The Problem with Unitized Cost. Presented by: Greg Cass, Partner Constraints Management Group

Transcription

1 The Problem with Unitized Cost Presented by: Greg Cass, Partner Constraints Management Group

2 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? 2

3 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) Lowest unit cost b) Best resource efficiency c) Best total system flow Results: a) Lowest unit cost 30.0% b) Best resource efficiency 53.3% c) Best total system flow 34.7% 3

4 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 4

5 "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 5

6 Some Historical Reference Pre 1934 management accounting was the focus of reporting information 1934 SEC is legislated and GAAP accounting is born 1965 material requirements planning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 closed loop MRP integrated capacity scheduling and reconciliation 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 6

7 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. 7

8 The Trouble With Convention Today companies act as if unit cost minimization is undeniably the 1 st 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 8

9 Today Two Competing First Laws Plants feel pressure to maximize monthly profit plan - minimize unit cost /maximize resource efficiency & utilization - KPIs Cost-Centric Metric Versus Plants feel pressure to meet their on time performance KPI. Flow-Centric Metric Do you see the problem? 9

10 Conflicting Planning & Execution Actions Tactical Objective Cost-Centric Action Flow-Centric Action Efficiency/Plant OE 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 Margin Maximization Inventory Turns Focus on lowering unit product cost Impose an inventory dollar value; postpone inventory receipt; mandate across the board reductions Focus on increasing service level, premium pricing, leveraging constrained resources and incremental revenue opportunities Commit to strategic stock positions that meet the lead time strategy 10

11 Conflicting Actions (cont.) Objective Cost-Centric Action Flow-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 Plant Performance, Continuous Improvement 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 11

12 IMA 2 nd Polling Question What wins out in your organization? a) Cost centric tactics and actions b) Flow centric tactics and actions c) We oscillate back and forth between expediting to protect flow and actions to protect cost Results: a) Cost centric tactics and actions % b) Flow centric tactics and actions 17.7% c) We oscillate back and forth 43.4%

13 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

14 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. 14

15 Relevant Range, Tactics and Metrics Strategic or Tactical Plan Time Period Schedule of Resources Execute schedule Metrics Financial & Nonfinancial Strategic Annually Capacity plan Financial & Non ROI Tactical Quarterly Capacity plan Financial & Non ROI Metric Objective 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? 15

16 Cost Volume Profit (CVP) Analysis Material Cost $300,000 $250,000 $200,000 Figure 6.3 Cost Volume Profit Graph: X Axis = Volume; Y Axis = Dollars $150,000 $100,000 Total Material Cost $50,000 $

17 Cost Volume Profit (CVP) Analysis Total Fixed Cost $600,000 $500,000 $400,000 Figure 6 4 Cost Volume Profit Graph: X Axis = Volume; Y Axis = Dollars $300,000 $200,000 Total Fixed Cost $100,000 $

18 Cost Volume Profit (CVP) Analysis Total Cost $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 Figure 6.5 Cost Volume Profit Graph: X Axis = Volume; Y Axis = Dollars Total costs Fixed costs

19 Cost Volume Profit (CVP) Analysis Total Revenue $1,400,000 $1,200,000 $1,000,000 Figure 6.6 Cost Volume Profit Graph: X Axis = Volume; Y Axis = Dollars $800,000 $600,000 $400,000 $200,000 Y Values Total costs Total Revenue Break even Relevant range $

20 Cost Volume Profit (CVP) Analysis Unitized Fixed Cost Figure 6 7 Total Volume Unit variable cost Total variable cost Total fixed cost Unit fixed 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.

21 CVP Profit Maximization Company XYZ s current reality starting point Dollars Initial Profit Potential Total Mix Revenue Break-even Total Cost Fixed Costs Relevant Range Volume

22 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 Break-even Max Profit Potential Total Cost Fixed Costs Relevant Range Volume 22

23 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 Break-even Total Cost Fixed Costs Relevant Range Volume 23

24 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) Revenue Potential Dollars Rate Based Exploitation Total Mix Revenue Max Profit Potential? Total Cost Break-even Fixed Costs Break even volume reduced Volume 24

25 The P Q Example First seen in the book the Haystack Syndrome by Dr. Eli Goldratt

26 P Q, Inc. P Q Resource Count Weekly Availability A minutes $90/U 100 U/Wk $100/U 50 U/Wk B minutes C minutes D minutes Weekly Expenses = $6,000 Purchased Part $5/U C 10 min./u D C 5 min./u D 5 min./u B How much money will this company make? A B A 10 min./u RM1 RM2 RM3

27 First Attempt Purchased Part $5/U C 10 min./u P $90/U 100 U/Wk D C 5 min./u Resource Count Weekly Availability A minutes B minutes C minutes D minutes Weekly Expenses = $6,000 Product P Revenue P $9,000 Material Cost $4,500 Cash from P $4,500 A B RM1 RM2

28 First Attempt P $90/U 100 U/Wk Q $100/U 50 U/Wk Resource Count Weekly Availability A minutes B minutes C minutes D minutes Weekly Expenses = $6,000 Purchased Part $5/U C 10 min./u D C 5 min./u D 5 min./u B Product P Revenue P $9,000 Material Cost $4,500 Cash from P $4,500 Product Q Revenue Q $5,000 Material Cost $2,000 Cash from Q $3,000 A B A 10 min./u Total Cash from Sales $7,500 Weekly Expenses ($6,000) RM1 RM2 RM3 Weekly Profit $1,500 Did we make a mistake?

29 Considering Flow P Q Resource Count Weekly Availability A minutes $90/U 100 U/Wk $100/U 50 U/Wk B minutes C minutes D minutes Weekly Expenses = $6,000 Purchased Part $5/U C 10 min./u D C 5 min./u D 5 min./u B Load Analysis A 1, = 2,000 OK B 1, ,500 = 3,000 Bottleneck C 1, = 1,750 OK A B A 10 min./u D 1, = 1,750 OK RM1 RM2 RM3 Which product to emphasize?

30 Product Comparison P $90/U 100 U/Wk Q $100/U 50 U/Wk Criteria P Q Sales Price $90 $100 Raw Material Cost $45 $40 Contribution Margin $45 $60 Purchased Part $5/U C 10 min./u A D C 5 min./u B D 5 min./u B A 10 min./u Labor Investment 60 Minutes 50 Minutes Conclusion: Emphasize Product Q RM1 RM2 RM3

31 Emphasizing Q Load Analysis A 1, = 2,000 2,400 OK P Q B 1, ,500 = 3,000 2,400 Bottleneck C 1, = 1,750 2,400 OK D 1, = 1,750 2,400 OK $90/U 100 U/Wk $100/U 50 U/Wk Product P Product Q Revenue P $5,400 Revenue Q $5,000 Purchased Part $5/U C 10 min./u D C 5 min./u D 5 min./u B 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 A B A 10 min./u Total Cash from Sales $5,700 Weekly Expenses $6,000 RM1 RM2 RM3 Weekly Profit ($300)

32 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.

33 Product Comparison P $90/U 100 U/Wk Q $100/U 50 U/Wk Criteria P Q Sales Price $90 $100 Cash Contribution $45 $60 Constraint Investment 15 min/unit 30 min/unit Purchased Part $5/U C 10 min./u A D C 5 min./u B D 5 min./u B A 10 min./u Cash velocity per minute of the constrained resource $3/min $2/min Conclusion: Emphasize Product P! RM1 RM2 RM3

34 Emphasizing Q Load Analysis A 1, = 2,000 2,400 OK P Q B 1, ,500 = 3,000 2,400 Bottleneck C 1, = 1,750 2,400 OK D 1, = 1,750 2,400 OK $90/U 100 U/Wk $100/U 50 U/Wk Product P Product Q Revenue P $9,000 Revenue Q $3,000 Purchased Part $5/U C 10 min./u D C 5 min./u D 5 min./u B 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 A B A 10 min./u Total Cash from Sales $6,300 Weekly Expenses $6,000 RM1 RM2 RM3 Weekly Profit $300

35 Questions?