Bryan E Logan - 1. NEW MANAGEMENT THINKING - Measurements

Clarke: Bryan Logan worked for twenty years for the Ulster Business School at the University of Ulster.  He is a Jonah and he taught TOC as an elective module on the MBA course for five years.  This is the first of seven articles he has kindly agreed that I can share here.

Among the industrialised nations of the world the United Kingdom has to be one of the most conservative when it comes to accepting new management thinking. The majority of UK businesses never achieve their full potential and constantly fall below levels of performance that could reasonably be expected in today’s commercial world. As a result wealth creation is less than it should be, and consequently the exchequer does not receive the volume of revenues needed to adequately fund the services required by a demanding modern society. One only has to observe the need to supplement mainstream revenues with an ever-increasing reliance on ‘stealth’ taxes. 

One of the principal reasons for this under-achievement would appear to lie in an almost irrational reluctance to change the way we manage our organisations. There is a seeming unwillingness on the part of top decision-makers in industry, government, academia and the professions to acknowledge that new management ideas even exist, let alone implement them for the future well being of the country as a whole.

In this series of short papers I am putting forward six new management ideas that are in regular use around the world, unfortunately less so in the UK, that would make significant improvements to any organisation taking them onboard. The ideas cover; ‘measurements’, ‘strategic navigation’, ‘innovation and technology transfer’, ‘increasing productivity’, ‘how to sell more’ and ‘turning talent into performance’. None of these ideas, which I refer to as ‘silver bullets’, are expensive to implement, unlike the vast sums spent currently on consultants in vain attempts to improve performance.

In this first paper I will look at how we measure the day-to-day operation of our organisations, and how we can improve greatly on the traditional approach.

How might the financial performance of every organisation in the United Kingdom be improved at a stroke? The easiest and quickest way is by adopting an alternative measurement system for the management of day-to-day operations. As a ‘silver bullet’ this action alone would deliver significant results for virtually no outlay, and is the first of six such ‘silver bullets’ that I will identify and explain in this and subsequent papers.

The way we currently manage the day-to-day operation of our organisations, and its attendant measurements, relies on what I shall refer to as the ‘cost world’. This is based on the principles and conventions associated with traditional financial accounting. It is the accepted system; indeed the only system most of us know and have grown up with, having been around for longer than any of us care to remember. So accustomed are we to the concept of the ‘cost world’ that we don’t give it a second thought. It is so ingrained in us, that it wouldn’t even cross our minds to challenge this approach to managing our organisations, never mind look for anything else.

Yet, as we shall see, there are many potential problems from using this approach to managing our organisations, and these problems actually hinder our ability to make the correct decisions needed to optimise the present performance of our organisations, let alone benefit from future improvement initiatives.

Tony Rizzo, formerly with AT&T, said:-

“Consistently, accountants confuse two models with two distinct purposes. The first is the model defined by GAAP, (generally accepted accounting principles). This has the purpose of distributing profits after they are generated. The second model is an operational one, which is required to generate these profits in the first place. These are two distinct purposes, which are not served well by just one model.”

It is entirely understandable that there should be a standard and accepted format, or model, for reporting the financial results of organisations, indeed HMRC insist upon it. Traditional financial accounting is the universally accepted means by which the profits or surpluses accrued by an organisation are calculated and then distributed. Underlying this accounting system is a range of standard conventions, in particular the concept of cost allocation and cost absorption, which allows us to apportion costs to the value of work-in-progress and finished goods. It is this concept of cost allocation that epitomises and distinguishes the ‘cost world’.

Unfortunately, it is also this concept of cost allocation that underpins the system of cost accounting, or management accounting, that is most commonly used to manage the day-to-day operations within our organisations. In this ‘cost world’ approach we allocate costs to machines when making investment decisions, we allocate costs to parts in make-or-buy decisions and we allocate costs to products and services when judging and ranking their profitability. At the very best this approach can have unintended consequences, which inevitably influence the way we behave as well as the decisions we make and the results we achieve. It is based on a series of erroneous assumptions, which lead to false thinking and result in arbitrary and frequently wrong decisions. 

Among the assumptions we readily accept, but should challenge are:-

1. If all the constituent parts of an organisation are efficient, then this will add up to an efficient whole,

2. An idle resource is a significant source of waste,

3. The sum of individual improvements within an organisation equates to the aggregate improvement to the system as a whole,

4. More data equals better decisions,

5. Too many set-ups are bad,

6. The only way to produce more is to work harder.

The effect of accepting these and other assumptions has been to develop a ‘cost world’ measurement system and ‘silo mentality’, which is aimed at ensuring the efficient operation of each individual department or function within an organisation. It uses measures such as ‘output per hour’, ‘cost per part‘, ‘machine utilisation’ ‘standard costs’ and other efficiency metrics. However, none of these metrics enable departmental managers to assess the impact of their local decisions on the performance of the system or organisation as a whole. Each department is busy being efficient, oblivious to the impact, good or bad, which its actions are having on the organisation as a whole. Under such circumstances it becomes difficult, if not impossible, to coordinate activities towards achieving the goal of the organisation as a whole. A question I used to ask students was: “what formula connects efficiency with net profit?” The answer of course is none, except for the belief contained in the first of the erroneous assumptions above. 

To quote Peter Senge in his book ‘The Fifth Discipline’:-

“From a very early age, we are taught to break apart problems, to fragment the world. This apparently makes the complex tasks and subjects more manageable, but we pay a hidden, enormous price. We can no longer see the consequences of our actions; we lose our intrinsic sense of connection to the larger whole.”

If management accounting has any purpose, it must be to provide managers with the information needed to make decisions in line with the organisation’s goal. The goal of most commercial organisations is to make money now and in the future. The erroneous assumptions underlying the use of the ‘cost world’ lead to faulty decision-making, concentration on wrong priorities and difficulty in implementing and achieving genuine improvements for the organisation.

What measurement system then should we use? It must, above all, recognise that any organisation stands or falls by its performance as a whole, and not by the efficiency of its individual parts or departments. The output or throughput of any organisation depends on the interaction between its constituent parts and the synchronised management of these interactions; a concept seemingly alien to most of today’s managers and executives.

To quote Dr E M Goldratt, author of the book ‘The Goal’:-

“The measurements must induce the parts to do what is good for the system as a whole”.

So where do we start? Almost every management accounting textbook advises against using GAAP generated numbers as the basis for making management decisions, and also contains a statement to the effect that; “A company will maximise profit when it makes and sells the product or service with the highest contribution margin per unit of its scarce resource”. However, so strong is the hold of the ‘cost world’ on all of us that we completely ignore both of these pieces of advice. What organisation, business or other managed system, even knows its scarce resource, or limiting factor, let alone manages its performance around such knowledge?

The alternative system to the ‘cost world’ is the ‘throughput world’, in which the concept of a limiting factor is central. The ‘throughput world’ focuses on the organisation as a whole, as opposed to optimising individual departments, and focuses on managing the limiting factor in order to maximise profitable throughput. This is achieved by a process of five repeating steps, which are:-

1. Identify the limiting factor, which can be either internal or external to the organisation and may be a physical scarcity or a managerial policy,

2. Squeeze the maximum amount through the limiting factor, as this dictates the ultimate output and hence performance of the organisation as a whole,

3. Subordinate the actions of all other departments in the organisation to continuously maximising the performance of the limiting factor,

4. Find ways of increasing the capacity of the limiting factor. As a consequence of opening up its capacity, the limiting factor or scarce resource may alter and move,

5. Return to step 1 above and identify the new limiting factor.

The ‘throughput world’ actively encourages the expansion of profitable throughput, whereas the ‘cost world’ seems fixated on cutting costs. There is only so far that you can actually cut costs, whereas expansion of throughput has theoretically no limit. Unfortunately British industry has been and continues to be obsessed with cost cutting. The late Peter Drucker said:-

“Enterprises are paid to create wealth, not control costs. But this obvious fact is not reflected in traditional measurements.”

The ‘throughput world’ is based around three new performance measures; T, I & OE:-

T Throughput; this is the rate at which the system generates money through sales. It is defined as sales less all totally variable costs, such as material, commissions and any sub-contracted items such as transport,

I Investment; this is all the money the system invests in purchasing items the system intends to sell,

OE Operating Expense; this is all the money the system spends in turning investment into throughput, including salary and wage costs.

Using these three measures and the fact that every system has to have a limiting factor opens up an entirely new world for any organisation, when it comes to managing their day-to-day operations. These new measures translate easily into familiar and recognisable terms. 

Net Profit = (T – OE) and Productivity = (T/OE)

Now decisions can be made in line with the organisation’s overall goal, and not in pursuit of the local optimisation of individual departments or functions. Managers can gauge the impact of local decisions on the organisation as a whole and the profitability of products and services can be correctly assessed against their contribution per unit of limiting factor. How many salespersons are currently being well rewarded on the basis of promoting the wrong product or service, in terms of their relative profitability? 

In future papers I will demonstrate the gains to current and future performance that can be leveraged from focusing on and managing the limiting factor. Managing using the ‘throughput world’ inevitably exposes and releases excess capacity, of which most organisations are totally unaware. This spare capacity can then be utilised in further strengthening competitive advantage. To me the two words that epitomise the ‘throughput world’ are ‘focus’ and ‘leverage’.

Everything becomes easier and makes more sense when the ‘cost world’ is replaced by the ‘throughput world’. Business improvement initiatives that many organisations are trying to implement, with less than convincing results, suddenly flourish. The ‘throughput world’ environment sharpens all improvement initiatives such as ‘Lean’ and ‘Six Sigma’. It focuses these techniques on the actual leverage points within the organisation. 

It must be pointed out, however, that transferring from the ‘cost world’ to the ‘throughput world’ is not as easy as just introducing a few new measures. It requires managers to acquire a new mindset and operate contrary to concepts they previously held sacrosanct and had regarded as second nature. 

Not actually knowing that the ‘throughput world’ exists is unfortunate, as its adoption offers a ‘silver bullet’ to enhance the performance of any organisation in the UK. The fact that the majority of executives in the UK have never heard of the ‘throughput world’ is disappointing, if not criminal when you consider the amount of money currently being spent on consultancy, in a vain attempt to improve organisational performance by traditional methods.

What further compounds the misfortune is the fact that the UK will continue to fall further and further behind other industrialised countries through not adopting the ‘throughput world’. The following is a quotation made in 2005 by Mark Abrahams, President and CEO of Delstar Technologies Inc.:-

“In 1996 Chesapeake Consulting looked at our manufacturing process and taught us a ‘throughput model’, which in our opinion has been the single best tool for evaluating profitability and simplifies the day-to-day decision-making process for the business.”

Delstar Technologies Inc. is the world leader in its field of thermoplastic netting, meshes and extruded components. Headquartered in Delaware USA, they have a presence at Bristol in the UK and now a brand new factory in Shanghai.

Finally to quote again the late Peter Drucker:-

“You don’t have to do anything, survival is not mandatory”.

In the next paper I will look at why ‘strategic planning’ doesn’t work for most organisations in the UK, particularly SMEs, and how another ‘silver bullet’ can quickly and at minimum cost provide any organisation with the right strategy and a logical roadmap for its achievement.