This Focused Performance Weblog started life as a "business management blog" containing links and commentary related primarily to organizational effectiveness with a "Theory of Constraints" perspective, but is in the process of evolving towards primary content on interactive and mobile marketing. Think of it as about Focusing marketing messages for enhanced Performance. If you are on an archive page, current postings are found here.
Tuesday, March 09, 2004
On Unit Costs -- The comments to my recent post on the misuse of the concept of unit cost in decision-making include a few good questions. One is...
Is the claim there is no such thing as unit costs a common accounting practice in your experience?
Common practice, no. But that does not make it wrong. Common practice is not necessarily good practice. In my corner of the world -- in organizations that have embraced the concepts of constraint management, unit costs do appear in the mandated GAAP number crunching, but a distinction is drawn between the reporting of financial results according to the requirements of somebody's external rules and the use of such numbers for operational decisions. A good example is Toyota's US plant in Kentucky, as described in Profit Beyond Measure by Johnson and Broms. The allocation of non-variable components of cost only muddies the water when one is trying to determine the value of incremental or decremental volumes, new offerings, offers, or contracts that use primarily existing resources, product mix decisions, or pricing.
It's that last one -- pricing -- that gets most companies in trouble. By bloating the cost per unit with allocated overhead and other essentially fixed expenses like labor, many businesses forgo potentially profitable work because of the perception of insufficient margin or unit profit when, in reality, they might have sufficient capacity to deliver that work only incurring purely variable costs such as raw materials, shipping, or commissions. The concept of unit cost leads directly to the idea of acceptable unit margins or profits when compared to possible prices. This then leads one to believe that there is some "fair price" that one should set for one's offerings (related to cost plus some reasonable margin), and to forget that prices are not in one's domain of control, but rather in that of the market. A slippery slope indeed. In the world of T, I, and OE, as long as the price is greater than incremental direct costs attributed to Throughput plus incremental Operating Expense, it is probably a situation that deserves careful consideration...
...with one caveat...
If the product in question consumes the time and attention of an internal constraint of the organization (that piece of the organization that constitutes it's limiting factor regarding capacity), then the decision process needs to take that into account, favoring those products or jobs with a higher ratio of Throughput per Unit of Constraint Usage.
Another advantage of the T, I, and OE accounting paradigm is that it is scaleable. Addition of T, I, or OE at any level of an organization "add up" to the total T, I, and OE of larger components of the system. Unit costs that take into account allocations of "fixed" costs that, in all likelihood, stay behind (at least partially) if the business -- the units -- go away do not maintain a similar integrity as the costs erroneously allocated to the old units now need to be re-allocated to the remaining ones. Yes, it is a simple system, but in my mind, that is its strength. One still has the ability to break down OE to its various components and analyze their detriment to the bottom line, and for that matter, this is simplified when one doesn't have to un-allocate for analysis.
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