Uncertainty: The Elephant in the Room

Not long ago I was fortunate enough to have a conversation with two very fine gentlemen in the software business. They were part of an organization well-recognized for its leadership as a reseller and a developer providing an ERP (enterprise resource planning) solution for Tier 2 and upper-crust SMB firms.

As part of the conversation, I mentioned the fact that uncertainty is “the elephant in the room” throughout the IT (information technology) business.

What I meant by that is this: while the sales process is underway, it all too frequently happens that the two parties have differing views of the uncertainty involved in any project that might be undertaken as a result of their conversation. While they hold these differing views, however, they almost never speak openly and explicitly about the uncertainty itself.

My experience shows me that these two parties hold views of the uncertainty that take shape somewhat along these lines:

• The Client or, more correctly, at this stage in the process, “the prospect” may believe that there is very little uncertainty about which to be concerned. After all, he and his organization have tried to be forthcoming with the reseller. They have answered all the questions the resellers’ folks have raised from the first day they met, and they have done so as directly as possible.
  
  Because “the prospect” feels this way, the only “uncertainty” he may feel about any proposed agreement is whether the reseller is capable of delivering on all the promises he has made over the course of the negotiations.
  
  Also, since “the prospect” will hold the checkbook during the project execution, he feels pretty sure that he can force the reseller into assuming whatever uncertainty might remain in the anticipated project.
  
• The Reseller has been through this many, many times. He is well aware that every project is full of uncertainty. A short list of the uncertainties in the reseller’s mind might look like this:
  • Have we asked enough questions?
  • Have we asked the right questions?
  • What don’t we know that we should know about this company and how it works?
  • Can the modifications we anticipate be completed in the time we have estimated?
  • Will the prospect’s company allow this project to proceed in the time we have estimated, or will their inefficiencies, indecision or other operational problems cause us to incur unanticipated time and expenses?
    

Accidentally induced uncertainties

W. Edwards Deming once summed up very succinctly the uncertainty included in all human communications. Following a meeting between two parties, as one party was exiting the room, Deming turned to the manager he was consulting and said, “We know what we told him, but we don’t know what he heard.”

Communications between two human beings are full of such foibles. The fact that the reseller’s salesperson does not believe that he has made any “promises” upon which the reseller cannot readily deliver does not mean that the prospect has not heard “promises” that are very different from what was intended by the salesperson.

Under such circumstances, there is—more likely than not—no intention by the reseller’s sales team to mislead the prospect. Neither, most likely, is there any intent by the prospect (now, client) to somehow misconstrue what was said in order to take undue advantage of the reseller.

Nevertheless, such accidentally induced uncertainties too frequently lead to cost overruns, hard feelings between the reseller and the client, and—sometimes—even to failed projects.

Why don’t we talk about it?

My question is simple: When it comes to IT projects (or any kind of projects, for that matter), and whether it is a relationship between an external IT provider or an internal customer relationship, why do we so often ignore “the elephant in the room”?

Why are both the customer and the supplier both so reluctant to speak explicitly about the uncertainties that almost inevitably affect a project of any significance or size?

Let me know your thoughts. Thanks.

Misaiming about metrics

In order to protect the guilty, my source for some the silly statements I read about business management will not be revealed. Recently, I read this statement in a book about business metrics.

“Measurement is the connecting fiber that can make all the parts work together [in a business or government enterprise]. Achieving this kind of coordination and alignment is impossible without exceptional performance measurement.”

Let’s consider the metaphor of a multi-movement mechanical watch. You know: the kind of watch that keeps time in minutes and seconds, tells you the day of the week, the day of the month, and the phases of moon.

Now, without a doubt, a huge number of measurements were made, formulas developed, and calculations made about the sizes of the gears, the number of teeth in each gear, their placement in relationship to one another and more. A watch is all about measurement. A watch’s whole purpose “measurement.” It only exists “to measure.”

Nevertheless, it is not the accuracy of the measurements that make the watch fulfill its functions properly. When you get right down to it, it is not even the accuracy of the calculations that went into the design of hundreds of moving parts. It is not the accuracy of its manufacture that—at the root—cause the timepiece to function as a “system” and do precisely what is expected of it.

It isn’t any of those things—at the root!

What, then, is at the root of a “system” that functions smoothly, efficiently and effectively? At the root of that highly effective watch’s ability to function is something entirely distinct from “measurement.”

What is that mysterious thing that all too frequently escapes the business intelligence fanatics? What lies at the very core, but is often overlooked by the “metrics maniacs”? What seems to conceal itself from those who seem to be convinced that if management could just get enough “information”—enough metrics—they could manage flawlessly?

The answer is—as W. Edwards Deming told us years ago—“theory.”

The people who designed all of the components of the multi-movement “watch” that does what it does so smoothly, efficiently and effectively had a “theory” about watchmaking long before they ever drew the first plans or began fabricating the first gear.



The business metrics book from which I got the quote at the opening of this article contained a diagram similar to that above. But this diagram is wrong in lots of ways. But, really, only two are critical.

Here’s what the diagram ought to look like:



The foundation of making a business that works—and stays working—is theory. And, more importantly, if the only “goal” of your “measurements” and “management” is a bunch of departments surrounded by a compensation system, then your business probably won’t last too long—except by “luck.”

The “goal” of your “system” should be—indeed, must be—profit. And, as W. Edwards Deming put it so well, “Information tells you nothing without theory.” Theory is the context by which information is interpreted and made the basis for action to change the outcomes.

[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.]

Simpler is better: Dynamic Buffer Management (DBM)

Somehow, in the dark recesses of the past, someone came up with the idea that we should (at least in our minds) segregate our regular stock (inventory quantities) from our “safety stock” as if there were some difference between the two. “Safety stock,” APICS and others suggest, is to cover “variations” in lead-time or demand, while our “regular stock” is to cover “normal demand”—whatever that is. But for most businesses today, variation in demand is the rule, and not the exception. Furthermore, isn’t it true that our whole stock quantity is really what we want to manage—not some isolated portion of our stock that we describe logically as “safety stock.”

Simpler is better. Our whole stock quantity should buffer the system (read: the whole enterprise) from losses in throughput (read: profits).

For years I have worked with small-to midsized enterprises (SMEs), many of which I first touched when they were in transition from entrepreneurial to enterprise in nature. When I found them, they generally knew very little about their inventory. Oh, sure: they knew in a general sense which items were profitable and which were not. They also had a general handle on which items in their inventory were the “fast movers” and which were “the dogs.” Nevertheless, when it came to managing their inventory quantities they almost all struggled with the all too common problem of being sold-out of some items (and thus incurring losses of potential sales and profits) while, at the same time finding that they were overstocked on dozens of other items (so that they were simultaneously incurring high carrying costs and lower cash flows as a result). The problem was, from month to month, it was almost never the same items that were sold-out versus over-stocked. They could never predict what quantities were going to sell, so they couldn’t predict what quantities to stock.

Constraints management (Theory of Constraints) suggests—as I said above—that our whole stock of any item (taken in total) should serve one purpose: to buffer the system from losses to throughput. Now, it is not the purpose of this present writing cover all of the various details of a full Dynamic Buffer Management solution. The simplicity of Dynamic Buffer Management (DBM) is what makes it so appealing. The following is a real-life application of DBM in action.

The raw data we have on our example SKU looks like this:

We have just two months of data from 2007, full years’ data from 2008 and 2009, and a partial year for 2010. Note that demand in 2008 was fairly stable, ranging between 72 and 220 units per day. However, demand is 2009 become wildly erratic—ranging from just 1 unit per day to 389 units per day. Over the entire recorded history for this SKU, we find the following statistics:

If we graph these data, the results look like this:

Now, it’s nice to know that a third-order polynomial curve fits pretty nicely with a six-period moving average of these data, but most SMEs do not have a staff statistician available to them to help analyze all their inventory history in order to determine how to set parameters like stock levels, safety stock, reorder points, line points and more. Nor, do they have confidence that statistics will necessarily serve them better than their intuition has in the past.

What they are looking for is something SIMPLE, RELIABLE, EASY TO UNDERSTAND and EFFECTIVE. Dynamic buffer management is all of that.

Let’s imagine that we are at the end of year 2008 and we want to set up DBM for year 2009. We’re going to do so based on our 2008 history.

The first thing we need to know is: how big should our starting buffer be for this item?

Well, it ain’t rocket science! Establishing a starting buffer quantity requires the knowledge of a few facts because it is more important to be “approximately right” than to be “precisely wrong.” No matter how much precision (read: time, energy and money) is put into calculating a “precise number” for the size of the buffer (or any other business ‘forecast’ number) that number will end up being “precisely wrong” 99.999 percent of the time.

So, to find an “approximately right” number for the starting buffer is more important than finding a “precisely wrong” one. In our example, we used the following formula:

Starting Buffer Size = average period consumption over the Last 12 months + (safe replenishment time in days * average consumption/day * 2 * paranoia factor)

Some of these numbers are arbitrary:

1. “Safe Replenishment Time” is nothing more than a “safe” estimate of the time it would take to replenish the item under normal circumstances. Almost anyone working in purchasing or replenishment or manufacturing can pick that number for items with which they work day-in and day-out. If one says, “Five,” and another says, “Eight,” then use eight. It’s that simple.
2. The number “2” used in the formula is also arbitrary. It is nothing more than an additional safety factor to cover unusually high demand or unusually slow delivery. In a moment you’ll see why it is not terribly important in the long run.
3. “Paranoia Factor” is our third arbitrary number. This value is used to cover management’s concern about things like:
1. “Our inventory will skyrocket” – so let management set a paranoia factor of less than 1.0 on some items
2. “If we run out of this item, we lose sales on other things, too! – so increase the paranoia factor
3. “This is a high-margin item and we don’t want to lose a single sale” – so make the paranoia factor larger

For our example, we calculated a starting buffer size of 11,954 base on a paranoia factor of 1.000. Let’s watch what happens using the actual consumption figures from year 2009.

Now, let’s see how DBM helps us out:

• Period 1: We just stocked up to almost 12,000 units and in period one we had the worst month ever! We sold only 23 units! Have we done the right thing here?!?
  Even though it seems like we have plenty of stock, we follow our basic rule: Whatever we consume, we replenish. So, we place a replenishment order for 23 units.
  
  At the end of the period, our “Buffer Status” = 99.81 percent. We have almost a full buffer.
• Period 2: Things return to normal now. We consume 3,315 units, we get our replenishment supply of 23 units, and we end the period with a buffer status of 72.27 percent. That’s okay. We really don’t get concerned as long as the buffer remains in the green zone—that is, above two-thirds.
  
  We dutifully place our replenishment order for your consumed quantity—3,315 units.
• Period 3: We consume 2,153 units and get our 3,315 units from our replenishment order. True to form, we order replenishment for the 2,153 units, and we end with the buffer solidly in the green at 81.99 percent.
• Period 4: Wow! We consume 7,903 units; get our replenishment of 2,153 units and our buffer status ends up in the red zone. The red zone is a buffer below 33.33 percent full. [NOTE: Here I’m going to play along with some anomaly in Excel’s failure to calculate and apply conditional formatting correctly. We’re at 33.89 percent and this should be “Yellow,” but it’s not. Excel says it’s “Red,” so we’re going to call it “red.” Close enough!] We take no immediate action other than to note that this is the FIRST PERIOD in which our buffer has fallen into the red zone.
  
  We place our standard order to replenish period consumption.
• Period 5: We have another great period for this item. We consume 8.476 units; get our replenishment order for 7,903 units, and end the period for the SECOND PERIOD IN SUCCESSION in the red zone. The buffer reached 29.09 percent.
  
  Other than placing our replenishment order, we take no specific action.
• Period 6: We’re hit with record sales and move 11,666 units. Even after replenishment order arrives, we still are sitting near the bottom of the red zone at 2.41 percent.
  
  Since this is the THIRD SUCCESSIVE PERIOD where we have ended up in the red zone for this buffer, we take action to INCREASE THE BUFFER SIZE BY ONE-THIRD. Our replenishment order is now for the 11,666 units consumed PLUS the buffer increase of 3,985 units.
• Periods 7 and beyond: We will continue to monitor and manage the buffer dynamically applying these simple rules…
• THREE CONSECUTIVE PERIODS IN THE RED ZONE, then INCREASE the BUFFER by ONE-THIRD
• FOUR CONSECUTIVE PERIODS IN THE GREEN ZONE, then DECREASE the BUFFER by ONE-THIRD

As you can see, this is a very SIMPLE, YET EFFECTIVE, way to facilitate stock management. There are some other principles that should be understood—such as the fact that the BUFFER actually contains both the stock in the warehouse and what is in-transit (or, in manufacturing, if a make-item) and is due within one “Safe Replenishment Time” period.

This is so simple!

Most inventory systems could do this with relatively minor tweaks. It is really just managing inventory by “max stock level”—when quantities fall below the maximum stock level, replenish back to the maximum stock level—with some kind of data view (perhaps even using Microsoft Excel™) to display the buffer status with action signals.

Let me know what you think.

[Cross-posted at Kinaxis Supply Chain Community.]

The Dangerous Dichotomy—Part 2

[Continued]

In the preceding article we discussed how—all too frequently—management inadvertently creates a schizophrenic organization by assigning responsibility for increasing revenues to one part of the organization while assigning cost-cutting to another part of the organization. Usually the other part of the organization is everyone else—everyone not assigned to the task of increasing revenues.

What happens in such cases, is that the business is driven to a dichotomy that tends to pull the organization apart.

Of course, this effect of pulling the organization apart is entirely unintentional. Management wants to move the business toward greater profits and profitability. Sales and marketing—those generally commissioned with increasing revenues want the organization to succeed and grow. And, all the others, whose marching orders are to cut costs also really want the company to find success. So they are doing their best to keep costs down.

Nevertheless, seeming unreasonable demands made by sales and marketing are a nearly constant irritation to inventory and production managers. And what appears to be the simple inability of folks in purchasing, production, scheduling, warehouse and shipping to get their house in order so that sales and marketing can achieve their goals of increasing revenues is a cause of very real frustrations.

So, even though everyone in the organization really wants to move the organization toward success, it is clear that no one in it has a view of what it takes to make the whole organization—the whole “system”—move in the desired direction. Those who are instructed to “increase revenues” have no real view or interest in holding the line on costs or operating expenses. But, what is worse, those who have been instruction to “cut costs” generally have no visibility into what it might take to increase revenues. They are not privy to the “levers” that might affect increasing sales. Plus, the various departments involved in “cost cutting” are quite often, themselves, fragmented in their view of what it takes to be effective.

A simple example

Let’s take one simple example relative to supply chain thinking.

Most businesses vastly underestimate their losses from what they too frequently believe is a good thing. When they say, “Folks, we sold out of product X!” they are frequently thinking: “This is great! ‘Sold-out’ means we have lower inventories! It means we sold more than we expected to sell!” or similar thoughts.

But look at the results of out-of-stock conditions in the example above.

First, everyone needs to recognize that the things that “sell-out” are the most popular items. Second, because these are the most popular items, there is no reliable way to know how many more units the firm might have sold if they had had more units in stock. Certainly extrapolating from “average sales” is insufficient.

In our example (above), a product comes in five styles (‘A’ through ‘E’). The firm chose to stock 280 of each of these five styles and the quantities actually sold are found in the “Qty Sold” column.

In our scenario we are supplying what cannot actually be known—that is, the actual market potential (“Mkt Potential”) for each style. In this case, the firm ended up selling-out of two styles (‘C’ and ‘D’), while being overstocked on Styles ‘A’, ‘B’ and ‘E’. Extrapolating from “Average Sales” one might believe that the firm lost $5,400 in revenues. However, when calculated from “market potential” for each style, the actual amount surrendered in lost revenues due to being sold-out calculates to $12,900—more than double the estimated losses from averages.

Of course, this lost-sales number is a guess—since there is no reliable way to know the actual market demand for a sold-out item. But, what is not a guess is that when a business is out-of-stock on a popular item, it is almost certainly also losing sales on other items when customers go elsewhere for the items they are seeking. Plus, every time a customers goes shopping somewhere else, the “out-of-stock” business stands a good chance of losing the customer to another supplier.

Doubtless, reducing out-of-stock occurrences will increase revenues. That will help satisfy the sales and marketing team in our troubling dichotomy above. But, the question remains, can that be done in such a way that will satisfy what should be everyone’s goal: helping the business make more money tomorrow than it is making today?

[To be continued]

The Dangerous Dichotomy - Part 1

Far too many business executives have created an artificial dichotomy within their own organization that is potentially dangerous to their firm's survival and almost certainly destructive of profits. What is that artificial dichotomy, I hear you ask?

The answer is simple: Businesses all too frequently put the responsibility for increasing revenues into the hands of one part of their organization, while putting an entirely different group--usually most of the rest of the organization--in charge of reducing costs.

While, on the surface, this may seem to make sense; it really does not.

Here's why.

The Revenue-Increasing Group
The folks in the organization put in charge of increasing revenues--usually the sales and marketing departments--generally are measured only on the things pertaining to revenues. Because it is not a part of their reward metric, the folks in sales and marketing are, therefore, wont to make decisions that may:

1. Increase the costs of production
2. Drive inventories up
3. Increase operating expenses
4. Reduce output

Now, they don't do these things intentionally. They are just trying to do what they have been mandated to do by management and senior executives.

But, if increases in revenue are stymied or shrunken by, say...

1. Failures to meet delivery-time promises
2. Out-of-stock conditions on finished goods or components
3. Lay-offs or cut-backs in production, warehousing or elsewhere

Then, the revenue-increasing group has an "out" for not performing up to expectations or forecasts. Their excuses are generally based on the performance of the other part of the organization.

The Cost-Cutting Group
The other part of the organization is, as I said, usually all the rest of the organization. These folks have all been instructed and, frequently, are being measured based on "keeping costs down." There interest is in doing everything they can to...

1. Keep the costs of production down
2. Holding inventory levels as low as possible
3. Making sure that operating expenses are minimized

These parts of the organization's management also want the organization to succeed. But they are not being measured based on the organization's (the "system's") success. They are being measure on their performance against budgets for costs and expenses.

The folks working in these other departments have no malice of intent, but when sales and marketing brings a request to engineering or production that is going to increase the costs of production, they are not likely to look too kindly upon the idea. When sales tells these folks that they could sell more if they just had more inventory, they may nod their heads in affirmation, but the are not likely to take affirmative action because they aren't rewarded for that effort. To the contrary, they are more likely to be rewarded for holding inventory levels down and increasing inventory turns.

So, the battle rages
And, of course, the battle does not end there. When cost-cutting fails to make the firm more profitable, this group is just as willing and able to point fingers at the "sales guys," and point out how their frequent interventions, their calls to change production or shipping priorities, and their demands that end-of-period orders "get out the door" prevent serious cost-cutting by...

1. Driving overtime expenses up
2. Increasing requirements for both raw material and finish goods inventories
3. Reducing production by breaking up shop floor production runs with new priorities on a daily basis

 Hence, these two separate factions--who should be working toward a single end--are first formed by management and then each becomes the excuse for the other for non-performance. Meanwhile, the firm as a whole suffers reduced profits, higher operating expenses, and--generally speaking--too much inventory (made even more unbearable by having too little of the things that the customers want when they want them).

To be continued...
If your organization is not presently experiencing this warfare--even if subtle or boiling just beneath the surface of a "mask" of "team work"--then you are a fortunate one and, more likely than not, you know a firm or have worked in a firm where this is or was true.

This internal conflict is evidence of the lack of "system thinking." When executives give different directives to different parts of the organization--in the hope of squeezing some profit out of "local optima," rather than global metrics that encompass the goal of the whole system--the whole organization--this is what one must expect.

There is an answer.

[Continued next post....]

Considering Project Accounting for Increased Profit

Many folks confuse the terms “project management” with “project accounting.” These terms are not synonymous. As might be inferred from their distinctions, project accounting is all about tracking the monies associated with projects. Project management is related to managing project tasks, time and resources.

While there are some software applications that handle both the project accounting (PA) and the project management (PM) aspects, most common applications handle only one side or the other. For example, Microsoft® Project™ is a very commonly used application for project management. It is worthless, however, for anything related to project accounting.

Why aren’t project management and project accounting found in the same application?

In most organizations, the fact that project management recording and project accounting transactions do not occur in the same application typically poses few hurdles to operational effectiveness. The reason for this is simple: typically the personnel intimately involved in managing tasks, time and resources (i.e., the project managers) are not the same folks who are intimately involved with handling the accounting aspects of the project (e.g., calculating, printing and sending the project invoices, making payments to project vendors, or assuring that expense or payroll transactions are processed on time). Therefore, the ability to share data via simple integrations or even via ad hoc queries or reports is quite frequently sufficient.

In fact, not infrequently, organizations actually prefer to have project managers and their activities kept separate from project accounting and its related activities. Doing so functions as a double-check and adds control in itself.

“We don’t do projects?” we hear you saying

You don’t think you’re in a “project”-type industry? Well, maybe you’re right. But consider these possibilities:

• Internal projects – Does your organization do internal projects for which you’d like to track costs accurately, even if you never bill anyone for the services? Do you do advertising campaigns? IT projects? Opening new locations? If so, then it is possible that your business could benefit from the additional controls provided by a project accounting solution.
  
• Engineer-to-Order – If you are a manufacturer in an engineer-to-order (ETO) industry, then project accounting might be applied to track your costs leading up to the manufacturing. Professional services and related costs and expenses can be tracked and managed using project accounting’s capabilities.
  
• Installation or After-Market Service – If your manufacturing or distribution operations extend themselves into the fields of installation, configuration or after-market service, then chances are project accounting is not the right solution for you. In such cases, you should read the section on Service Management.

What can Project Accounting do for you?

There many time-saving functions brought to you through the project accounting capabilities that dramatically reduce the time, energy and effort that would otherwise be required. Here is a sampling:

Profit Recognition

Projects may recognize profit/(loss) in several different ways. Most PA solutions allow users to assign the profit recognition method by project. The typical profit recognition methods include:

1. Manual
2. Cost-to-cost percent
3. Percent of revenues
4. Non-WIP
5. Project completion
6. Percent of elapsed time

“Percent of elapsed time” is a profit-recognition method commonly used with prepaid date-limited service contracts. If this is a common method in your firm, be sure to investigate Service Management solutions as well. In some circumstances, service management may be the more appropriate solution to apply.

Project Billing Methods

Project accounting software typically offers several options for billing and projects may be of different billing types:

1. Time and materials
2. Fixed price
3. Fixed price plus

When a project is designated a “time and materials” billing type, most project accounting systems allow the materials items to be passed through at cost to the customer, or billed with a mark-up add to designated materials and other non-labor charges.

Billing for Employee Time

Businesses that bill their clients for employee time spent on various projects often face the daunting task of keeping the billing correct based on agreements with their various clients. Not infrequently such agreements may involve complexities that would require considerable time and care if attempted without the support of a project accounting system.

For example, clients may negotiate different rates for different specific employees when working their projects. Indeed, they may end up negotiating different rates for the same specific employee on different projects—several of which projects may be underway at any one time with the same client. As you can imagine, assuring that project billings are assigned the right rate for the right resource on a project by project basis could become a difficult task. Project accounting systems handle such billings effectively and simply with little effort.

Add to the potential complexity described above the ability to also bill different rates to different projects or different customers based on the employees’ titles in their assignments to different projects and you can readily see that manually tracking all of the potential combinations could become a nearly impossible task. Here, for example, employee Jim Smith might bear the title “Project Manager” on one project for one client and, as the Project Manager be billed at $225 per hour. However, due to Jim’s lack of experience in another type of project, he may bear the title “Developer” on that project and be billed to the same client (or a different client) at a rate of only $150 per hour.

Increasing throughput and profits

Now, you might say, “I don’t need all that complexity in my projects. We’re content with billing just one rate per project, one rate per client, or one rate per employee across all projects and clients.

Our question in response is this: “Why wouldn’t you want to make more money tomorrow than you are making today if you could do so without adding significantly to your operating expenses by doing so?”

We ask this because this is precisely what a project accounting solution could do for you and your firm.

Chances are your client’s aren’t stupid. They know that a good and effective project manager is more valuable to them than a heads-down programmer or a project secretary or, perhaps, a QA staffer. Right now, you are likely charging the same for each of these, which mean you must be using an “averaged” rate.

By adding project accounting’s flexibility, you are also adding the low-cost option of further segmenting your market and closing more deals. You can charge clients more or less based on how your crack sales team identifies the prospect’s or client’s view of “value.” Two projects that are virtually identical in their execution may have two significantly different values to two distinctly different clients. Consider the following chart:

Project ID	Est. Project Cost	Est. Project Revenues	Est. Project Profit
A	$ 165,000	$ 260,000	$ 95,000
B	$ 165,000	$ 220,000	$ 55,000
C	$ 165,000	$ 200,000	$ 35,000

Here we see virtually identical projects on the “cost” side. However, three different clients perceive the “value” of the efforts differently in their businesses. One is willing to pay $260,000 for the work; another is willing to pay $220,000 for it; and third sees only $200,000 in value and won’t pay a cent more.

If your PA system only allows you to charge these clients one rate—or if you don’t want to burden your accounting department with manually managing different billing rates per client—you may be tempted to turn down Projects ‘B’ and ‘C’.

Why give up the profits?

But, if your firm has the capacity to do projects ‘B’ and ‘C’, and no more profitable project prospects stand in your way, why would you turn down an extra $90,000 ($55,000 plus $35,000) in project profits simply because your accounting system makes it too difficult to manage. (Actually, that is not the reason such profits are all too frequently passed by. Instead, it is because executives and the sales team—hemmed in by preconceptions about their accounting limitations—never think of making these offers. Instead, they offer their ‘bids’ using the firm’s standard costs and markups and end up losing the deals for Projects ‘B’ and ‘C’.)

Leveraging new capabilities for new profits

In short, leveraging the new flexibilities delivered by a project accounting solution may allow your firm to dramatically increase revenues and profits through market segmentation. However, doing so means bringing to your firm new ways of thinking (as seen above) and an understanding how newly delivered capabilities can, in fact, be applied to create new markets or extend existing ones. This means finding the right implementation partner is essential.

It is imperative that you not make the common mistake made by some many executives and managers when considering the purchase and implementation of project accounting software. Typically they spend more than 90 percent of their time and effort in what the process of “software selection,” carefully considering a long list of features and functions. Then, when this is all done, they simply take whatever consulting firm and consultants come along with the software. We believe this is a wrong-headed approach and many firms to make investments in software with little return on their investment.

There are three critical aspects necessary for a project accounting implementation leading to rapid and high return-on-investment:

• The ability to unlock “tribal knowledge”
  
• The ability to reduce complex problems to simple solutions
  
• The ability to help your organization “design” new ways to leverage new capabilities for increasing throughput and profit

If the software reseller cannot bring to your firm these critical elements, perhaps you should look elsewhere.

On Seeking Success

In a recent informal poll I conducted, I asked "Which ERP success is most important to your organization in the long run?" I offered the following options:

1. An ERP project that is on-time and within budget
2. An ERP project that increased throughput (i.e., revenues less truly variable costs)
3. An ERP project that reduces inventories or the need for other investments
4. An ERP project that reduces operating expenses

I was somewhat dismayed when the results were that fully two-thirds of respondents count success in ERP as a project that reduces operating expenses. The only worse answer, in my opinion, would have been "An ERP project that is on-time and within budget."

Here's why I believe that is true.

First, consider that I can dramatically reduce the operating expenses of any business enterprise virtually over night -- saving the organization, perhaps, millions of dollars every year -- and I can guaranty those results. All I have to do close the business. That automatically reduces operating expenses to zero.

If an organization is seeking "success," and they are making progress in that direction. It would seem to me that they would want more and more of whatever it is that they are calling "success." That would just make common sense, would it not?

But executives and managers that pin their "success" hopes on "reducing operating expenses" want only "partial success." Few of them are really endeavoring to reduce operating expenses to the "ultimate prize" of zero dollars.

What is worse is that they constantly face the law of diminishing returns. If they reduced operating expenses last year by five percent, the chances that they can reduce costs this year by another five percent are pretty slim, and even if they do, this year's five percent will still be a smaller actual dollar amount than last year's five percent. And next year will require even more effort for less dollar-savings.

However, for people caught in cost-world thinking, this does not seem foolish. They see no contradiction or futility in these efforts (sadly), ususually because that is all they know or have been taught to think.

On the other end of the spectrum are those one-in-three executives and managers who have discovered that real and enduring success comes from the "throughput" side of the business. If you can increase T (Throughput, which is Revenues less Truly Variable Expenses) this year by five percent -- all else being equal -- then you have made gains. In fact, if operating expenses have not increased, then that five percent increase in T falls directly to the bottom line just like a five percent reduction in operating expenses does.

What is even more exciting is the fact that there is no law of diminishing returns at this end of the enterprise. If you are able to increase T by five percent next year, that five percent will bring more dollars of profit to the bottom line than last year's five percent increase did. And next year's five percent will make an even larger contribution to stakeholders in the business.

Success on this end of the business -- if repeated year after year -- leads to real success, not "closing the business" (as "ultimate success" in reducing operating expenses does).

So, why are not more managers and executives seeking ERP success differently?

Are IT Vendors Driven by the Business Results of Their Customers?

Writing for CIO UK, David Henderson suggests several reasons “Why IT vendors must raise their game”. The second major point he mentions is that “IT vendors tend to be driven by their portfolios rather than business outcomes” for their customers. Henderson points out that IT vendors “continue to make significant investments in their portfolios but aren’t prepared to make the same investment in understanding how these apply to their customers’ businesses,” which can “lead to huge inefficiencies” once implemented at the customers’ sites.

As a result, Henderson continues, “vendors… tend to give poorly defined generic presentations that bear only passing relevance” to the challenges faced by the customer or prospect at hand. Henderson goes on to berate the ERP vendors for “me, too” solutions and their inability to “connect the dots” between their product offering real value for the firm that buys the technology.
I agree that IT vendors need to change. The economic picture is vastly different in 2010 than it was even three years ago.

Where I disagree with Henderson’s writing, however, is who should know what.

Starting off on the wrong foot

Computer-based technologies really were not available to any significant number of SMBs (small-to-mid-sized businesses) until after the introduction of the personal computer (PC) in 1981. Prior to that, computing power available from mainframe and mini-computers was available only to larger firms with significant capital for investment in such technologies.

So, in the early days of the computerization of the SMB market, almost every new prospect was anticipating moving off a system dominated entirely by paper and the necessary manpower to keep the paper flowing. As the price of PC-based technologies fell, more and more companies made the switch. This movement dramatically increased productivity and return on investment (ROI) for such a move was almost a certainty. As a result, many ERP salespeople came in the door talking about increasing productivity and providing rapid ROI for almost every SMB they approached. And, almost without exception, the implementation of that first round of technologies provided consistently rapid payback for the firms.

Unfortunately, as the market changed (i.e., SMBs’ next round of technology purchases were not taking them off paper-based systems but, more frequently, moving them into a comprehensive suite of application modules or moving some SMBs off the high cost of maintenance associated with mainframe and mini-computer systems), the sales approach of most technology vendors did not change. The technology vendors’ salespeople continued to make the same claims about productivity improvements associated with the first round of ERP implementations and the executives and managers at the customers’ sites continued to drink up the claims like Kool-Aid. In many cases, the SMB management was spurred on by the impending arrival of the year 2000 and the Y2K epidemic of fear. Many executives felt they needed to spend the money to upgrade their systems and took little thought as to the ROI of such an expenditure.

Nobody grew up and nothing changed

By the early 2000’s the ERP market had changed yet again. By 2005 or so, almost every CEO or CFO of every SMB had been through at least one – and usually two or three – implementations of new software (or other technologies) in their business environment. Add to that experience the fact that they now had easy access to the Internet by which to explore and make inquiry regarding almost any ERP software on the market, and the ERP-buyer had changed dramatically over a bit more than two decades.

When ERP was starting to be sold (20-plus years earlier), when the technology salesperson first met a prospect, the prospect was hungry for information about products and capabilities. Furthermore, these green-horn technology buyers were more than willing to make the salespeople their de facto “instructors” in the purchase and application of new technologies in their businesses.

In addition, as previously stated, ROI was pretty easy to achieve. Almost any SMB moving off labor-intensive paper-based processes or coming from costly mainframe or mini-computer technologies was bound to reap savings in operating expenses, and was almost equally likely to achieve increases in Throughput. However, by the middle of the first decade of the 21st century, all the easy ROI from traditional ERP – Everything Replacement Projects – was gone and not likely to return. Sadly, much of the technology salespersons’ product positioning remained unchanged and the sales rhetoric and promises from a good many ERP vendors still harkened back to days gone by – without, of course, actually mentioning that fact.

This unwillingness to face the change in the marketplace was not entirely one-sided. As the traditional ERP sales hype continued to make sweeping “rule-of-thumb” claims about delivering ROI for the ERP-buying executives and managers, these executives and managers proved themselves equally willing to accept the claims without taking the time and effort to discover for themselves what they really needed to know about their particular organization and its potential for reaping ROI from any particular foray into new or upgraded technologies.

What every executive and manager needs to know

As Eliyahu Goldratt has put it so well, there are three – and only three – things that every executive and manager needs to know to make effective decisions in every situation. These are they:

1. What needs to change
2. What the change should look like
3. How to effect the change

If, before making the leap to buy technologies based on “rules of thumb” and sales-speak, executives would just take the time to figure out the answers to these three questions, there would be far fewer stories about traditional ERP implementations failing to deliver expected business results.

IT vendors are not necessarily driven by business results for every client. And, as executives and managers, you should be aware that rules-of-thumb may not apply to you and your enterprise – and the ERP vendor or VAR is not responsible for your business’s not fitting the rule-of-thumb by which other enterprises may have achieved return on investment.

As executives and managers in your organization with your particular circumstances and requirements, you – not the technology vendor or reseller – need to know what needs to change in order for your firm to start making more money tomorrow than you are making today. You – not your vendor or reseller – need to know what the change should look like in your particular organization. (The vendor or VAR may help you understand how new technologies may be part of what that change should look like, but you need to understand the precise need in order to effect your desired ROI. (Read more in many articles found right here at GeeWhiz To R.O.I.)

And lastly, as executives and managers it is your responsibility to understand how to effect the change within your enterprise. (Here again, the technology vendor or reseller may help you understand the technology-related components of the change, but you and your team need to take full responsibility for creating a roadmap for change.)

Need help?

Contact me at rcushing(at)GeeWhiz2ROI(dot)com and I can show you a way to unlock your firm’s “tribal knowledge” to discover what needs to change so you can start making more money tomorrow than you are making today, and you won’t spend money needlessly on technologies that don’t bring almost immediate ROI.

©2010 Richard D. Cushing

ERP Vendors and Customers: The Blind Leading the Blind

Writing in CIO UK magazine online, David Henderson’s article entitled “Why IT vendors must raise their game” makes several salient points. Not least among the points raised is the fact that “too many IT vendor sales personnel don’t really understand my underlying business processes and investment criteria….”

For me, however, the issue is somewhat stood on its head. Far too many business enterprises with which I have been involved have precisely the same problem internally. CEOs, CFOs and CIOs in many businesses buy new technologies without understanding their own underlying business processes and by what criteria they should invest.

What executives and managers should know

Executives and managers seeking ways to improve their business enterprises (read: make more money tomorrow than they are making today) too often buy new technologies out of “hope” or “desperation,” rather than with a clear and concise understanding of

1. WHAT needs to change in order for the business to begin making more money tomorrow than it is making today;
   
2. What the change should LOOK LIKE; or
   
3. HOW to effect the change (including what role any new or upgraded technologies might play in delivering the improvement).

Since they do not have the tools to concisely analyze what needs to change in order to make more money tomorrow, then they cannot know what the change should look like or how to bring about the change effectively. So, in the absence of clarity, they grope about in their darkness hoping that some change – any change – will bring them their desired end of higher profits.

Blind leading the blind

Like the blind leading the blind, the technology vendors and resellers who do not fully understand their prospects’ underlying business processes or appropriate criteria for investment (in fact, they understand them less clearly than the executives and managers, in many cases), console the yearning executives with platitudes and “rules of thumb” about how their latest and greatest “gee-whiz” technology will “reduce costs by X percent” and “improve sales by Y percent.”

Of course, this is precisely what the executives want to hear. Like the Sirens of old, the vendors and resellers lead many to spend. Even if they don’t fully believe what they are hearing from the vendors and VARs, the executives and managers frequently do not take time to calculate with any precision just how or why the new technology should, could, or would produce a return on investment (ROI) in their particular organization and circumstances. Instead, they close their eyes and ears to any negative thinking and, In the absence of any better ideas, these executives take out their checkbook to purchase the latest and greatest of new technologies. Of course, the correct general ledger account to which this “investment” should be charged is “Hope and Earnest Expectation.”

Serendipity

Sometimes good things come of this method. According to the industry literature, we can say that about one out of three such “investments” lead to noticeable improvement. Many times, however, the measure of improvement cannot be known with certainty. A growing company that shows improvement after some implementation cannot know which results may have occurred even in the absence of the new technology. A far greater share of SMBs (small-to-mid-sized businesses) simply assume they are “better off” if they are not clearly “worse off” following the deployment of some new technology. Some merely breathe a sigh of relief after some trying implementation period and, like a good Calvinist, say, “I’m glad that’s over,” without ever looking back to measure their return on investment.

My argument, however, is that “hope” and “serendipity” are not strategies and, while a few companies come to excel and even to dominate some markets for a short period of time based on little more than serendipity, it is not a sound strategy for long-term growth in any enterprise. For executives and managers return on investment should be seen as a primary responsibility. This responsibility should not be handed over to the technology vendor or VAR (value-added reseller). Neither should it be left to chance.

As W. Edwards Deming said so clearly: “It is management’s job to know.”

It is management’s job to figure out WHAT needs to change in order to start making more money tomorrow than the firm is making today. It is management’s job to come to a clear understanding as what that change should look like when it occurs. And, it is management’s job to define an unambiguous roadmap to effecting the necessary change. Then, it should be management’s job to measure and report on the return on investment yielded by their own keen insight.

Need help with this? Contact me at rcushing(at)GeeWhiz2ROI(dot)com and let’s talk.

©2010 Richard D. Cushing

5 Things SMB Decision-Makers Aren't Getting Right Yet About ERP

5 Things SMB Decision-Makers Aren't Getting Right Yet About ERP

Despite more than a quarter-century since the arrival of 'ERP' on the scene, far too many executives and managers are still struggling to get things right.

Click the link above to read the article in full.

Business Processes and Real Management – Part 2

1. (continued) In the second scenario, the owner or chief executive is not in charge of the sales team. In fact, the firm has generally hired an experienced “sales manager” based on this persons history and background of producing sales at some other firm in the same or a similar industry. This person has then hand-selected a team of salespeople, the sales manager often doting over them making certain that each is uniquely satisfied with their particular arrangements. This is a variation on the same prima donna theme, but with a layer of middle management.
   
   In both of these cases, however, the general attitude of top management at the firm is that, while they may give lip-service to something they call their “sales process,” when one digs deeper, it becomes abundantly clear that the “sales department” is really surrounding by mystique. Each hand-picked salesperson has his or her own mystical mojo that is performed in a somewhat ritual-like fashion. This mojo, when properly carried out and when not too much interfered with management and administration produces a life-stream of sales to support the rest of the company.
   
   In these situations, the rest of the company’s executives and managers are under the implicit understanding that “I must not mess with the salespersons’ mystical mojo or things will go badly for the whole company.” Frequently, even top executives fear treading too much on the mojo, for fear there will be bad repercussions.
   
   
2. The second matter is that comes to mind is “sales commissions.” On numerous occasions I have asked executives, “How do you calculate and pay commissions?” A simple question?
   
   To this simple question, I am not infrequently given a simple answer: something along the lines of, “We pay commissions based on gross margins.”
   
   Simple enough, don’t you think? Until you begin to dig into the details. Then one starts hearing things like this: “Well, yes, we do pay commissions based on gross margins. But, if our buyers get a special deal on a purchase, we pay commissions on the ‘regular’ gross margins, not the actual gross margins of the sale of those special purchases.” Or, “Yes, we do pay commissions based on gross margins but, because the contract we signed with salesperson X is different from the deal we reached with salespersons Y and Z, the way we calculate ‘gross margins’ is different for each of salespersons X, Y and Z.”
   

So, I hear you ask, “What is the similarity between my daughter’s situation and the two examples I just mentioned?” The similarity is this: In each case the executive in charge called their decision-making a “process” (or, in the academic world, a “rubric”) or suggested that they were managing “a process” (i.e., “the sales process”). However, close inspection revealed that each decision was being made on a case-by-case basis without reliance upon a process or rubric, at all.
Note, my objection is not to the case-by-case decision-making – although I offer that this is likely not a sound approach to managing a growing SMB. Rather, my objection is to the managers’ beliefs that they are actually managing to a “process” or by “a process.”
(To be continued)
©2010 Richard D. Cushing

Business Processes and Real Management – Part 1

I had a conversation with one of my daughters on the way to the airport today. She was telling me about something that went on with regard to management decision-making at her work. (She works in the field of education, but the principle I wish to discuss applies everywhere, in every type of organization.)

The scenario is something like this: An executive (and here I use the term “executive” in the broadest sense, meaning any manager in a position to not only choose, but also to execute upon the decision made) states that he or she is going to make a management decision based upon a process (or, in this academic environment, a rubric – a process for scoring an otherwise subjective decision). However, upon further discovery and discussion, it becomes apparent to all involved that whatever “process” or “rubric” is ostensibly being applied is purely subjective and intuitive to the manager alone. That is to say, what is pretended to reduce an otherwise purely subject and intuitive decision to a “process” – a “rubric” – is merely that, a pretense. The decisions being made remain purely subjective and intuitive and are not correlated to a “process,” at all.

Now, let me be clear. I am a free-market guy. I believe that business owners and their executive agents should be able to hire, fire and make other management decisions at will. I am fully committed to the fact that they may do as they please so long as their actions do not include coercion or deceit. In this scenario, it is not the executives decision with which I take issue – which is why the decision itself is not discussed herein.

What I wish to discuss is how many times executives and managers are themselves deceived as to the presence of a “business process” or any kind of rubric by which they manage. From my experience, if I spent time cogitating, I’m certain that I could come up with a large number of examples. However, for brevity’s sake, let me just toss out a couple.

1. Foremost in my mind are the numerous discussions I have had with executives over the years regarding so-called “sales management.” I say, “so-called,” because I have too many times been faced with one of two variations on the same theme in this regard. The first is where the owner of the small-to-mid-sized business (SMB) was the companies first salesperson (which is quite natural, as the organization was likely an outgrowth of some entrepreneurial venture) and remains today as the firm’s sales manager. He or she has, over the years, created a sales team of hand-selected folks, and the executive is convinced that each of these salespeople is unique and each requires special handling – a sort of prima donna approach.
   

(To be continued)

©2010 Richard D. Cushing

Fractured Planning Processes

In a report entitled Retail Merchandising: Buckling Down in a Tough Economy, authors Paula Rosenbaum and Steve Rowen of Retail Systems Research (RSR) tell us that nearly half (47% on average, but 55% of performing laggards in the survey) of respondents to their survey said that their leading business challenge was “fractured [inventory] planning processes.”

Unfortunately, in the published report to which I have access, Rosenbaum and Rowen do not elaborate on just what the respondents consider to be a “fractured planning process,” although the accompanying prose tends to suggest that this description relates to business processes tied to inventory planning that are not unified or even in good end-to-end communications across the enterprise and beyond.

A common problem

While this survey deals with retailers and inventory specifically, it does highlight a problem in small-to-mid-sized businesses (SMBs) that I have observed for nearly 30 years: that is, the lack of “planning” at all. For sure, most SMBs do develop plans for special projects. If they are going to purchase new or upgraded technologies, build a new or extend existing facilities, open a new location, or add a new product line, then they do prepare and plan in a more or less formal way.

What executives and managers do not do on a regular basis is develop a plan for making more money – both now and in the future. Most executives tend to get their business rolling and then set the “cruise control.” Then, with the vehicle barreling down the road, they spend their time fighting fires and trying to keep up the organization’s momentum with little or no thought about how the terrain (read: business environment) has changed until something big hits (like a recession or big competitor appears on the horizon).

So, what keeps executives from “planning” more frequently and more effectively for business improvement?

My experience suggests the some blend of following key components comprise the answer:

1. Many executives developed a business plan once, and now they have a business. It never occurred to them that planning for “improving” the business is required or would even help. Being entrepreneurs, they tend to manage by the seat of their pants and trust their “gut” for what will bring improvement.
2. You can’t drain the swamp when you’re up to your neck in alligators. Many executives spend the bulk of their time being reactive, rather than proactive. There time is spent taking care of things that others don’t get done or fighting fires so people can return to doing what they need to do to keep the business running.
3. Unless something big is happening, most executives don’t think time spent in “planning” – rather than “doing” – is a good investment.
4. Far too many executives do not know of – or know how to apply – a good “tool” for effective planning. In the absence of a good tool, most executives feel that time spent in planning is not going to be effective anyway.
5. Things are changing too fast. We just need to do the best we can to survive, right now. Of course, in good times, or when things were not “changing too fast,” these same executives used other excuses for not planning.

A POOGI: A Process Of On-Going Improvement

In times like these – challenging economic times – it is more important than ever for executives and managers in companies that hope to survive despite the economic upheaval to make a concerted effort at ongoing improvement. That is, to start a POOGI within their firm.

Why?

Because it is becoming increasingly difficult to compete for the consumers dollars.  If you are not improving your value proposition in a process of on-going improvement, then day-by-day your products and services are losing out. Dollars that used to come your way are now going to other businesses – and I don’t mean just businesses that you see as your competitors. I’m talking about dollars that consumers used to spend for your goods and services are now going, instead, to buy groceries, fuel, or pay off credit cards – anywhere but into your bank account. That’s why you need a plan to increase the value of your offerings in an on-going way.

How to begin

How should you begin a POOGI?

You should begin by figuring out your present situation. You need to unlock your organization’s “tribal knowledge” and understand your current reality. Naturally, the right tool for doing this is called the Current Reality Tree (CRT).

For more information on Current Reality Trees, including step-by-step information on how to begin constructing one, click here. If you would like to have help unlocking your firm’s “tribal knowledge” effectively and in constructing your CRT, then contact me directly.

Next steps

Once your CRT has given you and your management team a clearer view of what needs to change, the next step is to decide what should the change look like. In other words, if you and your team took steps to reduce or eliminate Un-Desirable Effects (UDEs – pronounced: YOU-dee-eez) revealed by your CRT, what would your organizational cause-and-effect flow look like? The Thinking Processes tool used to expose this future state is called the Future Reality Tree (FRT).

Other of the Thinking Processes may also be applied, including:

• Evaporating Cloud
• Prerequisite Tree
• Negative Branch Reservations

However, for your “planning roadmap,” the tool that will you and your team move from where you are today (your CRT) to your planned future state (FRT), you will want to build a Transition Tree (TrT).

Again, if you’d like to have assistance in effectively applying the Thinking Processes and in creating a POOGI in your organization, then feel free to contact me directly. But, whatever you do, do not sit and do nothing and let the recession drive one more enterprise out of business.

©2010 Richard D. Cushing

Collective Fixation on Short-Term Profits

Vivek Sehgal brings up an important point in the post Putting Your Money Where Your Mouth Is (3 March 2010) here at Supply Chain Expert Commnity. Even though, at GeeWhiz To R.O.I. I talk a lot about the the goal of business being to make more money, I generally add ...tomorrow than you are making today. Making more money "tomorrow," should not be predicated on actions that will diminish the long-term prospects for making more money. Nevertheless, a lot of companies -- especially publicly traded companies -- have a fixation on short-term profits that is damaging to the long-term health of the enterprise.

W. Edwards Deming diagnosed this issue early and brought it to our attention about 30 years ago. He called it "paper entrepreneurialism." The investing relationship of real entrepreneurs looks like this:

Entrepreneurs sitting in this relationship have a vested interest in the ability of the firm to produce profits over the long term. Such investor-entrepreneurs seldom intentionally make decisions to reap short-term profits at the expense of the long-term prospects for the business.

Speculative investors have a slightly different relationship with the firm(s) in which they take stock. That relationships looks like this:

The most connected investors are those that hold a relationship similar to that of the real entrepreneurs. They invest in shares directly with the company (or at least have an more intimate relationships with the firm and knowledge of its management, even if they must make their stock acquisitions through a broker). However, most of the investors agreed to buy stock in the specific firms based on the advice of their broker. They may know little or nothing about the firm or the firm's management directly. They trust the advice of their broker.

The intervention of the broker/brokerage house makes buying and selling of stocks easier, and the brokers are typically incented to produce results (return on investment) for their customers (the shareholders) over both the short-term and long-term. The focus of the broker and the guidance given to the investors will vary based on personal preferences. Nevertheless, it is easy to see that the investors are abstracted from their investments by the borkers and management at the publicly held companies must satisfy the short-term expectations of the brokers or, in the interest of their customers, the brokers are likely to shift investment away from companies performing poorly in the short-term in favor of those with better short-term returns on investment.

Paper entrepreneurs are even further abstracted from their holdings as shown in the following diagram:

With the introduction of mutual funds and government-incented retirement plans, more capital has moved into the markets, but at the price of having the investors abstracted from the companies in which their dollars are invested by three or four layers, which layers tend to be focused entirely on short-term performance and profitability. By a huge factor, a majority of the investors in today's capital markets do not even know the names of the companies in which they hold stock. How can they be anything but "paper entrepreneurs"?  They seek the highest return on their investments without any concern for the long-term viability of the companies providing the returns.


Consider that the mutual fund manager. He care not one whit for the companies in which the fund he manages invests beyond the companies' ability to provide solid growth for the mutual fund over the next reporting period. He will gladly shift millions from company A to company B at the hint that company B's short-term return will outstrip company A's performance.

Next in line come the brokers and the brokerage houses. They are willing to recommend mutual fund C over mutual fund D on the basis of their likelihood of producing short-term returns to the investors. The brokers and brokerage houses are incented to provide this kind of advice without consideration for the long-term survivability of the companies which their investments ultimately reside.

Then, of course, for the vast majority of investors, there are the corporate retirement and pension fund managers. They, too, have only one incentive: to see good performance in the funds they manage. They, like the investors themselves, quite often have no knowledge -- ultimately -- about the companies in which their investments ultimately are put to use.

All of this leads to the boards of directors in publicly-held companies providing incentives to their chief executives to provide short-term profitability so as to keep market capitalization up -- which is almost entirely based on stock prices. So, how do CEOs and CFOs react to all of this? They are willing to sacrifice the long-term prospects of their own organization for short-term performance during the particular CEO's or CFO's term in office -- and their successors will do the same.

This constitutes a grave danger to publicly-held companies in the U.S.  What is the answer?

Contact me!

The Right Cost-Cutting Formula

The formula above is the only real formula that should be considered by companies considering cost-cutting during this recession.

Here is what the formula means.

The upper-case Greek letter delta (the triangle-shaped character) is used in mathematics as a symbol meaning “the change” or “difference.” Therefore, we read this formula as follows:

The change in P = the change in T minus the change in OE,

where P = Profit, T = Throughput and OE = Operating Expenses.

Throughput (T) is defined as Revenue (R) less Truly Variable Costs (TVCs), and TVCs are further clarified as only those costs that vary directly with incremental changes in Revenues. For example, raw materials probably vary directly with changes in unit sales of a manufactured item. However, production payrolls do not vary directly with changes in Revenues. If your firm produces 1,000 widgets this week and only 850 next week, but 1,200 last week; chances are the production payroll was substantially the same for each of these weeks.  Therefore, production payroll cannot be classified as a TVC.

Substituting for T

Since T = R – OE, we can substitute into our formula and make it read like this:

The change in P = the change in R minus the change in TVC minus the change in OE

Thinking about cost-cutting

Based on this formula, we can safely state the following:

• An increase in R will result in an increase in P, provided there is no change in TVC or OE
• A decrease in TVC will result in an increase in P, provided there is no change in R or OE
• A decrease in OE will result in an increase in P, provided there is no change in R or TVC

Where executives get into trouble during recessions

Pay attention to the “no change” clauses in the three statement above. These are critical, but all too frequently overlooked by executives and managers in making cost-cutting decisions. We just saw a terrific example of this with Toyota.

Some executives at Toyota thought that they could increase P (profits) by reducing TVCs through the purchase of lower-priced components for their automobiles. For a while, it probably worked. However, in February 2010, Toyota’s year-over-year sales for the month were down 43%, and for the first time in several decades, Ford Motor Company sold more units than Toyota in a calendar month. This is not to mention the fact that some billions of dollars will be expensed by Toyota over the coming months and years due to the recall.

So, what were the affects of Toyota management’s decision to reduce TVCs in order to increase Profits?

1. Revenues down 43% year-over-year
2. Several billion dollars added to Operating Expenses (OE) due to recall effort
3. Lost customers, which will require additional expenditures in OE (marketing) to reclaim
4. Additional expenditures in OE (public relations, legal, etc.) for damage control

Think it through

It is a simple thing for executives in a firm facing recessionary pressures think, “We will cut our operating expenses (OE) by laying off some people,” without considering the long-term affects that the move may have on customer satisfaction, for example. How many customers will be lost due to the cut-back in staffing? How much more will need to be spent in OE (sales and marketing, for example) to maintain the same levels of revenue as a result?

Use the formula

If, as an executive, you are considering cost-cutting, then consider the whole formula. Go over it with your management team. Carefully consider any short-term and long-term impact on Revenues and Operating Expenses. Do not simply assume that you can change one factor and the others will remain unchanged.

Contact me!

©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