A helicopter perspective to profitability

Business is about the fact that the result of the process of processing products & services generates more money from customers than the company has to pay for all the resources they consume. That is, a productivity that generates profit and/or return on invested capital. This may be illustrated by The Refinement Bowl:

refinement potpng
The Refinement Bowl



But what if the productivity is blurred by a fog, with no or little transparency? How do you manage and control your business then?

A possible growing bureaucracy, which consumes resources only, but which does not contribute to the value increase of the products or services, therefore means a deterioration of productivity and thus decrease of profit or return.

Maximized productivity builds on full visibility throughout the processing process from supplier to customer in order to manage and control resource consumption relative to its contribution to the value increase of the product or service.

The formely accounting firm Arthur Andersen divided resource consumption into the concepts "Added Value Cost" and "Non Value Added Cost". A division that was accepted by large parts of the consultative community and also by the education system. A division we as founders of the expertscenario initiative strongly questioned.

The reason we didn't accept this division was because the breakdown means accepting resource consumption in the business that does not have to confirm its existence based on its contribution to the value increase of the products and services or to the return on invested capital. In other words, the acceptance of the concept of Non Value Added Cost opens for a growing unproductive bureaucracy which nobody wants.

A paradigm shift

The Post-Industrial Society has resulted in increasing overheads in product estimates of resource consumption with little or no link to the Direct Materials or Direct Payroll bases. Hence a resource consumption that is not directly measurably linked to any increase in value of the products or services concerned. A non-measurable resource consumption, which is a result of, among other things, the sharply increased range of information technology and that more and more work linked to products and services occurs as "soft refinements" behind administrative desks in offices.

Hard vs Soft refinementpng

The growing overheads, in practice, mean that productivity transparency is more blurred across the entire process from suppliers through the operations and finally to the customers. Worse, this is reinforced by the existing industrial economic governance models.

In our book The Hidden Treasure Chest (Bergstrand, 1993), we pointed out the consequences of the increasingly dense fog: "The direct costs in the refinement flow are generally managed well by businesses.

But costs like different common services, on the other hand, businesses don't have a clear or complete picture of. Thus, they cannot make a fair distribution of the specific resources a certain product consume. These costs may be described as a fog that is routinely distributed on a flat-rate basis to the product and and affects its price unfairly, as well as increasing overhead costs budgets.

The Hidden Treasure chest was written 35 years ago, but nothing has happened to measure or to remove this fog. Instead, the accelerating growing share of resource consumption associated with IT and administrative tasks has resulted in an increasingly dense fog and thus, weaker tools to manage and control your business to optimal productivity and bottom line.

Today, we describe the productivity fog as:



Productivity fogpng

The increased costs for IT and administration are applied to the products or services in the refinement process in form of growing overheads where there is no clear cost-related relationship between the resource utilization and the refinement process.

Overhead costs are financed through a cost budget. Since there is no measurable link between these costs and their contribution to the refinement process, there are huge risks that other factors determine how much funding different departments receive from the cost budget.

The law of Parkinson and Lean Accounting failure

Parkinson's law tell us that "work expands so as to fill the time available for its completion".

This law includes the claim that "the one who has the least to do is most stressed." Parkinson also believes that the number of employees and the working volume is not in relation to each other. Two arguments for this are:

  • An official wants to increase the number of subordinates, not the number of rivals
  • Employees create work for each other
Through some mathematical formulas, Parkinson's law describes how to get seven employees in a short space of time to do the job of what only one did before.

According to Practical Lean Accounting (Maskell, Baggaley & Grasso, 2011), the overhead costs illustrated in the above picture may result in negative Lean consequences the authors claim:

”Many companies also focus on the absorption of overheads. This again leads production supervisors and operators to make too much product. They may not have a full understanding of how the overhead absorption works, but the they know they can keep the cost accounts off their backs by making more products and building inventory. This is particularly marked in the month-end and often contributes to the wasteful and non-Lean month-end push of production out of factory the last few days of the period”.

“The Financial Vice President complained of the underabsorption of fixed costs caused by the reduced production”.

These two quotes may well be correct in their problem description and conclusions but, unfortunately, also be completey false. That means there is a risk that the authors in their conclusions allow Lean Accouting to suboptimize instead of the opposite.

If there are correct conclusions or not, we simply don't know because of:

  • The productivity fog makes it impossible to measure the connection between IT and administrative contributions to the value of products or services and thus to overall productivity and profit.
This means, at least in the short term, that the productivity may be improved as a result of the use of IT and administration when more products are manufactured and stocks is increased
  • The productivity fog certainly reflects a "soft" refinement that should be managed and controlled based on the same priciples as the "hard" refinement. However, instead of identifying possible soft refinement, Lean Accouting neclect the entire issue by neutralizing the product calculation as a control tool and instead works with different measurements associated with Value Chain.

The disaster of the Balance Sheet

An additional complexity associated with the productivity fog problem is the management of soft investments in the balance sheet.

Hard investments are balanced in the balance sheet and consumed linked to production. It is a foundation for a functional pre- and post-calculation of product profitability and a fair judgement of profitability of a business. But the increasing share of soft investments is not balanced in the balance sheet but directly affects the entire business and destroys pre- and post-calculations of a product profitability and - worse - provides a false cost perception of a business.

Summary

The cost of using IT and administration must be measured on the basis of its contribution to the value increase of the services concerned. Likewise, soft investments must be taken into consideration.

We will investigate how to handle this within the framework of PIAM linked to our proven Staircase model.

Bert-Olov Bergstrand
Senior Advisor