How not to set your IT budget

If you have read my posts in the past, you will know that I advocate the use of the following formula for determining the ROI for any given improvement project (whether IT-related or not):

Where

• ROI = Return on Investment
• delta-T = Change in Throughput, and Throughput is defined as Revenues less Truly Variable Costs (TVC)
• delta-OE = Change in Operating Expenses
• delta-I = Change in Investment

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Incidentally, where there is no change in I (Investment, including changes in inventory) or the change in I is negative, then projects can be compared based on profit alone. That formula is simply:

Profit = delta-T – delta-OE.

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However, here’s what far too many IT project’s ROI calculations look like:

ROI (don’t know) = ((never took time to estimate it) – (never took time to calculate it)) / $200,000

 

The only figure the company knows going into the project is the estimated “investment” or “cost” of the project.

The common excuse

The common excuse for not calculating an ROI for an improvement project is that changes in Throughput and changes in Operating Expenses are “too hard to estimate,” and “if they are estimated, they will be wrong anyway.”

This argument is specious on the face of it. Think about it!
The $200,000 estimated “cost” or “investment” value of the project is likely to be wrong, too. But that does not keep the CIO and CFO from making their best efforts to calculate that value.

The Real Reason

Of course, the real reasons that CIOs and CFOs do not take time to calculate a real and measurable ROI for their IT (and other) improvement projects is likely two-fold:

1. Too many CFOs and CIOs are under the wrongheaded impression that the value of IT (or other improvements) is both “automatic” and “cannot be measured.” When it comes to new technologies they have succumbed to the strange notion that new technologies are like an engine additive for business—you just pour them in and somehow your business will run smoother, faster, longer and get higher mileage! And, just like people who buy engine additives, they never take time to calculate whether there was any real benefit from using the product.
   
2. They have never taken time to actually determine what root-cause they are attacking with the IT (or other) improvement project, so they do not really know whether the project will actually lead to increased Throughput or will, in fact, drive down or hold the line on Operating Expenses. In fact, they probably do not even know what the “weakest link” is in their customer-to-cash stream or whether that weakest link is internal to their organization or whether it lies somewhere outside their organization in their supply chain.

Isn’t it time to stop that kind of folly? Can businesses still expect to thrive and grow without taking a sound look at how and why they are spending their most valuable resources—time, energy and money?

I don’t think so.

What’s wrong with EOQ?

Economic Order Quantity (EOQ) EOQ is essentially an accounting formula that determines the point at which the combination of replenishment costs and inventory carrying costs are the least. The goal being to minimize both the ongoing costs of carrying inventory and the expenses involved with replenishing inventory.

The basic EOQ formula looks like this:

As you can see, this formula attempts to balance (simultaneously) the following factors related to the business expense linked to holding and replenishing inventory:

1. Usage rates – how many are sold or consumed over a period of time (one year in the basic formula)
2. Cost of replenishment – how much it costs the firm to replenish a single inventory item (SKU) from the point of recognizing the need for replenishment through putting the quantities back on the shelf
3. Carrying costs – all of the costs and expenses related to storing and handling of the inventory quantities held

Let us take a look at how these factors interact in a practical example:

In our example, we have an item that has a cost of $25 per unit, and the average daily demand is five (5) units. For this firm, the cost of replenishment is slightly above average—sitting at $30 per PO line processed for inventoried goods.

Observe what happens to the EOQ on this item as the cost of carrying inventory moves through the range from five percent (5%) to 40 percent.

When inventory carrying costs are very low compared to the cost of replenishment (five percent and $30, respectively), EOQ recommends big orders. In this case, each order would support more than 75 days of average demand.

On the other end of the spectrum, when carrying costs are quite high (40 percent) relative to the cost of replenishment, EOQ suggests smaller inventories (as the result of smaller orders) and the order cycle is slashed to almost one-third its former value (now, just over 26 days).

Underlying assumptions

The assumption being made in the construction of the EOQ formula is that the cost of carrying inventory is linear. That, at a five percent rate, a one dollar decrease in inventory on-hand will lead to a five cent reduction in carrying costs to the firm. Similarly, at a 40 percent carrying cost rate, a one dollar decrease in inventory on-hand will lead to a 40 cent decline in carrying costs.

Unfortunately, the linear relationship assumed by the EOQ formula simply does not exist.

When calculating the cost of carrying inventory, a large number of factors are generally considered:

1. Warehouse space rental (or equivalent)
2. Utilities expense
3. Property tax expense
4. Maintenance expenses on the warehouse and warehouse equipment
5. Inventory write-offs/write-downs
6. Other inventory shrinkage
7. Financing expenses for the warehouse, the equipment, and the inventory itself
8. Insurance expenses on the warehouse and the inventory
9. Labor expenses related to warehouse operations

When inventory is reduced $1,000 in a warehouse with a calculated 25 percent carrying cost, what are the likely real impacts on expenses for carrying inventory?

1. Warehouse space rental (or equivalent) – no change
2. Utilities expense – no change
3. Property tax expense – no change
4. Maintenance expenses -  no change
5. Inventory write-offs/write-downs – possibly some change, but not necessarily at the same “average” rate
6. Other inventory shrinkage – same as above
7. Financing expenses for the warehouse, et al -  no change
   Financing expense on the value of the inventory – some change possible
8. Insurance expenses on the warehouse, et al – no change
   Insurance expenses on inventory – some change
9. Labor expenses – no change

In short, only three of the nine items involved in calculating the cost of carrying inventory would likely change based on $1,000 reduction in inventory. That’s because increases or decreases in the volume and dollar amount of inventory held in a warehouse operations produce relatively large but non-linear changes operating expenses.

As inventory grows, changes like adding a second shift in the warehouse, acquiring additional warehouse space, or adding manpower to handle increased volumes happen incrementally. The EOQ formula has no way to account for these non-linear changes to operating expenses. Therefore, your EOQ decision-making my be entirely off the mark for success and increased profits.

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What’s the answer?

To manage your inventory quantities, I would highly recommend the application of Dynamic Buffer Management. [Click on the link and read the article there.]

To deal with non-linear changes in your enterprise—decisions that may lead to major changes in inventories (increases or decreases)—you need a broader formula that considers your system (your enterprise) as a whole. That would be this one:

Where,

• ROI = Return on Investment
• delta-T = Change in Throughput 
• delta-OE = Change in Operating Expenses
• delta-I = Change in Inventory or demand for other Investment

This formula would cover changes like adding a second shift (change in Operating Expenses) or building a new warehouse (change in Investment).

Think about. Contact me if you need further clarifications.

Finding Common Ground Between the CFO and COO–Part 1

It seems as though many organizations are at war within. During boom-times, the war is more subdued, but is still there. But in tough—really tough—economic times the war is more evident than ever.

What is that war?

The war is that age-old dispute between meeting customer service level demands and holding inventory levels within reason. In really tough times, keeping inventory levels down becomes even more critical to the CFO—and the organization’s survival, perhaps—because cash held in inventory for long periods of time puts a real crunch in the vital cash-flow of the firm.

Now, it is likely that the COO will surrender in times like these. He or she will understand that (too frequently) it really is a matter of survival to maintain the cash-flow. So, the COO might say something like:

“Okay. I get it. I’ll reduce inventories as much as I can. But don’t blame me if we can ship orders or keep our customers happy.”

What are your options?

Some have put it this way: In tough economic times you firm is going to

1. Sink,
2. Shrink, or
3. Prevail.

I prefer to put that into four categories. Furthermore, I do not believe that those four categories are applicable only in tough times. I believe that they are fully applicable to every business enterprise all of the time. Here they are shown in the figure below: 1) failing, 2) risking, 3) competing or 4) leading.

I believe the determining factors in every business enterprise are inherently simple and are only two in number:

1. Effectiveness – The measure of how effectively the firm employs the monies invested and how effectively does it spends its working capital in the process of turning inventory (or services) into throughput? This is a measure of managements effectiveness in managing its internal workings and the inbound side of the supply chain.
   
2. Differentiation – This is the measure of effective management is in dealing externally in the outbound side of the supply chain. This measure covers everything from R&D (research and development) through to marketing, sales and customer service.

The problem with these two terms (i.e., effectiveness and differentiation) is not that they are hard to grasp. Everyone seems to know in a very general way that they need to manage the firm to be effective in using its resources and that, in order to be profitable, they need to differentiate themselves in the marketplace.The problem is that many people seem to have difficulty these two words into concrete and effective actions.

So, let me restate the same figure using a different set of terms.

Note that I have redefined the two factors as follows:

1. Effectiveness = Increasing Throughput
   
   and
   
2. Differentiation = Breadth of Market through Irrefusable Offers

But, in dealing with my clients, I go beyond that. I use Eliyahu Goldratt’s definition of throughput:

Throughput (T) = Revenues – Truly Variable Costs (TVC)

Now, simplicity is at the root of this whole approach.

I know the CFO needs to do certain things to satisfy other executives, the bank, investors, and others. I know he needs to do some relatively complex allocations of operating expenses to costs for various reasons.

But, the COO needs to have a way to tell his people—from sales to shipping—how to easily differentiate good actions from bad actions. And, those fancy allocations just get in the way—muddying up the waters—when it comes to decision-making in operations.

We will take a look at that relatively simple equation for throughput again. But before we do, we need to define another term: TVC.

Truly Variable Costs (TVC) are limited to those costs that vary in an absolute way with incremental changes in revenues. Typically, TVCs are limited to a few categories:

1. Raw materials
2. Contract labor or outside services paid for on a piece-rate or batch-rate
3. Commissions

You will note that so-called “direct labor” is not a part of TVCs. Here’s why: If your company sells, on average, 100,000 widgets a month, does your labor actually vary if, in month one you sell only 80,000 widgets and in month two you sell 130,000 widgets? In month one was your labor bill on 80 percent of “average,” and was it 130 percent of “average” in month three?

Probably not. Labor is an operating expense that does not vary directly with changes in revenues.

Given that premise for TVCs and going back to our formula, there are really only three (3) ways to increase throughput:

1. Increase revenues
2. Decrease TVCs
3. Increase revenues and decrease TVCs

Meanwhile, back at the war…

One of the problems with (the many times unspoken) “war” between the CFO and the COO is that when they do reach common ground, it is all too often found only in “cost-cutting” rather than looking at ways to increase revenues.

The reason for this leap to common ground, of course, is made most clear by my first figure: typically, both the CFO and the COO feel more prepared and confident in dealing with the internal operations than with all the nebulous factors that lie outside the organization. So, dealing with internal effectiveness trumps trying to achieve higher levels of market differentiation—especially in challenging times.

[To be continued…]

Uncertainty: The Elephant in the Room–Part 2

In a previous article on uncertainty, we talked about how uncertainty is viewed by the “customer” of IT versus how it is viewed by the information technologists (e.g., value-added reseller or VAR, IT department) themselves. We mentioned how the “buyer” or the “customer” may feel the only uncertainty for them is the questionable performance of the IT provider.

In this present article I hope to bring out some of the ways traditional methods of project management and corporate management may actually contribute to uncertainty rather than diminishing it. We will speak of this in the context of IT projects, but it actually holds true in almost any project environment (whether or not management recognizes that they have and manage “projects”.)

Pretending about numbers

In out business dealings we like to think that our dealings—both internally and externally—are driven by numbers and facts. What management almost always fails to acknowledge is that a great percentage of our dealings are as much driven by intuition as they by numbers. In fact, intuition frequently ends up driving the numbers.

Take for example the VAR who brings a prospective deal to his project managers (or equivalent) and asks them for an estimate for the services on a project that includes development, training, deployment and post-go live support. The project management (PM) team does its due diligence and comes back with an estimate: “We think it’s going to take $278,000 in services to get this done right.”

The sales managers and executives put their heads together and, purely out of intuition, say, “We can’t sell this project for that much money, but we really need the work right now.” Then, based on the sales department’s intuition and clout with the executives, the PM team is “encouraged” (read: “pressured”) to reconsider their estimate to see if they can’t get the project done for $232,000—which the salespeople believe is the number the prospect will “bite on.”

To make a long story short: the deal gets done and the client is quoted $232,000 in services for the project.

Now, even though the final number was not predicated on numeric calculations and numerical estimates—no, indeed, it was based almost entirely on intuition—there is nothing imprecise nor “intuitive” about the $232,000 figure that was written into the agreement.

The intuitive number now bears pretends to be a precise calculation—an “estimate” or a “project budget.”

In so doing, the reseller has just introduced at least $46,000 in uncertainty into the project. At a typical billing rate, let’s say 250 man-hours or about six-and-a-half man-weeks.

There are no “price complaints”

Several decades ago I had the privilege of working with the national sales manager of an organization with which I was doing considerable business. The gentleman told me something that I will never forget. He said, “There is no such as a ‘price complaint.’ There are only ‘value complaints.’”

I bring this up because the “pretending about numbers” scenario I mentioned above happens more frequently than most folks in the IT business care to admit. But, I don’t believe it has to happen.

Why is it that, most of the time, folks in the IT business never have any real discussions about the “value”—the hard ROI—that their solutions will deliver?

I believe that they do not have those discussions for a couple of very elementary reasons:

1. The customer doesn’t ask. Of course, one of the reasons the customer doesn’t ask is because they’ve heard all the typical “rules of thumb” benefits already. Another reason is because many executives and managers do not even believe in ROI from IT. They consider it a “cost center” and just throw money at it whenever they think it might help. These managers and executives frequently see adding new “IT stuff” or replacing their ERP systems akin to pouring an engine additive into their car. They expect if they do that their engine (their company) will run smoother, faster, longer and get better mileage, but they have no idea how to measure the benefits of “smoother,” “faster,” or “longer.”
   
2. The IT folks don’t know how to calculate it. No, I’m not saying that the executives and other folks in IT don’t know the formula for “ROI.” I’m saying that they are (generally) unwilling or unable to walk their clients or prospects through the process of developing the performance metrics by which the results of their combined (i.e., IT or VAR together with the firm or business unit affected) efforts will be measured.

If both parties—the customer and the IT service provider—are unwilling to confront the subject of real ROI from IT investments openly, objectively and with the aim of mutual agreement on the intended measurable results for the investment, then how can the VAR (or IT department) expect to build “value” in the mind of the buyer to support the “investment” required?

In my opinion, they can not. So, instead, they reduce their “estimates” and cut corners to make it fit into someone else’s “intuitive” budget constraint that is generally predicated entirely on “cost” and almost never on anything like a hard ROI.

Isn’t it time to stop doing business this way? It’s just adding more to the uncertainty in every project. No wonder there are so many IT project failures—or self-proclaim or assumed “successes” with no substantiation—all around us.

Let me know what you think.

Simpler is better: Metrics not working? Check your complexity.

Are your metrics working against one another?

In the former Soviet Union (USSR), an professional weight-lifter was promised a bonus every time he broke a world record. So, being a shrewd “capitalist” (I guess), he decided to break world records one at a time—one or two grams at a time. Naturally, he got many, many bonuses, but it isn’t exactly what his handlers had in mind.

Some organizations pay rewards to their marketing department based on a “new customer” metric—the number of new customers garnered over a specific period of time. Of course, the idea is to build the customer base.

Meanwhile, many of these same businesses reward their sales department to meet or beat quarterly sales goals. So, in far too many cases, their salespeople are out burning through customers—alienating them through high-pressure sales techniques—in order to make their quarterly bonuses.

They may also reward their inventory managers to keep their inventory lean. So, while the salespeople are out making customers angry while getting their end-of-quarter orders (to get their sales bonuses), the warehouses are leaning out their inventory to meet end-of-quarter inventory numbers in line for their own bonuses. So, when many of those orders need to be delivered, they will be late—making the an already alienated customer all the more angry with the treatment endured.

I could go on, but I won’t. I’m sure you get the idea and you’ve suffered (or at least heard of) some similar well-intentioned reward systems go awry.

Some have suggested that these are “reward-motivated abuses,” seeking to blame the employees for doing exactly what management has told them to do, and for which management has agreed to reward them. How, then, can these be “abuses”?

Too much complexity

The problem here is not that the intended goals are not worthy: of course companies want more customers, more sales and lower inventories. The problem is the inherent conflicts evoked by the presence of too many “levers” being offered without linkages.

What’s lacking is a unified goal upon which the whole “system”—the whole organization—can be measured and each participant in the process of reaching that goal might be appropriately rewarded.

Simpler really is better.

“Simple” levers and the “simple” linkages

The linkages are simple, but in order to prevent your organization—or any part of your organization—from sacrificing tomorrow’s profits for today’s bonuses, your (for-profit) organization’s singular goal should be simple as well. Eliyahu Goldratt set it forth so clearly years ago: The goal is to make more money tomorrow than you are making today.

This simple goal is very easy to understand and very measurable—and it will help prevent improper actions like the following (an many, many more):

• Burning through customers to make short-term sales goals—because of the reduced long-term Throughput and the added operating expenses required to capture new customers
  
• Slashing inventory to reach inventory goals at the risk of alienating customers—because it drives Throughput down and operating expenses up
  
• Using company politics to cover or support inefficient or ineffective work efforts or policies—because it drives operating expenses higher (among other things)

Think about it. I think you’ll really like “simplicity” compared to “complexity” once you understand how it can drive your whole “system”—your whole organization—toward improvement (instead of piecemeal).

What do you think?

[Cross-posted at Kinaxis Supply Chain Expert Community]

What does technology project “success” mean to you?

I’m sure many of you are familiar with the common Venn diagram of “project management success.”

PMI (Project Management Institute) and others advocate that a project is successful if it is on-time, within the budget, and of high quality (or, at least, meeting the project’s original standards for quality). Of course, this is true when compared to the alternatives of over budget, late or of poor quality.

But, in the business world, we shouldn’t undertake projects—any kind of improvement project—for the sake of the project itself. So, while this might a satisfactory view of the project manager’s or the project team’s performance, it really doesn’t tell us very much about the net effect on the business.

Another popular Venn diagram used relative to technology deployments is the processes-people-technology one.


Here the aim is assure that the technologists involved in the project carefully consider the business processes that must be supported by the technologies deployed. Furthermore, the IT folks should also understand the people involved and they will desire to apply and benefit from the new technologies.

However, once again, we should be reminded that a business enterprise should never undertake any kind of improvement project merely to automate business processes for automation’s sake. Nor should they undertake an improvement project with the sole aim of people-pleasing.

In a for-profit organization, there are proper metrics to use for IT decision-making, but these are not the ones.

Consider, for example, the business that spends $150,000 on an IT project. The project is deemed to be “a resounding success” based on the following results:

1. The project was completed on time
2. The project was completed under budget
3. The project met all of the initial quality requirements
4. The project’s technology deployments properly supported the intended business processes
5. The project’s new technologies were well accepted and utilized by the people involved
6. The company was no worse off after this major undertaking (and everyone has heard the horror-stories of huge IT failures)

So, the project management team all got big pats on the back and a few VP’s got bonuses and all the stockholders and stakeholders are pretty happy about the whole “successful project” thing.

But, my question is: Should they be happy?

They just spent $150,000 with an admitted ROI (return-on-investment) of a big fat ZERO!

To me, that’s just not good business!

There is a Venn diagram that I, personally, have never seen, but it is the one Venn diagram that makes sense for business investments of every kind because it includes the three factors that should always be considered for “success.” Here it is.

Here are the questions that should be asked about every improvement project—IT-related or not:

1. How much does the project increase Throughput (where Throughput is defined as revenues less truly-variable costs directly linked to producing the revenues)?
2. What affect does the project have on Operating Expenses? Do they go up or down? If so, by how much? Is the change “real” or a calculation based on “savings” when no one will actually be laid-off or no additional Throughput will consume the man-hours “saved”?
3. How much will our Investment change? Besides (as in our example) the $150,000 we will invest in the project itself, will our inventory go up or down? Will we need to invest in new buildings, or can we sell off some capital equipment and increase our cash?

When you have the answers to these questions you will have the answer as to whether your technology project was just a “project success” or a “business success.” And, while the numbers may not be precise, knowing that they are approximately right will give you far better understanding of your company’s success or failure than not considering them at all.

What do you think?

[Cross-posted at Kinaxis Supply Chain Expert Community.]

Why Small Businesses should invest in an integrated Excel-based Business Intelligence solution: Reason No. 3 | The BI Blog - Powered by Alchemex

 Business intelligence investments should always be made with the goal of using the information supplied for one of three purposes (listed in priority order):

1. Increase Throughput
2. Decrease Inventories or other demands for (new or increased) Investment
3. Slash or hold the line on Operating Expenses while sustaining significant growth in Throughput

Decision-making about ROI and your technology spending

Dan Gilmore wrote in “The ‘Probability’ of Supply Chain ROI” propounds properly and rationally the fact that any “forecast,” including forecasts of ROI (return on investment) should not be a single number. Rather, as anyone properly trained in statistical methods will tell you, it should be a range of numbers. The range of numbers would generally be calculated based on a single calculated value plus and minus values that represent the confidence intervals or, simply put, how likely the statistician believes his estimates the calculates will approximate reality. A larger range indicates lower levels of confidence and a smaller range higher confidence levels.

Now, while Gilmore is mathematically correct, the fact remains that most small-to-mid-sized businesses (SMBs) simply do not have anyone trained in statistics on their payroll and they are not likely to go out and hire a statistician to produce ROI forecasts for their IT projects – since this would, by definition, automatically reduce the ROI of the enterprise as a whole in the short term.

Back on a growth trajectory

Gilmore makes another comment in his article with which I wholeheartedly agree: “[T]here is some evidence that companies are in fact looking at investments that can help them to get back on a growth trajectory (read: increasing Throughput) without having to add much in the way of head count (read: Operating Expenses) by achieving productivity gains.” Given the world-wide economic malaise that is showing some signs of lessening (for the moment, at least), Gilmore’s description probably suits the vast majority of SMBs across the U.S. and beyond.

Furthermore, many others besides me have written that a firm stand on return on investment will be the hallmark of technology spending in the 2010 and beyond. So, I can hardly fault Gilmore for suggesting that SMB executives and managers need to become increasingly sensitive to and realistic about ROI for every kind of investment in their firms’ futures.

Too much complexity already

Despite my agreement with Gilmore on theoretical grounds regarding forecasts – including ROI forecasts; and despite my agreement with him regarding the goal of companies to get back on a growth trajectory through wise investment of capital resources, I must disagree with him on the matter of adding useless complexity to the return on investment forecasting process.

Allow me to explain why I use the harsh term “useless” to describe such an effort in the development of a ROI forecast for an IT project.

First  of all, let me say that statistical methods ought to be applied where they make sense. Statisticians generally agree that a valid statistical sample must contain at least 30 members. This works great where you have 30 dogs, 30 cows, 30 houses, 30 automobile, 30 miles of roadway, and so forth for comparison. Then, of course, you need to factor for environmental differences. Thirty or more cows all in the same pasture, eating the same foods, and enjoying the same climate would make a pretty good statistical sample for some studies of cows. On the other hand, three Holstein cows in northern Minnesota, two long-horns in west Texas, 15 black whiteface cows in eastern South Dakota, and ten mixed-breed cows in central Florida are not likely to constitute a good “sample” for cow studies.

Why?

Simply because there are too many environmental dissimilarities surrounding the cattle. By the time these factors were accounted for, (generally speaking) any results would have such a large confidence interval as to make any prediction almost meaningless.

When considered as a whole, a typical SMB has tens of thousand of variable at work within the enterprise. Any number of those variables are likely to dramatically separate it any “sister” enterprises in a sample group used to forecast ROI outcomes.

Of course, the fact that traditional ERP – Everything Replacement Projects – are going to affect the whole enterprise is a big part of the problem of predicting ROI outcomes. With tens of thousands of variables at play, picking the winning number is far more challenging than winning the lottery.

Reducing the scope reduces the complexity

First of all, a good many SMBs today have a “pretty good” ERP system in place – regardless of its brand. Unless there is some pressing reason to undertake a traditional ERP – Everything Replacement Project, it is probably a far better idea to consider a New ERP – Extended Readiness for Profit project instead.

Narrowing the scope of the project reduces the complexity. And, reducing the complexity increases the likelihood that your ROI forecast will be more on-target. Allow me to give you a couple of examples:

• Warehouse automation – Suppose your Current Reality Tree (CRT) shows you that, in order to increase Throughput, you need to enable your warehouse to be able process 80 to 100 shipments per hour, rather than the present 30 to 40 per hour. Furthermore, you need to do this while holding the line on Operating Expenses.
  
• Business intelligence – After reviewing their Current Reality Tree and laying out a Transition Tree (TrT), your marketing and sales team has assured you that, if they are provided tools with which to better understand customers and markets, they will be able to segment the market and create UROs (un-refusable offers) and increase Throughput by 130% in two years. No additional staff or other increases in Operating Expenses would be required.

If your executive management team were to elect to pursue either of these projects – or both – the goals are specific and measurable – as would be the expected outcomes. ROI calculations become simple:

Where T = Throughput (Revenues less Truly Variable Costs), OE = Operating Expenses, and I = Investment.

Simple. Elegant. And ROI calculations are far more likely to be right than any calculation around traditional ERP – Everything Replacement Projects.

©2010 Richard D. Cushing

Taking the Easy Way (Down and) Out

In a LinkedIn group discussion today, many people were offering advice regarding how to save a small business that has been struggling due to the recession.  There has been no shortage of advice.  However, one comment today really stuck out to me. Here is what the contributor had to say:

A company is making 1 million a year.
From that it makes 10,000 profit (1%).
Each sale yields 25% return - i.e. if you sell 1,000 250 is profit.
To double its profit it can:
1. Reduce costs by 10%
2. Increase sales by 40%
Do the math(s). Which is easier?

Now, perhaps this example was intended to demonstrate what a clearly bloated and, likely, wasteful company really looks like. After all, the firm is grossing $250,000 on $1 million in revenues, but net profits are only $10,000 (1%).  That means that the firm is spending $240,000 (99%) on “expenses.”

If this is true – that the company really is bloated and wasteful – then, by all means, the quick and easy way to making more money is to “reduce costs by 10%.” It may even be likely for a $1 million revenue company that is spending $240,000 in expenses that $24,000 could be cut out and not do a bit of damage to the firm’s ability to survive and thrive.

The real state of things

For better or for worse, most small businesses today do not have a profit-and-loss statement that looks anything like that – at least not in terms of being bloated and wasteful. Most of the SMBs (small-to-mid-sized businesses) that I encounter are already running a pretty tight ship. There is no extravagance left in the firm’s operating expenses and, typically, they have already cut back on staffing so that many of the folks in the organization are working long hours and have taken on multiple duties so that fewer people are needed to keep things running. These organizations do not have any “fat” left to trim away. If they seek to cut expenses by even five percent (5%), it would mean cutting away “muscle and bone” – the strength that has allowed the organization to survive until today.

Cost-cutting may have gotten here

If management in such organizations are trapped in cost-world thinking, it could be that cost-cutting is what helped bring them to the brink of destruction, as it is. Here is how cost-world thinking can take a executives and managers astray and lead them to make decisions that are damaging to the organization:

Misleading allocations of overhead expenses

Using the figures offered by the contributor to the discussion (above), this company believes it has a gross profit of 25% ($250 for every $1,000 in revenues). Let us say that this is being calculated in the following (traditional) manner:

Cost Classification	Cost Amount
Raw materials	$250.00
Direct Labor	$100.00
Allocation of indirect costs and overhead	$400.00
Total Calculated Cost of Product	$750.00

For the sake of simplicity, let us say that each “widget” sells for a price of $1,000, so we have the following:

	Amount
Unit Revenue	$1,000.00
Unit Cost (incl. allocations)	$750.00
Calculated Gross Profit per Unit	$250.00

Also, let us assume that, due to the recession, this company also has excess capacity at this time.  (Otherwise, how could their operating expenses possibly be $240,000 on revenues of $1 million?)

Opportunity knocks

Now, one of this firm’s salespeople comes back from a long discussion with a potential new customer in Europe. This firm wants to buy up all the remaining capacity at the firm. That means 1,200 units. However, they are only willing to pay $650 per unit.  What should the company do?

Far too many executives caught up in cost-world thinking would turn this offer down. They would say, “We can’t take a loss of $100 per unit and ‘make it up’ in volume! That’s crazy!”

But, let us look at what is really happening. The company already has excess capacity. It could produce the additional 1,200 units without investing in any new facilities or equipment. Furthermore, it would not add to operating expenses, because no additional back-office staff would be required and no overtime is expected to meet the new demand. So, here is a contrast between cost-world thinking and reality:

COST-WORLD THINKING	Amount
Unit Revenue	$650.00
Cost-world Cost	$(750.00)
Gross Margin per Unit	$(100.00)
Number of Units Sold	1,200
Gross Profit from Offer	$(120,000)
Gross Profit from Current Operations	$250,000
Total Gross Profit	$130,000
Operating Expenses	$(240,000)
Net Profit	$(110,000)

Throughput Thinking

THROUGHPUT THINKING	Amount
Unit Revenue	$650.00
Truly Variable Costs (TVCs) (Raw Materials)	$(250.00)
Throughput per Unit	$400.00
Number of Units Sold	1,200
Change in Throughput from Offer	$480,000
Throughput from Current Operations	$250,000
Total Throughput	$730,000
Operating Expenses	$(240,000)
Net Profit	$490,000

Escaping from cost-world thinking

Here is a simple formula to help rescue firms from making the error we have illustrated above:

Where ROI = Return on Investment,
delta-T = Change in Throughput, where T = Revenue less Truly Variable Costs (TVCs),
delta-OE = Change in Operating Expenses, and
delta-I = Change in Inventory or Investment

In this case, we have determined that the change in OE = zero, and for simplicity’s sake, we have also assumed that the change in Inventory or Investment is zero (or negligible).

Essentially, when looked at properly this offer to “sell below cost,” actually increases the firm’s net profit by $480,000 with virtually zero investment. (In a real situation, some change in inventory is likely, but the effects would still be small.)

I trust this sheds new light on your business situation. Contact me at rcushing@GeeWhiz2ROI.com if you’d like to have help getting a better view of your business and how to make more money.

©2010 Richard D. Cushing

The New ERP – Part 14

Compare with Traditional ERP – the Everything Replacement Project – approach

Let us stop to compare where our management team is now in its decision-making process with what an organization that embraces traditional ERP – the Everything Replacement Project – might be going through in their processes.

How do most small- to mid-sized businesses go about setting budgets for their major or minor IT initiatives? We will take a look at a few of the methods I have run into over the years:

• Don't set a budget: Far too many firms simply find out what the executives and managers think needs to be done, and then get quotes from some vendors or resellers on what it will cost. This gives them the "cost" – assuming it is accurate, but many times it is not. As for "benefits," may management teams just "expect improvement" in some unquantified and unquantifiable way. They don't have a "budget" and they don't have an "ROI." Furthermore, they generally don't measure the results of "improvement" afterwards either.
  
• Educated "guess": In such cases, frequently the CFO, the president, or someone from IT is simply asked to "put together some numbers." Frequently, these almost exclusively "cost" numbers come from telephone conversations with vendors or resellers, Internet searches, or conversations with people from other companies that have done something similar. Again, in far too many cases, the management team does not even attempt to quantify the "benefits" or calculate an ROI for the proposed initiative.
  
• How much can we afford? Naturally, this attempt at "budget"-setting comes directly from cost-world thinking and entirely neglects the fact that, if the organization is going to see no increase in Throughput (T), no decrease in Inventory or Investment demands (I), and no significant decrease or future savings in Operating Expenses (OE), then the budget that should be assigned to the project is zero-dollars.
  
• Find out: This approach is almost equivalent to "Don't set a budget" above inasmuch as the method (if you can call it that) amounts to "finding out" how much an Everything Replacement Project will cost, then factoring it for "overruns," which have come to be expected in the industry. Again, this approach has no bearing on the value the traditional ERP project will bring to the organization, only the anticipated "cost" to the firm accompanied (frequently) by only the vaguest of notions as to how the change will actually increase Throughput (T), or reduce Inventories or demand for new Investment (I), or drive-down or hold the line on Operating Expenses (OE) while sustaining growth. Unfortunately, often times even the "growth" itself is merely assumed.
  
• Comparatives: This approach is simply a variation on "Don't set a budget" or the "Educated 'guess'" methods. Here the way it's done is to get the CEO or other executives to ask their golfing buddies or other industry friends (and maybe even relatives) how much their companies paid for their last Everything Replacement Project. Once again, no focus is placed on specific areas of improvement and the far too frequently the estimates of "benefits" and "ROI" are vague – to say the least.
  

Now, I know you probably laughed out loud (or at least chuckled to yourself) when you read some of the above "methods." The fact is, it is funny to read these when the truth is laid out in some embarrassingly plain language. However, as sad as it may be, many of the budgets for IT initiatives I have run into over the years have no more substantial basis in reality or value for the enterprise what I have described above.

Of course, given the scenario for "budget setting," it can hardly be a surprise to find that many owners, executives and managers make many, many wrong decisions about what kinds of investments their firms should make in information technologies – or other improvement efforts, for that matter. They also frequently make wrong decisions regarding how much to spend on improvements in any given functional area, since they are quite often at a loss to link daily execution improvements with financial results.

By the way, as you can see from the approach we have laid out in our radically new Extended Readiness for Profit – the New ERP, it may be as foolish for a CEO to under-invest in technology (or other improvements) – because she does not understand the dollar-benefits that would be delivered by such investments – as it is to over-spend on technologies. (Here I draw the clear distinction between investing and spending. An organization is investing if they have calculated the benefit relative to the expenditure; whereas, an organization is only spending if they have not calculated the benefit relative to the expenditure or no actual increase in Throughput, reduction in other Investment, or decrease in Operating Expenses will likely result from the expenditure of time, energy and money.) Either way, the CEO is probably doing long-term damage to her own organization – making it less capable, not more capable, of delivering more profit today and in the future.

This clearly highlights the value of the Current Reality Tree (CRT) (see prior posts) in helping your management team identify "what needs to change" before taking any steps toward assuming that new technology – applied in a general way – will deliver some general, but unquantifiable, benefit to your organization.

If you and your management team are following along in our Extended Readiness for Profit – the New ERP approach for your own organization, then you now need to take some time to calculate the values for the changes in T, I, and OE with regard to the actions you may have under consideration – whether they are technology-related or not. Your proposed actions, of course, should be based on the findings at the roots of your CRT. (For those of you just catching up, you will probably need to go back and read prior posts on The New ERP.)

[To be continued]

The New ERP – Part 12

Jeepers! Creepers! Where'd you get those numbers?

In the last post, I said that the management team in our unnamed example company had estimated the following for a change proposed in their warehousing operations:

• Change in Throughput (delta-T) = $0
  
• Change in Operating Expenses (delta-OE) = $168,942
  
• Change in Inventory/Investment (delta-I) = $75,000
  

Let us now take a look at a relatively quick way to get to numbers such as these without suffering paralysis by analysis.

One shorthand way to estimate changes in OE is the use of the value of a typical or average FTE (full-time equivalent) in the department or area being affected. This effective and rational method allows us to create estimates of potential savings (or added costs, if that be the case) even if no actual employees are going to be laid off or hired as a result of the proposed change. Here is how: While firms seldom layoff employees as a result of process improvements – and we highly endorse such acts of employee retention – if the firm is focused first and most importantly on increasing Throughput (T), the organization will actually experience these savings over time by being able to support growth in Throughput of 30%, 60% or even 100% or more without adding to Operating Expenses by forestalling the hiring of additional personnel.

So, here's how our example company's team calculated FTE values for their warehouse operations:

By extrapolating from this calculated FTE value ($49,686), here is how the management team took the next step to estimate annualized savings from the proposed changes in the warehouse and picking-shipping operations:

At this point, our example management team also made an arbitrary decision. They established a preliminary investment budget of $75,000 to cover the cost of technologies to provide (at a minimum) the three critical functions of:

1. Integrated bar code printing
   
2. Integrated ASN processing, and
   
3. Paperless (or near paperless) picking and shipping operations
   

Since our management team has no predisposition for an Everything Replacement Project (traditional ERP), they have many options open to them. They are focusing solely on Extended Readiness for Profit – my radical new approach to ERP. Therefore, they could take advantage of any one or more of the following courses of action:

• Develop integrations between existing bar code applications and their inventory management software. Most of the better bar code applications on the market today already provide APIs (application program interfaces) and ODBC (open database connectivity). These capabilities would help keep the cost of development reasonably low and permit relatively easy and low-cost changes as demands on the organization change over time.
  
  
• Purchase and integrate an EDI (electronic data interchange) engine with their existing inventory management and sales order processing software in order to generate and deliver ASNs (advanced shipping notices) for them. This project would have to be coordinated with the solution chosen to handle the paperless picking and shipping operations, however.
  
  
• Acquire a paperless shipping and manifesting application and leverage its APIs to integrate it with the firms existing inventory and sales processing application. They might even hit the jackpot and discover a shipping and manifesting solution that includes ASN processing as part of the package, or has already been successfully integrated with their existing inventory and sales processing application.
  
  
• Roll their $75,000 budget into a large project that may be part of replacing an existing inventory or sales processing application.
  

If they choose the last option, they should still predicate their purchase and implementation budget on the sum total of all measurable improvements and savings anticipated from all outcomes when compared to their Current Reality Tree (CRT). They should not arbitrarily throw money into the budget "kitty" based on some vague feeling that "more technology" or "newer technology" will automatically make the organization more profitable or stop losses. That is to say, never substitute a traditional ERP (Everything Replacement Project) for a focused and measurable Extended Readiness for Profit (the New ERP) program.

[To be continued]

The New ERP – Part 11

Evaluating alternatives

Based on the management team's analysis in our example company (see prior posts in this series), they have come to the conclusion that their system's current "bottleneck" – or, constraint – is in their pick-pack-ship operations. Since they have already agreed that there are so many crossovers in personnel and functions between general warehousing operations and picking-shipping, they are going to consider CRT roots 1, 2 and 5 together.

This makes a lot of sense inasmuch as any technology that might be applied to the warehouse is likely to include functionality that will supplement multiple areas. The areas of concern, as determined by the CRT roots, are:

• Integrated bar code labeling
  
  
• Integrated ASN generation
  
  
• Reduction or elimination of paper-based processing of picking, packing and shipping operations
  

Using this list of critical factors generated directly from the organization's CRT, the management team knows already "what needs to change" and, by implication, the key functions that any technology must supply to help the organization actually move toward increasing Throughput while holding the line (or maybe, cutting) Operating Expenses.

While intuition alone might bring some organizations to this point, if the management team has not documented (I mean literally written down) the logic that brought them to these decisions, they are in a far poor position to evaluate the failure or success of any implemented changes that may flow from their decisions. (It is beyond the scope of this present discussion to cover these matters in more detail, it is at this point that other Thinking Processes tools – like the Transition Tree and Future Reality Tree – might be applied by our example company's management team to determine what the change(s) should look like and how to effect the change(s) required.) This means, of course, that if the team were to take the approach of Traditional ERP – an Everything Replacement Project – it is quite likely that the project will lose focus and end up not having metrics by which to guide decision-making or measure success or failure.

Taking the next step of putting numbers to their intuition and the logic they have mapped out using the Thinking Processes will further sharpen the focus of the management team. Here is one way they might go about developing metrics around the proposed changes.

In order to begin, the team will need to come up with valid numbers related to two factors: If they make the proposed changes by applying new or expanded technologies in their warehousing and shipping operations, how much more Throughput (T) will they be able to support while holding the line on Operating Expenses (OE)? Of course, they already know the key features that they are looking for in their search for supporting technologies, too. These were identified also by the Current Reality Tree (CRT): 1) integrated bar code labeling, 2) integrated ASN generation, and 3) reduction or elimination of paper-based processing.

These folks are already far ahead of any company that has started their search for a new ERP system by the traditional "requirements gathering" from all the departments. Plus, they are looking only at creating an Extended Readiness for Profit (the New ERP) by focused technology selection and deployment, not the wholesale approach that comes with traditional ERP – an Everything Replacement Project.

Well, this firm's management team is as honest as the day is long! So, even though they realize that the improvements they propose in the warehouse and shipping operations will allow these departments to support dramatic increases in Throughput, none of the changes being made will actually add Throughput to operations. They acknowledge that they are already getting almost every shipment out the door every day. The problem is that they are doing it using extra personnel and a lot of overtime. Of course, all that falls under the category of Operating Expenses.

The management team thus concludes the following:

• delta-T = $0
  
• delta-OE = $168,942 per year
  
• delta-I = $75,000
  

I hear you ask: "Where did they ever come up with numbers like those?"

[To be continued]

The New ERP - Part 8

Creating your Current Reality Tree (CRT)

STEP 5:
Once you have completed your CRT, take a close look at the "roots." Roots are those entities at the bottom of the tree that have no arrow leading into them. Generally speaking, you will find that the roots of your CRT will fall into two very broad categories:

1. Things you can change or affect in some way, and
   
   
2. Things you likely cannot change or affect (de facto roots).

When classifying entities into the latter category (de facto) take great care. Do not allow yourself or your team to make excuses by simply saying that "we have no control over that." For example, quality issues from outside suppliers may not be in your direct control, but they are certainly within your realm of influence -- especially if you are a major customer of the vendor.

Once your team has identified all of the roots that fall into the first category, you will likely find that these roots may be further subdivided into three more categories:

1. Root causes for which improvement requires no new technologies
2. Root causes where you may achieve some improvement without the aid of new technologies, but further improvement may also be achieved by applying new technologies as part of an ongoing improvement process
3. Root causes where the most logical and most effective action toward improvement will involve the deployment of new technologies

Most of the organizations we work with find that more of the things they need to change for improvement do not involve investments in new technologies. If this is your case, then "Congratulations!" In less than one day (most likely) you and your management team have discovered how to begin system-wide improvement that

• May be commenced immediately
  
  
• May involve little or no cost
  
  
• Will likely deliver improvements that increase Throughput, reduce Inventories or the demand for new Investment, and/or will probably help you hold the line on Operating Expenses while you grow your business

Equally as important, however, is the fact that if you find the need for new technologies, the cash flow from the non-technology early-win improvements can help pave the way for the investment in new technologies in the near future.

[To be continued]

The New ERP - Part 2

So, what's wrong with traditional approaches to ERP? Why do so many ERP implementations lead to disappointing results? Why do so many companies spend so much money on new technologies and then end up reaping so little return on their investment?

Failure No. 1: Not achieving the planned return on investment (ROI)
It remains today a regrettable fact that many small to mid-sized companies considering new technologies have only the vaguest of notions about the ROI that their new investment should deliver. This is not to say that executives and managers haven't thought out ROI, or even that they may not have already "pinned a number" on the ROI that they'd like to see from the expenditure of their time, energy and money.

What they do not know -- far too frequently -- is precisely how the new technology will deliver results. They have not tied the expected results to specific improvements in Throughput, specific reductions in Investment, or specific savings in Operating Expenses. Rather, there appears to be a general consensus among executives and managers -- despite considerable evidence to the contrary -- that investments in information technologies (IT) sort of auto-magically deliver a return on investment (ROI). That, somehow, IT and automation investments bear an inherent capacity to make the company better and more profitable.

Over the more than 25 years that I have been working with IT from both sides of the desk -- as an executive and as a consultant -- there have been fewer than a handful of companies with which I have worked that actually calculated an ROI for their investment in technology. Fewer still had any measurable objectives for specific IT investments beyond some number clearly picked from the air like "increase revenues by 5%" or "cut manufacturing costs by 7%." Almost none of these firms could tie specific technology functional deployments to the expected ROI.

Given these facts, it is no wonder that traditional ERP (Everything Replacement Project) fails to deliver ROI. The executives and managers deploying the new ERP have not based their ROI expectations on much more than "gut feelings" and some vague sense that having more data will make them better managers.

Failure No. 2: "Go-live" delayed inordinately
Substantial delays to "go-live" in Everything Replacement Projects (traditional ERP) are generally attributable to one or more of the following factors:

• Poor decisions related to customizations or modifications -- when they are selected; how the program code is designed, developed and managed; and the methods chosen for testing and deployment
  
  
• Executive management's improper view of the goals and objectives of a valid ERP project -- thus leading to out-of-control scope creep, usually with absolutely no correlation to project ROI
  
  
• The organization being overwhelmed by an Everything Replacement Project -- rather than being focused on leveraging specific technologies for the benefit of the "system" (i.e., the organization) as a whole

[To be continued]

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