The Problem with Unitized Cost
Presented by: Greg Cass, Partner
Constraints Management Group
Today’s Deep Truth ↓ Unit Cost = ↑ Return on Investment (ROI)
Today’s Deep Truth is Totally, Completely,
Unequivocally False!
How Deeply Ingrained Is Unit Cost?
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IMA Polling Question #1
1,000+ finance and accounting professionals, 41 countries, 900+ organizations:
What do you think is the biggest factor in ROI?
a)
b)
c)
Lowest unit cost
Best resource efficiency
Best total system flow
Results:
a)
b)
c)
Lowest unit cost – 30.0%
Best resource efficiency – 53.3%
Best total system flow – 34.7%
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Principle #1: Flow Comes First
The First Law of Manufacturing:
All benefits (ROI) will be directly related to the speed of FLOW of materials and information.
George W. Plossl
Information
Materials & Information
Caveat:
Both Materials and Information must be RELEVANT
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"All Benefits" Encompass:
•
•
•
•
•
Service is consistent and reliable when a system flows well.
Revenue is maximized and protected.
Inventories are minimized. Expenses ancillary and/or unnecessary are minimized.
Cash flow follows the rate of product flow to market demand.
Protect and Promote Flow = ROI Maximization
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Some Historical Reference
• Pre‐1934 management accounting was the focus of reporting information
• 1934 SEC is legislated and GAAP accounting is born
• 1965 material requirements planning (MRP) revolutionized the way companies calculated what to make and buy and when.
• 1972 closed loop MRP integrated capacity scheduling and reconciliation.
• 1980 financials were integrated and MRPII was born. Manufacturing system designed to capture routing time and material usage input became focused primarily on providing a costing system for GAAP
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1990 MRPII Evolves into ERP
Today at the core of every fast, powerful, expensive ERP is MRPII are all of the problematic unit cost rule assumptions.
Most managers, executives and even accountants have come to relate/accept GAAP costing as relevant information to direct tactics, make decisions and judge resource performance.
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The Trouble With Convention
• Today companies act as if unit cost minimization is undeniably the 1st law.
• All reporting , measures, tactical planning and execution actions seek the following objectives:
–
–
–
–
Minimize total product unit cost
Maximize resource efficiency
Strive for positive overhead variances for both labor and volume
Initiate cost‐reduction efforts with emphasis on machine, labor and inventory reductions quantified on fully absorbed standard costs
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Today ‐ Two Competing First Laws
Plants feel pressure to
maximize monthly profit
plan - minimize unit cost
/maximize resource
efficiency & utilization KPIs
Versus
Cost-Centric Metric
Plants feel pressure
to meet their on time
performance KPI.
Flow-Centric Metric
Do you see the problem?
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Conflicting Planning & Execution Actions
Tactical Objective
Efficiency/Plant OE
Margin Maximization
Inventory Turns Cost-Centric Action
Flow-Centric Action
Run larger batches; extend the forecast; run only on optimal resource
Protect critical resources; run smaller batches to pull; run on any process capable resource
Focus on lowering unit product cost
Focus on increasing service level, premium pricing, leveraging constrained resources and incremental revenue opportunities
Impose an inventory dollar value; postpone inventory receipt; mandate across the board reductions
Commit to strategic stock positions that meet the lead time strategy
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Conflicting Actions (cont.)
Objective
Cost-Centric Action
Budget Performance
Focus on actions to achieve standard unit cost, high overhead absorption.
Focus on the incremental costs of leveraging flow to the market
Volume Maximization
Protect OE by running large volume batches (MOQ’s).
Focus on service, lead times and lower order minimums Identify unit cost reduction opportunities through increasing resource efficiency or labor reduction Identify the largest sources of variation and remove them to lower lead times and reduce investment in all strategic buffers – Max FLOW
Plant Performance, Continuous Improvement
Flow-Centric Action
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IMA 2nd Polling Question
What wins out in your organization?
a)
b)
c)
Cost centric tactics and actions
Flow centric tactics and actions
We oscillate back and forth between expediting to protect
flow and actions to protect cost
Results:
a)
b)
c)
Cost centric tactics and actions - 38.8%
Flow centric tactics and actions – 17.7%
We oscillate back and forth – 43.4%
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The Importance of “Relevance”
“Every decision involves choosing from among at least two alternatives. In making a decision, the costs and benefits of one alternative must be compared to the costs and benefits of other alternatives. Costs and benefits that differ between alternatives are called relevant costs.
Distinguishing between relevant and irrelevant costs and benefits is critical for two reasons. First irrelevant data can be ignored – saving decision makers tremendous amounts of time and effort.
Second, bad decisions can easily result from erroneously including irrelevant costs and benefits when analyzing alternatives. To be successful in decision making, managers must be able to tell the difference between relevant and irrelevant data in analyzing alternatives.”
Noreen, Brewer, Garrison,
“Managerial Accounting for
Managers”, McGraw Hill Irwin,
2008, page 500
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Relevant Range and Unit Cost Relevant range is the range of activity within which the assumptions about variable and fixed costs remain valid.
• In the “long run” all costs are variable.
• In the “short run” all period costs including, direct labor, are fixed and irrelevant Unitizing fixed costs create the false impression that overhead costs and direct labor will vary up or down with changes in activity/volume levels.
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Relevant Range, Tactics and Metrics
Strategic or Tactical
Plan Time Period
Schedule of
Resources
Strategic
Annually
Tactical
Execute schedule
Metrics ‐
Financial & Nonfinancial
Metric Objective
Capacity plan
Financial & Non
ROI
Quarterly
Capacity plan
Financial & Non
ROI
Tactical
Monthly
Capacity plan
Financial & Non
ROI & Flow
Tactical
Weekly
schedule
Weekly
Non‐financial
Demand Flow
Tactical
Daily
schedule
Daily
Non‐financial
Demand Flow
Tactical Hourly
Hourly
Non‐financial
Demand Flow
Managers can vary “some” fixed costs inside their annual plan and a few
inside their quarter.
What overhead costs can be varied inside a month, a week, a day?
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Cost Volume Profit (CVP) Analysis
Material Cost
Figure 6.3 Cost Volume Profit Graph:
X Axis = Volume; Y Axis = Dollars
$300,000
$250,000
$200,000
$150,000
Total Material Cost
$100,000
$50,000
$0
0
2000
4000
6000
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Cost Volume Profit (CVP) Analysis
Total Fixed Cost
Figure 6‐4 Cost Volume Profit Graph:
X Axis = Volume; Y Axis = Dollars
$600,000
$500,000
$400,000
$300,000
Total Fixed Cost
$200,000
$100,000
$0
0
2000
4000
6000
8000
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Cost Volume Profit (CVP) Analysis
Total Cost
Figure 6.5 Cost Volume Profit Graph:
X Axis = Volume; Y Axis = Dollars
$900,000
$800,000
$700,000
$600,000
$500,000
Total costs
$400,000
Fixed costs
$300,000
$200,000
$100,000
$0
0
2000
4000
6000
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8000
Cost Volume Profit (CVP) Analysis
Total Revenue
Figure 6.6 Cost Volume Profit Graph:
X Axis = Volume; Y Axis = Dollars
$1,400,000
$1,200,000
$1,000,000
$800,000
Y‐Values
Total costs
$600,000
Total Revenue
$400,000
Break even
$200,000
Relevant range
$0
0
2000
4000
6000
8000
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Cost Volume Profit (CVP) Analysis
Unitized Fixed Cost
Figure 6‐
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Total Volume
Unit variable cost
Total variable
cost Total Unit fixed fixed cost cost
1
$50
$50
$500,000
$500,000
2,000
$50
$100,000
$500,000
$250
3,125
$50
$156,250
$500,000
$160
4,000
$50
$200,000
$500,000
$125
6,000
$50
$300,000
$500,000
$83
The above figure illustrates how unitized fixed costs behave
and why they are a contrived number.
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CVP Profit Maximization
Company XYZ’s current reality – starting point
Dollars
Initial Profit Potential
Total Mix
Revenue
Total Cost
Break-even
Fixed
Costs
Relevant
Range
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Volume
The Pull‐Based Model
• Clearly define the chain
• Identify the limitations and strategic control points
• Quantify the initial potential of the chain given current limitations, control points, existing asset base and product mix
Dollars
Initial Profit Potential
Total Mix
Revenue
Max Profit Potential
Total Cost
Break-even
Fixed Costs
Relevant
Range
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Volume
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The Pull‐Based Model
• Quantify the potential of the chain by removing the limitations and squeezing the most from the strategic control points.
– Volume Maximization (protecting flow to and through control points, identifying “free” product opportunities and volume improvement activities (Lean and 6Σ tools)
Dollars
Volume Exploitation
Total Mix
Revenue
Max Profit Potential
Total Cost
Break-even
Fixed Costs
Relevant
Range
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Volume
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The Pull‐Based Model
• Quantify the potential of the chain by removing the limitations and squeezing the most from the strategic control points.
– Rate Based Exploitation (mix manipulation strategies towards products with the highest rate of return across the control points and product design/redesign to take less control point time)
Dollars
Revenue
Potential
Rate Based Exploitation
Total Mix
Revenue
Max Profit Potential
?
Total Cost
Break-even
Fixed Costs
Break even volume
reduced
Volume
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The P‐Q Example
First seen in the book the Haystack Syndrome by Dr. Eli Goldratt
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P‐Q, Inc.
P
Resource
Q
$90/U
100 U/Wk
$100/U
50 U/Wk
Count
Weekly Availability
A
1
2400 minutes
B
1
2400 minutes
C
1
2400 minutes
D
1
2400 minutes
Weekly Expenses = $6,000
D
15 min./U
Purchased
Part
$5/U
D
5 min./U
C
10 min./U
C
5 min./U
B
15 min./U
A
15 min./U
B
15 min./U
A
10 min./U
RM1
$20/U
RM2
$20/U
RM3
$20/U
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How much money will
this company make?
First Attempt
Resource
P
$90/U
100 U/Wk
Count
Weekly Availability
A
1
2400 minutes
B
1
2400 minutes
C
1
2400 minutes
D
1
2400 minutes
Weekly Expenses = $6,000
D
15 min./U
Purchased
Part
$5/U
Product P
C
10 min./U
C
5 min./U
A
15 min./U
B
15 min./U
RM1
$20/U
RM2
$20/U
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Revenue P
$9,000
Material Cost
$4,500
Cash from P
$4,500
First Attempt
P
Resource
Q
$90/U
100 U/Wk
$100/U
50 U/Wk
Count
Weekly Availability
A
1
2400 minutes
B
1
2400 minutes
C
1
2400 minutes
D
1
2400 minutes
Weekly Expenses = $6,000
D
15 min./U
Purchased
Part
$5/U
D
5 min./U
C
10 min./U
C
5 min./U
B
15 min./U
A
15 min./U
B
15 min./U
A
10 min./U
RM1
$20/U
RM2
$20/U
RM3
$20/U
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Product P
Product Q
Revenue P
$9,000
Revenue Q
$5,000
Material Cost
$4,500
Material Cost
$2,000
Cash from P
$4,500
Cash from Q
$3,000
Total Cash from Sales
Weekly Expenses
Weekly Profit
$7,500
($6,000)
$1,500
Did we make a mistake?
Considering Flow
P
Resource
Q
$90/U
100 U/Wk
$100/U
50 U/Wk
Count
Weekly Availability
A
1
2400 minutes
B
1
2400 minutes
C
1
2400 minutes
D
1
2400 minutes
Weekly Expenses = $6,000
D
15 min./U
Purchased
Part
$5/U
D
5 min./U
C
10 min./U
C
5 min./U
B
15 min./U
A
15 min./U
B
15 min./U
A
10 min./U
RM1
$20/U
RM2
$20/U
RM3
$20/U
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Load Analysis
A
1,500 + 500 = 2,000
OK
B
1,500 + 1,500 = 3,000
Bottleneck
C
1,500 + 250 = 1,750
OK
D
1,500 + 250 = 1,750
OK
Which product
to emphasize?
Product Comparison
P
Purchased
Part
$5/U
Q
$90/U
100 U/Wk
$100/U
50 U/Wk
D
15 min./U
D
5 min./U
C
10 min./U
C
5 min./U
A
15 min./U
B
15 min./U
A
10 min./U
RM1
$20/U
RM2
$20/U
RM3
$20/U
Criteria
P
Q
Sales Price
$90
$100
Raw Material Cost
$45
$40
Contribution Margin
$45
$60
60 Minutes
50 Minutes
Labor Investment
B
15 min./U
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Conclusion:
Emphasize Product Q
Load Analysis
Emphasizing Q
P
Q
$90/U
100 U/Wk
$100/U
50 U/Wk
D
15 min./U
Purchased
Part
$5/U
D
5 min./U
C
10 min./U
C
5 min./U
A
15 min./U
B
15 min./U
RM1
$20/U
RM2
$20/U
B
15 min./U
A
10 min./U
RM3
$20/U
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A
1,500 + 500 = 2,000
2,400
OK
B
1,500 + 1,500 = 3,000
2,400
Bottleneck
C
1,500 + 250 = 1,750
2,400
OK
D
1,500 + 250 = 1,750
2,400
OK
Product P
Product Q
Revenue P
$5,400
Revenue Q
$5,000
Material Cost
$2,700
Material Cost
$2,000
Cash from P
$2,700
Cash from P
$3,000
Time Remaining on B = 900
We can make 60 Product Ps
Total Cash from Sales
$5,700
Weekly Expenses
$6,000
Weekly Profit
($300)
Determining What is Relevant
The First Law of Manufacturing
“All benefits all proportionate to the speed of
flow of information and materials.”
Caveat = the information and materials must be relevant
George Plossl
A Fundamental of Management Accounting
“A company will profit maximize when it makes and sells
the products with the highest contribution margin per unit
of its scarce resource.”
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Product Comparison
P
Purchased
Part
$5/U
Criteria
Q
$90/U
100 U/Wk
$100/U
50 U/Wk
D
15 min./U
D
5 min./U
C
10 min./U
C
5 min./U
A
15 min./U
B
15 min./U
A
10 min./U
RM1
$20/U
RM2
$20/U
RM3
$20/U
P
Q
Sales Price
$90
$100
Cash Contribution
$45
$60
Constraint Investment
15 min/unit
30 min/unit
Cash velocity per
minute of the
constrained resource
$3/min
$2/min
B
15 min./U
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Conclusion:
Emphasize Product P!
Load Analysis
Emphasizing Q
P
Q
$90/U
100 U/Wk
$100/U
50 U/Wk
D
15 min./U
Purchased
Part
$5/U
D
5 min./U
C
10 min./U
C
5 min./U
A
15 min./U
B
15 min./U
RM1
$20/U
RM2
$20/U
B
15 min./U
A
10 min./U
RM3
$20/U
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A
1,500 + 500 = 2,000
2,400
OK
B
1,500 + 1,500 = 3,000
2,400
Bottleneck
C
1,500 + 250 = 1,750
2,400
OK
D
1,500 + 250 = 1,750
2,400
OK
Product P
Product Q
Revenue P
$9,000
Revenue Q
$3,000
Material Cost
$4,500
Material Cost
$1200
Cash from P
$4,500
Cash from P
$1,800
Time Remaining on B = 900
We can make 30 Product Qs
Total Cash from Sales
$6,300
Weekly Expenses
$6,000
Weekly Profit
$300
Questions?
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