## Keep it Simple

We have created an entire generation (or two) of managers who are very savvy with cost accounting models. They know exactly how “costs” and “profits” are calculated, and they know exactly what inputs to manipulate in order to make the numbers as good as possible.

They know, for example, how “inventory turns” are calculated, that “average inventory” is determined by end-of-quarter snapshots, and how to turn off production and pull in next quarter’s sales to starve the system for a week. Of course, anybody can also claim reduced oxygen consumption by holding his breath when it is being checked.

I put the terms “costs” and “profits” in quotes because one of the features characteristics problems(?) with modern cost accounting is that the models are complex. They are that way, not because costs are complex, they aren’t. They are that way because reporting is complex. They are that way because managers want to be secure in a fantasy that they can have a unit cost for every unit of production. “This product cost \$4.72 to produce.” And once they have that number, they can calculate margins, forecast profits.

Here is the rub: That \$4.72 cost figure is the result of a process that answers “What is 1+1?” with the statement: “It depends on your assumptions.” And by the time the PowerPoint Rangers are done with the summary, those assumptions are long buried and forgotten.

That unit cost figure is valid only for a certain level of production, because it includes allocation of costs that do not change as production levels change. Other costs that do change, change in non-linear ways.

There are lots of way to allocate fixed costs. Depending on which one you use (especially in multi-product operations), can completely alter the profit / loss numbers for a particular product.

So, while all of this cost accounting stuff is necessary to report taxes, and to report to the shareholders analysts, we forget that it is just a model. Aside from the top line (total sales) and the bottom line (the actual money we can keep), everything else is just someone’s representation of where the money actually went.

Here is my admittedly simplistic take.

A manufacturing company makes profit by adding value at a higher rate than they incur costs.
The value they add is the difference between what they pay for the parts and raw materials that are transformed into the final product, and the actual, real, cash-across-the-table revenue they get for the product when it is actually sold to a real customer who does not work for the same company. (This has nothing to do with internal transfer pricing, etc. because that is all just shuffling things from one column to another for the benefit of the cost accounting model. Until you actually cash the customer’s check, you have not sold the product.)

Since the idea of “unit cost” is really an artifact of whatever particular cost allocation you choose to use, then the idea of “unit margin” is equally dubious.

When I ask the finance folks to tell me how many units I need to sell to break even, they start by calculating a margin, then dividing the cost of operation by that margin, and presto!, break even.

Bzzzzt. The rub is that the margin per unit is only an estimate until the period is over, total costs are added up, and total margin is allocated across production. To use estimated margin to determine a break-even sales level is a circular reference.

But I can calculate how much value is added to each unit. [What can sell it for] – [What I pay for the pieces].

My break even is even simpler. Assuming that 100% of the value-add is allocated against the cost of running the factory (Total monthly payroll, total utilities, total everything except what I paid for what I will sell), until 100% of those costs are covered. With luck and good management, that happens before the end of the period. The total value add of the next unit is profit. And the total value add of every other unit after that is profit. This holds true whether you do it for a hour, a day, a week, a month, a year.

Now I can take projected sales, and determine, at any given rate of production (which drives a lot of the fixed costs), when I break even, and how much profit I can expect. Isn’t that what we are after anyway?

Why does everyone make it so complicated?

And yes, I know it is more complicated than this, but it isn’t THAT much more complicated.

As you may have noticed, there is a new look. This is the result of finally getting around to upgrading WordPress, and the unintended consequence that the new version “broke” the theme I was using. So I finally found another theme (which is easier than rolling my own or dissecting someone else’s code to figure out the problem), implemented it, and here we are.

There are still a few glitches in the categories, etc. which I am cleaning up but basically it works.

If you see anything weird, please let me know (a comment to this post is fine).

## Greetings from Nagoya

I hopped over the water this morning from Beijing to Nagoya. More about that later. But I can say it is just a bit of sticker shock to travel from one of the least expensive places to one of the most expensive places in the span of 2 1/2 hours. Ah, the miracle of jet travel I guess.

So what am I doing here? My company has seen fit to ask me to attend the Shingijutsu “Global Kaizen Seminar” this week. Actually this is my third time through this – first time in 1998, then 2000, and now. I will be commenting on it as internet connectivity allows. One thing that is different this time around, however – previous visits have included a second week of touring various Japanese Shingijutsu clients. That seems to have dropped off, though I expect I know why. The “shop floor kaizen” event now ends on Thursday, and we stuff a tour of Toyota and the Toyota Museum in on Friday.

Thats all for now – more later as things unfold on Monday.

I just had the host upgrade my version of WordPress, and you can probably see the results are not 100%.

I’m working on it. ðŸ™‚

If you see any problems other than the error message at the top of each post, please let me know.

Update 9:30 pm China Standard Time: I have reverted the upgrade. If anyone sees any problems, please let me know.

Nov 2, China Time – I am re-adding categories and the blogroll which did not survive this process.

## Just a question to contemplate…

There is a Wal*Mart here in Beijing. I haven’t been in it.

I wonder what they sell in at a Wal*Mart in China…

I encountered a new level of sophistication in comment spam engines today. This one actually hosts a “blog” of its own. The engine parses quotes from other blogs, posts them as comments in those blogs and links back to itself. On its host site, it looks like a “blog” but, in reality, it is nothing more than a link farm and host for Google ads.

I wrote a note to Google regarding a possible policy violation. In reality, I suppose I wouldn’t mind so much if it just posted things on its own site, but to make me deal with it, and have Google financing it, was a little much.

In an odd ironic twist, the spam filters are the dumb, but automated guardians and the spambots’ algorithms are created by clever people. In this war, people still win pretty much every time.

I suppose I can tie this back to my topic:

In spite of what some would want to believe, the Toyota Production System is not about blind execution of algorithmic standards. It is about continuous evaluation of those standards against a standard of perfection. It is shaped by people, but in ways which are unpredictable except in the macro sense.

As conditions change, the system adapts. As things break, it fixes itself. But all of this only happens if the organization actively works, every day, to ensure that people’s minds are fully engaged doing the right things, the right way.

## A Watershed of Sorts

I suppose it is some kind of rite of passage for a blog when the spam-bots finally find it and start commenting. I had my first three today in the moderation queue.

## Back in China

At the end of the last post I promised to write more when I was over the jet-lag of returning from three weeks in China. Well.. I didn’t, and how I am back over here.

While I was in the USA I took some time off, or at least I did during my “day job.” Since I live near Seattle, it is 5:00 pm there when the people here in China get to work and the Blackberry starts buzzing. Thus I am on and off email until either: Things get quiet long enough for me to just decide to go to sleep or 2:00 am when they end the workday here at 5pm.

For better or worse, my approach here has been to try to establish from the beginning a sense that we don’t wait for an “event” to study a process and look for improvements. Instead, we study and improve every time we do it. I am trying to instill a culture that continuously compares “what is happening” vs. “what should be happening” and acts whenever there is a gap.

Overall, however, I find the main role here is to get the right people equipped with the right skills and tools, and ensure they are working on the right things, then supporting them.

“Working on the right things” means taking responsibility for what is not going to get done right now rather than assigning a dozen “#1 priorities.”