@ Supply Chain Management


The blind spot in cost calculation…

Early on in my career (i.e. just after my undergraduate degree), I interviewed with BCG. (The only thing I learnt from those heady days was not to be a pompous arrogant ass). Personal distraction aside, I worked through a case with one of the consultants about “saving” a business making tractors from almost certain ruin given such and such market conditions. Coming from a mechanical engineering background, I was not only completely sold on the importance of R&D, good product design, quality etc etc but also unwilling to brook any spending cuts in those areas. The “answer” (or the best supportable answer most likely) to the case was cutting R&D and product development costs for the tractor manufacturer and redeploying those funds to marketing and what not. That and a love for engineering that couldn’t be hidden meant a ride on the road less taken and this during the Asia Financial Crisis of 97-98 (though it quite felt like 97-2000). Today, I have come full circle and its taken me 8 whole years – I still love engineering, trust marketing to elucidate value (not create value), am skeptical of accounting variances and varied accountants (though I realize the value and the limits thereof of accounting practice) and might still fail the BCG case again – taken honestly. Though, I work in supply chain consulting and using a quantitative and optimization approach, I am always keenly observing the limits of what works and what is plain hooey even if it is based on incontestable numbers – that might seem rather piquant but even incontestable numbers come from contestable underlying philosophies. And its precisely this underlying philosophy that this article at Panta Rei: Gemba Keiei, Chapter 6: The blind spot in cost calculation is all about.
Let me jump right in:

Just in Time is the design of production activity to be closely synchronized with customer demand according to the three principles of Takt Time, One-Piece Flow, and Downstream Pull. One of the major goals of Just in Time is to prevent the mother of the 7 wastes – overproduction – by making only what the customer needs, when they need it, in the right amount.

And thus manufacturing became an art. There is the science of manufacturing, the logic of manufacturing and the art of manufacturing. The above statement encapsulates what can be termed the logic of manufacturing. But somewhere in elucidating the above logic, manufacturing turned from being a science, from numbers, yields, WIP and lead times into an art. The art is the whole thing subsuming logic and science together into a practical effort.

Taiichi Ohno begins the chapter by saying that there is a misconception in the minds of people who calculate cost. They believe costs can be lowered on the basis of volume produced without considering the actual customer demand.

Well, it depends on where you draw the system boundaries. It is not that either of the above logic described is incorrect but one has to look at the completeness of the description. Costs can be lowered on the basis of production volume = economies of scale, nothing wrong here. However, the system drawn up here doesn’t take any inputs from any agent outside the purview/control of the firm when it calculates its manufacturing cost. In this day and age, when a firm goes through its product design and development process, it is not averse to getting customer input at critical design junctures or in the whole design process – doing so mitigates serious risks and thus future costs down the line. Why should manufacturing be any different? The key customer input here – the true nature and magnitude of customer demand. Sometimes demand data is simply unavailable or too difficult to obtain from customers and if manufacturing proceeds without taking efforts to control the risks that such uncertainty introduces in their business model – then system failure is not far off. Adopting JIT as a manufacturing philosophy means creating a system where customer demand uncertainty is reduced by waiting sufficiently long enough until the manufacturer can “see the whites of his customers’ eyes” before acting.

Ohno says “Make only as much as the customer will buy. Don’t make things the customer won’t buy” but the cost accountants reply “What are you talking about? Of course it’s cheaper to make 20 than to make 10.” Ohno recognizes that in terms of simple math what the accountants say may be true but says the reality of costs is not so simple.

Its not the simplicity of the math as Ohno says but the simplicity of the system that the accountants have drawn up and by which they practice their craft. The real world is not just that simple and we ought to adapt ourselves to mitigating uncertainty and risk wherever possible.
However, Ohno makes a larger point next which harkens back to the incontestability of numbers that are available when it is the underlying philosophy that is actually the source of contest.

Here he introduces the famous three equations for cost. Mathematically they are the same. They are very different in terms of the point they bring across. The equations are:
1) Price – Cost = Profit
2) Profit = Price – Cost
3) Price = Cost + Profit

Mathematical axioms are not subject to change by definition and therefore there cannot be anything logically untrue in the above statements. However, the question to us who have to act always is – what variable/constant is known, what are fixed/changeable and what are the underying systems that deal with the three variables/constants above?

In the case of equation 1 the market is competitive and the price is set by the customer.
In the case of equation 2 you need to make a certain profit, let’s say $0.25 per unit. So here you have to increase the value and increase the price so that if your cost is $1 you can now sell it for $1.25.
In the case of equation 3 the math may be the same but the underlying thinking is different, says Ohno. If $0.25 is a fair profit and the cost per unit is $1, then you may set the selling price at $1.25. However if the customer can purchase the same thing elsewhere at $1 then you can not set the price this way.

Nothing mysterious here. All you’ve got to do is choose your mode of competition or adapt a hybrid mode of competition – you can deliver value while trying at the same time to drive costs (what’s the definition of cost agian?) out of your system.
Here is something to savor from Taiichi Ohno:

Costs do not exist to be calculated. Costs exist to be reduced.”

Now, should an accountant’s performance be based on cost reporting or cost reduction? You decide.

Category: Lean, Reviews


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June 2006