s cost accountant.

It also points us toward an alternative approach to management decision-making.

A young manager operating an airline ticket counter is approached by an anxious traveler just as she is about to close the flight. The traveler offers to buy a ticket on that flight for $100 (one-third of the standard fare), if any seats are available.

The manager’s intuition tells her to take the money and let the traveler grab the one remaining seat on that flight. She knows that this is the last opportunity to sell that seat. She also knows that all meals have been loaded already, meaning there are no incremental costs associated with the sale of that seat.

But she denies the traveler the seat. She recalls a visit from a regional manager who talked about the airline’s operating costs. The regional manager explained that the airline’s operating expenses were equivalent to $250 per seat on every flight. This meant that around half the passengers on a typical flight were loss-making passengers.

Our young manager tells herself that she just saved the airline $150, even though this conclusion seems intuitively wrong.

There is no shortage of stories like this that highlight the laughably incorrect answers that can be furnished by cost-based reasoning.

But, rather than laughing at cost accountants, a better use of this story (and others like it) is to ask why the correct answer is so obvious. What is it, specifically, about this story that causes the manager’s intuition to be obviously more accurate than the cost accountant’s math?

And, if we can extract a lesson from this story, can we generalize it and package it so as to provide managers with a viable alternative to cost-based reasoning?

A Rosetta stone

In the story above, it’s easy to see that the last remaining seat on the outbound plane was a unit of capacity that was about to expire. The traveler’s offer would have generated contribution margin for the airline with no corresponding increase in operating cost.

The key insight is that the traveler’s proposal would have increased the yield on a capacity-constrained resource. Accordingly, all additional contribution margin would have dropped straight to the bottom line.

Here’s a general conclusion that we can draw from the story.

If we can identify the resource that limits the rate at which contribution margin is generated, then we can use the productivity of this resource as a proxy for the profitability of the organization.

It’s time now to introduce a couple of terms that will simplify this discussion.

Let’s use the word Throughput (capital “T”) in place of contribution margin. Throughput is revenue minus totally variable costs. (Totally variable costs exclude direct labor, which does not vary in direct proportion to transaction volume.) Additionally, Throughput can be used more generally to refer to a unit of value.

Let’s use the word Constraint (capital “C”) to refer to the resource that limits the rate at which Throughput is generated.

We can now introduce a formula that’s an alternative to the standard cost-accounting formula.

Article content — (T is Throughput. Cu is a Constraint unit.)

This formula tells us that a change in Throughput per Constraint Unit is equal to the change in the organization’s profitability.

A manager can use this formula to make a management decision so long as they are confident that the proposal will not cause the Constraint to move to another resource.

If we return to our airline counter manager and assume the plane has 175 seats, the traveler’s proposal (if accepted) would cause T/Cu to increase by $0.57. (This assumes that 174 seats each generate Throughput of $300, and one generates $100.) Consequently, the airline’s profitability would increase by $100 over the period under consideration.

The delta T/Cu formula is a Rosetta Stone that enables a manager to predict, with impressive accuracy, the impact that day-to-day decisions will have on profitability.

Is this insight useful?

I can anticipate your objection, but before I address it, let me point you to an organization that uses this method to make critical management decisions.

That organization is an airline!

If you have had any exposure to airlines (including as a customer), you already know that airlines do not use cost accounting to make decisions of the type described in the story above.

Airlines adopted dynamic pricing in the early 1980s and have been fine-tuning it ever since.

Dynamic pricing is based on exactly the logic described above. It recognizes that seats on aircraft (in conjunction with cargo hold space) are the resource that limits the rate at which the airline generates contribution margin. Pricing decisions are made explicitly so as to maximize that yield.

Increasingly, hotels are doing the same thing.

Now, your objection, I suspect, might be that the proposed approach to management decision-making will not work for many organizations because it’s impossible to identify the specific resource, at any point in time, that is limiting Throughput.

Now, this is true. But it doesn’t have to be.

The reason the Constraint location is unpredictable in most organizations is that organizations are managed with a view to minimizing cost rather than maximizing speed.

The relentless minimization of cost within an organization is beneficial up to a point, after which it causes the organization to become chaotic, meaning that it causes the Constraint to move unpredictably from resource to resource.

Once the organization becomes chaotic, whatever increases in profitability are generated by cost reduction are eliminated by a sudden decrease in the rate at which the organization generates Throughput.

And this is terrible news!

When the rate at which an organization generates Throughput slows, the rate at which the organization delivers value to its customers also slows.

Practically, this means that every customer interaction runs slower. It takes longer to get a quote. It takes longer to get an order filled. And it takes longer to get an issue resolved. This means that the organization has become less competitive.

If an organization is managed with a view to maximizing speed, it will never be allowed to become chaotic—meaning that the Constraint will not move unpredictably from resource to resource.

Speed as an antidote to chaos

There’s a very simple (and incredibly important) reason for this.

When it comes to generating Throughput, not all resources are equal. For each unit of available capacity, a few make a vastly greater contribution than others.

For example, if you own a printing business, you will be more profitable when your million-dollar printing press is fully activated and your design team is out to lunch than you will be when your design team is heavily loaded and the press is sitting idle.

If your goal is to maximize the rate at which your organization generates profit, it’s incumbent upon you to first identify your printing press: that resource that makes the most significant contribution to your organization’s profitability (per unit of capacity). You should then design your organization to ensure that this resource is:

Consistently fully activated
Loaded with the mix of work that generates the highest Throughput per Constraint unit

Once you have anchored your Constraint at its optimal location, the airline metaphor above suddenly becomes relevant. You can then use delta T/Cu to predict the profit implications of most day-to-day management decisions.

The solution: Throughput-based reasoning

Every meaningful management decision involves a prediction.

In a large, complex organization, effects are separated by both space and time from their causes.

When a manager considers a simple proposal (for example, should I offer a discount for a bulk purchase), their job is to try and predict the consequences of that proposal. And, ultimately, the consequence that really matters is the impact on the profitability of the organization.

So, cost-based reasoning is a means of making predictions. Throughput-based reasoning, proposed here, is an alternative.

The obvious questions, then, are which is the easiest to use and which has the greatest predictive power?

Two approaches to predictions

Cost-based reasoning excels when it comes to ease of use. You simply subtract the change in revenue from the change in fully loaded costs to arrive at the predicted change in profit.

Throughput-based reasoning requires that you calculate Throughput per Constraint unit for both the current and the proposed scenarios. The difference between the two is the predicted change in profit.

To determine if these additional steps are worthwhile, let’s consider the predictive power of both approaches.

Cost-based reasoning proceeds from the assumption that operating costs vary in direct proportion to transaction volume. If you sell one more unit, your operating costs increment accordingly.

We know this is wrong. The relationship between operating costs and volume is a step function. As you sell more units, operating costs remain unchanged until suddenly, they don’t!

This is consequential for two very important reasons. First, we cannot assume that the scale of an organization smoothes out this step function. Costs ratchet up periodically, but under normal circumstances, they don’t ratchet back down.

And, second, in a competitive market, profit is generated at the margins. What this means is that most of the Throughput generated by a large number of transactions pays down operating costs. The difference between being just profitable and very profitable comes down to just a few additional transactions. Cost-based reasoning actually obscures the outsized profit contribution made by those additional transactions.

The power of Throughput-based reasoning is that it recognizes the true nature of the relationship between Throughput and operating costs. It recognizes that these are not two independent variables (like a person running up a down elevator). It recognizes that, within a non-chaotic organization, there is a predictable relationship between a change in volume and a change in profitability.

The key to understanding this relationship is to recognize the reason why operating costs exist. Operating costs are the cost of our organization’s capacity: the capacity to do work and, consequently, to generate Throughput (either directly or indirectly).

Because we know that the profitability of an organization increases when Throughput increases relative to operating costs, then we can conclude that profitability is proportional to the yield on capacity.

In most organizations, this observation is correct but useless! Operating costs pay for all kinds of capacity (machines, real estate, insurance policies, HR departments, and so on). It’s simply impossible to reconcile the capacity of the organization with a unit of Throughput.

However, as discussed earlier, when an organization is managed for speed, management will act to ensure that the resource that makes the largest incremental profit contribution is fully loaded at all times.

When the organization is operating in this state it becomes easy to understand the relationship between Throughput and capacity. We can disregard all resources other than the Constraint, divide the capacity of the Constraint into units of useful work, and then simply estimate how many Constraint units will be consumed in order to fulfil each order.

Now that we understand the relationship between Throughput and capacity (and, accordingly, between Throughput and operating costs), we can quickly and accurately predict the (organization-wide) profit implication of most proposals.

A simple, bottom-up approach to management decisions

Throughput-based reasoning (unlike the alternative) empowers operators to make bold decisions: those critical decisions that have an outsized impact on the organization’s profitability.

If the location of the Constraint is obvious to operators, Throughput-based reasoning is intuitive. However, if the organization has been allowed to descend into a chaotic state, operators have no choice but to retreat to the relative safety of cost-based decision-making.

Accordingly, it is the responsibility of senior management to design the organization in such a way that the Constraint remains anchored at its optimal location by sufficient protective capacity at all other resources.

Senior management can also assist operators by identifying and visualizing metrics that reflect the contribution (positive or negative) that operators’ work is making to the productivity of the Constraint.

Upstream from the Constraint, metrics should be designed to ensure that the Constraint is never starved of work, and downstream, metrics should ensure that a unit of value generated at the Constraint is never wasted.

Obviously, operators should not be allowed to make decisions that will cause the Constraint to move. (We’ve all seen the catastrophic effect on airlines when a technology problem causes the Constraint to shift from their fleet of aircraft to the reservation system!)

However, in a healthy, well-designed organization, it should be very difficult to move the Constraint.

Containing costs

It should not be assumed that a shift in management focus from cost to speed is a license to spend indiscriminately. The overriding goal, obviously, is the generation of profit.

Raw-material costs are always considered in the calculation of contribution margin and any proposal to increase operating cost should be treated similar to an investment proposal.

The containment of costs is like wearing hearing protection on the plant floor. It’s not the goal, but it’s certainly a necessary condition.

The major difference in this new environment is a heightened awareness of the importance of protective capacity. An idle machine (or person) is adding value if they are preventing the Constraint from becoming idle. Think about it: you wouldn’t downsize your district’s fire brigade if you discovered that firefighters weren’t actually extinguishing fires 24 hours a day!

Two critical value chains

There’s another insidious way that cost accounting damages businesses. By abstracting away the concept of time, the cost-based approach to decision-making obscures the fact that businesses contain processes (or value chains) that must be decoupled.

By decoupled, I mean that they must operate with a high degree of independence.

Healthy businesses contain two such value chains. (I’m favoring the term value chain rather than process because these processes span multiple departments):

The first value chain generates Throughput.
The second value chain generates growth (a positive change in Throughput).

The Throughput value chain consists of the sequence of activities required to convert a customer’s order into money in the bank. (The various departments that perform these activities are typically members of the operations group.)

The growth value chain consists of the activities required to increase the rate at which customer orders are received. (The departments that contribute to growth include sales, new product development, quality, and acquisitions.)

If you consider the departments that contribute to growth, two things are clear. First, in most organizations, these departments are not managed as part of a distinct group. And, second, in most organizations, individuals within these departments are responsible for activities across both value chains.

For example, salespeople are frequently responsible for solving customer problems, and engineers are often responsible for both new product development and the processing of customers’ special orders.

The problem with sharing resources between these two value chains is that whenever there is resource contention between the two, the Throughput chain will win. Under these conditions, unless you have a lot of protective capacity (which is unlikely when cost-based decision-making is prevalent), what tends to happen is that the level of effort allocated to growth quickly goes to zero!

A better approach is to manage these two value chains as distinct groups. Each has its own goal. Each will have its own Constraint. And each will have its own set of metrics. If resources absolutely have to be shared between these two groups, those resources should have a lot of protective capacity and they should be formally scheduled to avoid contention.

Of course, these two groups are not fully independent—they are nested, like Russian dolls—but they should be managed independently. Money spent on growth should be treated like an investment, not a normal cost. This is because the output of this group (the addition of a new customer, the acquisition of a competitor’s business, or the commercialization of a new product line) is a new stream of Throughput that will persist for many normal reporting cycles.

An introduction to metrics

Eli Goldratt would often say, “Tell me how you’ll measure me, and I’ll tell you how I’ll behave.”

This idea should not be controversial, given that a metric is just a form of feedback. All but the most simple tasks require that the operator make regular adjustments to their work based on the evidence of their senses.

The purpose of a metric is to either augment or replace the operator’s senses (pilots, for example, learn to trust their instruments over their senses).

Metrics should be designed to synchronize the behavior of operators with the goal of the organization. A Kanban bin system is a perfect example of this in a production environment. If parts are present in a bin, the operator will process those parts, and when the bin is empty, they stop. The bin prevents overproduction and, more likely than not, results in the operator working faster when there’s actually work to be done.

Importantly, the Kanban system improves the profitability of the organization by causing the operator to be less efficient!

A system of metrics

It’s beneficial for the executive team to carefully design a system of metrics for the organization rather than inheriting traditional metrics or trusting that line management will select metrics that result in operators subordinating effectively to the goal of the organization.

Ideally, each department should have a single metric for value creation (or key performance indicator) and one or two necessary conditions that must be respected. The most effective key performance indicators (KPIs) are compound measurements that, under normal circumstances, make additional measurements redundant. (For example, if a production department is consistently averaging 95% on-time-delivery performance, we can assume that the assembly line is not suffering from unscheduled downtime.)

Your system of metrics should have a hierarchical structure.

At the top of the hierarchy, there’s a single metric that subsumes both the profitability and the growth of the business. That metric is enterprise value (or stock price, averaged over a sensible timeframe).

At the next level, we have the two value chains that drive profitability and growth. The metrics for these will be Throughput per period and new-business value per period, respectively. In both cases, the period should be the shortest sensible timeframe. Ideally a day (not a quarter!). New-business value is the net present value of new business won (think of the lifetime value of a new account, for example).

Now, each of these value chains will contain a nominated Constraint. Accordingly, metrics for each department within these value chains should be set with respect to the Constraint. Generally speaking, activities upstream should replenish the Constraint as rapidly as possible (so it is never starved of work), and activities downstream should ensure that work done at the constraint is converted to value rapidly (so the Constraint’s capacity is not wasted).

So, as an example, if we consider the procurement department in an engineer-to-order production environment, we might conclude that the role of procurement is to ensure that all inputs for jobs are received prior to the scheduled release. However, we would also recognize that building parts inventories is undesirable. Consequently, we might measure the percentage of procured parts that arrive during a pre-release Goldilocks zone.

Such a metric would penalize both late deliveries and inventory building and would encourage the development of healthy supplier relationships and the micro-management of those suppliers with less-than-optimal historical performance.

If you’ve ever spent time in a procurement department in a cost-focused organization, you’ll appreciate that these are not common behaviors!

Retooling for speed

The move from cost- to Throughput-based reasoning does not start by teaching operators new operating procedures. It starts with:

A commitment to speed, rather than cost, as the basis for optimization
A redesign of the organization to anchor the Constraint locations

The former requires that you read (and maybe reread) this paper and, ideally, the additional resources referenced.

The latter is a more significant undertaking. First, you need to determine the resource (or set of resources) that should be the Constraint (for your Throughput value chain). If you’re not sure, your Constraint should probably be the resource that makes the biggest contribution to your competitive advantage (as well as to profitability) when it is fully activated.

You will then need to change the way that work is planned within your organization so as to force your nominated resource to become the Constraint. The transition from chaos to a single Constraint must happen quickly (definitely within 30 days).

And then, when the transition is made, you can turn your attention to your system of metrics and your plan to drive growth and, accordingly, the design of your growth value chain.

In a typical organization, these first two steps involve a significant amount of work. But, if you have a commitment to growth, you must compare the level of effort associated with this approach with the level of effort demanded by the cost-focused alternative.

An ode to speed: part 2

At the start of this paper, I stated that if I were to give a single piece of advice to the owner of an industrial business, it would be to increase your organization’s clock speed.

I truly mean that. A business that runs faster is a business that delivers more value to its customers and generates more profit for its owners. Furthermore, a business that runs faster also grows faster.

The widespread adoption of cost accounting has removed the time dimension from day-to-day decision-making and has contorted the mental model that informs most managers’ intuition.

If you want to outgrow your competitors, it’s critical that you reintroduce the time dimension to decision-making throughout your organization.

Coda: two examples of Throughput-based decision-making

How should a manufacturer of countertops price a new product

A manufacturer fabricates countertops from engineered stone for commercial projects. They have developed a range of sinks that can be fabricated from the same material as the countertop. They need to know how to price these sinks.

There are four critical pieces of information this manufacturer should collect to make this decision:

What is the price that the market is paying for comparable sinks?
What are the totally variable costs associated with the sink?
How many units of Constraint capacity will be consumed in order to fill an order for a sink?
What is the current yield (T/Cu) at the Constraint?

Let’s assume that the market is paying $1,000 for comparable sinks. Let’s also assume that the raw-material cost will be just $100 (we predict that 60% of the stone will be scrap from countertop production that would otherwise be discarded).

Let’s assume that this manufacturer’s Constraint is its installation crew. This would imply that the manufacturer programs the plant operation around the availability of the crew. With careful programming, we’ll assume that the crew can do two installations a day.

The current yield on the Constraint (T/CU) is the total Throughput for a standard period divided by the number of installations over that period. If we assume the crew averages nine installations a week (one half-day is lost to callbacks) and that the total Throughput generated over that period is $47,250, then an average Constraint unit is yielding $5,250.

If we assume that it takes the installation crew 60 minutes to install a sink, then this is a lot less than the half-day Constraint Unit. But, there’s a danger that, in some cases, the additional time required for sink installation will prevent the crew from doing a second installation that day. In these cases, the sink installation consumes an entire Constraint unit. If this occurs just twice a week, then the sale of each sink generates $900 in Throughput but decreases T/Cu by $467.

Under these circumstances, the manufacturer would need to charge at least $1,467 for the sink just to maintain current profitability, which makes these sinks a questionable proposition.

However, the manufacturer should consider some additional options:

They could take steps to reduce the sink installation time and eliminate the risk of the installation consuming an additional Constraint unit.
They could sell sinks direct-to-consumer, which would would place no load on their Constraint.
Additionally, the manufacturer might consider having a separate specialist perform callbacks. After all, it’s unlikely that callbacks require exactly the same set of skills as installations.

The profit implications of the four scenarios presented here are wildly divergent. However, the important point is that this analysis would not normally be performed in an environment where cost-based decision-making is prevalent.

The danger of the departmental profit and loss statement

A year ago, a large commercial plumbing firm acquired a small manufacturer of pre-fabricated plumbing racks.

These prefabricated racks dramatically reduce the time it takes for a plumber to install bathrooms and kitchens in large projects (like hotels).

The plumbing firm’s assumption was that the manufacturing business would increase the productivity of its commercial plumbers (a limited and expensive resource) and generate some additional profits by selling its products to other plumbing firms.

A recent review of the performance of the acquisition revealed that the expected productivity improvements had not been realized. The only good (but somewhat concerning) news was that the manufacturing division was selling more units to competitive plumbing firms than expected.

The problem was that the manufacturing division continued operating autonomously after the acquisition. Specifically, it generated its own profit and loss statement and sold its products to the larger plumbing firm at market value.

Because the manufacturing division was attempting to maximize its profitability, it kept costs low (which limited capacity) and sold its products to the highest bidder. Because supply was limited, project managers within the larger plumbing firm had concluded that the division was an unreliable supplier and were electing to have plumbers do their own fabrication on-site.

The root cause of this problem is a failure to properly integrate the manufacturer into the larger organization. It should not have been allowed to operate autonomously, and it should definitely not have been expected to generate its own profit and loss statement.

The larger plumbing firm should have held its new manufacturing division accountable to a metric that drove proper subordination. The identification of this metric requires an understanding of the Constraint within the larger enterprise.

If (as is likely the case) the Constraint is the plumbing firm’s pool of qualified plumbers, proper subordination would mean ensuring that prefabricated racks could be delivered to building sites whenever required (without the requirement for quotations or purchase orders!).

The metric for the manufacturing division would be on-time delivery performance, which means that the manufacturer would be forced to maintain protective capacity to accommodate variability in demand.

This protective capacity would inflate the manufacturing division’s costs relative to the autonomous mode of operation, but some of these costs could be offset by using downtime to manufacture units for sale in the open marketplace.

These changes would result in the enterprise Constraint becoming more productive, causing a direct increase in Throughput. The acquisition would perform as expected if the increase in Throughput is meaningfully larger than the manufacturing-related operating expenses.

Interestingly, it would make total sense for the plumbing firm’s finance department to use cost-accounting methods to analyze the commercial viability of the acquisition both before and after the fact.

But it makes no sense whatsoever to use cost-based logic to make day-to-day management decisions. In addition to generating incorrect results, the resulting cost-based mental model will create a gravitational pull toward the atomization of the organization (the presumption of profits at the level of divisions, product lines, and transactions).

Assistance is available

Justin and the Ballistix team create and actively participate in Steering Committees for a small number of organizations. These Steering Committees are dedicated to transitioning those organizations to what we call a Speed-Based Operating System.

If you’d like an overview of this service offering, please send a request to [email protected]