Friday, October 3, 2014

Focus and Leverage Part 378

In my last posting in the accounting series, I told you that we would look into other problems related to or caused by traditional Cost Accounting, so in today's posting I want to discuss how Cost Accounting drives behaviors in the opposite direction of how companies should be run.  I will be quoting from another excellent book on this subject entitled The Measurement Nightmare - How the Theory of Constraints Can Resolve Conflicting Strategies, Policies and Measures written by Deborah Smith, published by the St. Lucie Press.  For anyone who wants to better understand the shortfalls associated with traditional Cost Accounting, I highly recommend this book.

In the Introduction section of Debra Smith's book she tells us that ?Companies seeking to maximize return on investment are increasingly forced to compete in a global environment that requires dramatic gains in the following factors:
  1. Increasing sales and market share
  2. Reducing cycle or lead time
  3. Increasing quality
  4. Reducing inventory
  5. Reducing costs
She continues, "Companies that excel in these areas have the ability to compete based on these features rather than on price alone.  This advantage gives them the ability to differentiate themselves in the marketplace."

From these 5 factors, it's common place for companies to develop a comprehensive strategy.  The problem that I see, is that the systems many companies use to measure success are not aligned with a system perspective.  Someone once asked me what I thought held back companies from maximizing their profitability.  I immediately replied and told this person that companies fail to recognize the interdependencies of the local actions that they take.  One performance metric that I believe causes many of the problems experienced in many companies is manpower efficiency.  So why do I think so?

To answer this question, I want to turn to Debra Smith's excellent book.  Debra tells us, "In a traditional costing environment, in order to produce a least-cost unit, all production resources must maximize their output and run at maximum efficiency.  This will increase overtime and work-in-process and raw material inventories and lengthen the cycle time. Clearly these are opposite actions with opposite results. No wonder floor managers are confused and constantly fight fires.  It is the logical culmination of compromising between maximizing local utilization and effectively moving product through the plant."  Debra's point is that by trying to optimize the performance metric efficiency, there are negative consequences.  By attempting to maximize local efficiencies, WIP explodes, cycle times become extended and on-time deliveries deteriorate.  And in an attempt to ship on time, companies typically resort to overtime which increases operating expenses and needlessly reduces profit margins.

What else?  In the Theory of Constraints there is a logic tool referred to as the conflict cloud.  The purpose of the conflict cloud is to present a simple method for logically diagramming conflicts.

The figure above is an example of a conflict cloud which reflects to very different approaches to meeting the objective of maximizing measured performance in an area of control.  The cloud is read as follows:  In order to maximize measured performance in area of control (A), the plant must ship on time (B) and in order for the plant to ship on time, all resources must run at the constraint's (bottleneck's) pace (D).  The opposite side of the conflict is read as follows:  In order to maximize measured performance in area of control (A), the plant must produce at least cost per unit (C) and in order to produce at least cost per unit, all resources must run at their maximum efficiency (D').

In Deborah Smith's book she has a figure she refers to as a Spider Web Conflict Cloud which lists 8 different conflicts that all are related in some way to the issues related to traditional cost accounting.  For a detailed description of the spider web conflict cloud, I encourage you to buy Debra's is well worth the investment.  The bottom line for me is that following the practices from cost accounting will lead you in the opposite direction you want to go.  I am not disputing that companies must follow GAAP reporting to the government, but as Debra rightfully points out, it is not the method of choice you should be using for making real time financial decisions.

In my next posting, I begin the discussion on what I believe is a much better accounting system named Throughput Accounting.

Bob Sproull

No comments: