Saturday, July 9, 2011

Focus and Leverage Part 42

I was reading the TOC-Lean Institute’s latest newsletter yesterday written by Dr. Ted Hutchin from England. If you don’t receive this newsletter, you really should because it’s always full of valuable tips and insights (www.toc-lean). Anyway, in this issue, Ted had a discussion about Deming, Ohno and Goldratt and he pointed out something that they all had in common, their dislike of traditional cost accounting (CA) for making operational decisions. They all agreed that we should be more concerned with things that result in system improvements rather than localized improvements. As I read his newsletter, I thought he probably should have included Henry Ford into this mix of “giants”, as Ted refers to them. All four of these men unsuccessfully fought against the dominant paradigm of Cost Accounting (CA). I say unsuccessfully because, even though all of them disliked using CA for decision making, and openly spoke out against it, many companies still use it to their detriment.

In the early twentieth century, the pioneers of the Industrial Revolution challenged "financial" accounting. In fact, Ford said that “We should not let Cost Accounting run the business!” Ford believed that Cost Accounting was simply a data dump whereas Cost Management was "information." Ford said that financial information signals to us that something is wrong, but it fails to tell us what is wrong. He further explained that Cost Accounting has only two real purposes, tax accounting and financial statements.

One of Ford’s famous quotes was, "We have never considered any costs as fixed. Therefore we first reduce the price to a point where we believe more sales will result, then we go ahead and try to make the price. We do not bother about the costs. The new price forces the cost down." (Ford, 1922)

Like Ford, Ohno focused in on the flawed judgments resulting from cost accounting thinking. To quote Ohno, "If you insist on blindly calculating individual costs and waste time insisting that this is profitable or that is not profitable, you will just increase the cost of your low volume products. For this reason there are many cases in this world where companies will discontinue car models that are actually profitable, but are money losers according to their calculations. Likewise, there are cases where companies sell a lot of models that they think are profitable, but in fact are only increasing their losses." He discussed the importance of not letting your understanding be clouded by thinking with the accounting mindset. Another of Ohno’s famous quotes was, “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.”

Ohno believed cost accounting thinking was the biggest obstacle he had to overcome in developing his TPS system. Workers believed they should make each operation very efficient, which often meant running big batches of parts. But Ohno knew this was detrimental to the total system.

Deming told us that a common mistake was to assume that an organization can be managed on the basis of economic performance. In fact, Deming said that using cost accounting metrics to make decisions is like “driving by looking in the rear view mirror.” As Deming said: “…we need good results, but management by results is not the way to get them”

Deming also said, “What we need to do is learn to work in the system, by which I mean that everybody, every team, every platform, every division, every component is there not for individual competitive profit or recognition, but for contribution to the system as a whole on a win-win basis.” “Eliminate numerical quotas, including Management by Objectives.” The following is an excerpt from Chapter 4 of The New Economics, second edition by W. Edwards Deming:

Accounting-based measures of performance drive employees to achieve targets of sales, revenue, and costs, by manipulation of processes, and by flattery or delusive promises to cajole a customer into purchase of what he does not need (adapted from the book by H. Thomas Johnson, Relevance Regained, The Free Press, 1992).

Like Ford, Ohno and Deming, Goldratt was very much opposed to using traditional cost accounting metrics to make decisions. In The Goal, Alex learns from Jonah several concepts which are directly opposite from what he has been taught before about business operations. Jonah explains that:

1. Money is more important to management over efficiency.

2. Cost accounting is the number one enemy of productivity.

3. A plant in which everyone is working all the time is inefficient.

Jonah points out that the best way to increase profits is by simultaneously increasing throughput while reducing inventory and operating expenses. Jonah also explains that a balanced plant is where the capacity of every resource is balanced exactly with demand from the market. However, the closer you come to being a balanced plant the closer you are to bankruptcy.

So if these four great men all were in harmony in terms of their opposition to cost accounting, why is it then that most companies still use CA in their daily decision making? There are serious shortcomings associated with both GAAP and Absorption Accounting not the least of which are that they encourage inventory accumulation and “paper profits” through overproduction; production expenses associated with WIP and Finished Goods; and allocations that further distort the true costs of production all of which lead to inappropriate decisions on pricing, staffing, capacity and scheduling.

I don’t know about you, but because these four truly great mean believed that traditional cost accounting was not in the best interests of companies, then maybe we should all take heed to their advice and opinions.

Bob Sproull

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