Saturday, March 17, 2012

Focus and Leverage Part 97

The other day I was having a discussion with a client and the subject turned to the best way to improve profitability.  This person was a staunch advocate of manpower efficiency and for those of you who follow my blog, you know I am not at all a fan of this metric.  I asked him why he thought manpower efficiency was a good metric and his answer floored me.  He said, "Because if I can get more product out of a worker, then I know my profits will improve and since increasing efficiency is a sure fire way to know if I'm getting more, I love this metric."  This is not an unusual response for those folks who believe in this metric, but they're wrong.  When I told him that the key to profitability was not through saving money, but rather the key is making money, he got such a confused look on his face.  We had a longer discussion on this subject and I want to share some of it with you.

In the early 1900's Cost Accounting (CA) was just coming into being and was starting to be used widely.  Then, as now, business owners understood that if they wanted to stay in business and make money, then the selling price of their products (or services) had to be greater than the cost to make it and ship it.  This fact hasn't changed, but the way we get there has.  Back then most workers didn't work your standard 40 hour week and were not even paid an hourly wage.  Instead they were paid based on a piece-rate system.  No matter what you made, your take home pay was based upon how many "things" you made.  In other words, labor costs were variable in nature.

Somewhere down the line the way laborers got paid changed from a truly variable piece rate system to a fixed rate.  That is, laborers were now paid an hourly wage so labor was now a fixed cost.  The problem is, the accounting system didn't change with it.  When this change happened, it became apparent to the business owners that in order to increase their profits, they had to get more products out of their existing work force.  This is when manpower efficiency came into existence and the common belief was that if you could drive efficiencies higher and higher, then profits would surely increase.....right?  Business owners drove efficiencies higher without regard to sales orders, but since they believed they were more profitable with higher efficiencies, then how could they be wrong?

There was a problem with this type of thinking.  Because their factories were filling up with all of these cheap products, they had to build warehouses to store these cheap products in.  Because their output exceeded their sales volume, inventory kept growing and growing.  The prevailing view was that because high efficiencies resulted in less expensive products, it was ok to over-produce.  But sooner or later the raw material suppliers came knocking at their doors wanting to be paid, but because their costs now exceeded their sales, they were short on cash.  The problem was, that although labor costs had changed from variable to fixed costs, the cost accounting rules had not changed.  The owners were still trying to treat their labor costs as variable and allocate labor costs to individual products.  And when this happens, the owners work very hard to drive efficiencies higher so they can drive down the labor cost per part.  This is the cost saving mentality and many owners have simply saved their way to bankruptcy.  So if saving money isn't the answer, what is?

In my next posting, we'll talk about a different way of viewing the path to profitability.....the difference between saving money and making money.

Bob Sproull

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