made it the basis for strategy and management. The authors believe these leaders would be astonished at how off the mark modern companies are when it comes to flow; they are surviving in spite of themselves.
Thus, Plossl’s Law, while incredibly simple, should not be taken lightly. This one little statement has always defined the way to drive shareholder equity and it was articulated by one of the main architects of conventional planning systems! Embracing flow is the key, not to just surviving but adapting, taking a leadership position or being a fierce and dangerous competitor. It is the first step to becoming a Demand Driven Adaptive Enterprise. In order for that first step to be taken, however, a huge obstacle must be overcome: the universal fixation, emphasis, and obsession over cost.
Cost and Flow
Executives of corporations around the world obsess over cost performance, most particularly unit cost. It dominates discussions on a daily basis and constantly influences a majority of strategic, tactical, and operational decisions throughout the organization. We need to understand what unit cost is (and is not) and why it became so prominent.
Any unitized cost calculation has always been based on past activity within a certain period. The calculation of standard unit cost attempts to assign a cost to an individual product and/or resource based on volume and rate over a particular time period. Essentially, fixed and variable expenses within a period are accumulated and divided by volume within that period to produce a cost per unit. This cost per unit can also be calculated by resource and location. This cost then becomes a foundation for many metrics and decisions at the operational, tactical, and strategic levels in the present and for the future.
Where did unit cost come from? In short, unit cost can trace its origin from the 1934 adoption of Generally Accepted Accounting Principles (GAAP) by the United States government as an answer to the U.S. stock market crash of 1929. Many industrialized countries have since followed this example. GAAP is an imposed requirement for the fair and consistent presentation of financial statements to external users (typically shareholders, regulatory agencies, and tax collection entities). GAAP reporting and the unitized cost calculations based on it was then incorporated into information systems circa 1980 with the advent of manufacturing resources planning (MRP II), the pre-cursor to enterprise resource planning (ERP). That incorporation continues today in every major ERP system.
Why was GAAP incorporated into information systems? It was not driven by the need to manage cost today, or to make management decisions or develop strategy in the future; it was driven by the need to fulfill the financial reporting requirements of GAAP in a much easier and quicker fashion. Even today most ERP implementations begin with the financial module. In the United States the Sarbanes-Oxley act of 2002 drove ERP software companies to provide technology that allowed even faster financial reporting using these rules.
GAAP, however, does not and should not care about providing internal management reporting. Why? Because GAAP’s entire purpose is to provide a consistent reporting picture about what happened over a past period, not what should be done today or suggestions or predictions for the future. GAAP is simply a forensic snapshot of past performance within a certain defined time period, meaning that if it is done as required by the law, it is always 100 percent accurate in determining past cost performance information only.
The incorporation of these cost data quickly led to its numbers and equations becoming the default way to judge performance and make future decisions. Why? The higher-level metrics like return on investment, contribution margin, working capital, etc. are much too remote to drive through the organization. Management needed something to drive down through the organization to measure performance. Cost numbers were readily available and constantly updated in the system.
Now, unfortunately, most of management actually believes or accepts that these numbers are a true representation of cash or potential. The assigned standard fixed cost rate, coupled with the failure to understand the basic aspects of a complex system leads managers to believe that every resource minute saved anywhere is computed as a dollar cost savings to the company. GAAP unit costs are used to estimate both cost improvement opportunities and cost savings for batching decisions, improvement initiatives and capital acquisition justifications. In reality the “cost” being saved has no relationship to cash expended or generated and will not result in an ROI gain of the magnitude expected. Cost savings are being grossly overstated.11
In 2018 a joint study released by APICS and the Institute of Management Accountants named three significant issues regarding costing information that supply chain professionals receive from costing systems.
It is the job of management accounting, which is a different profession with an entirely different body of knowledge than financial cost accounting, to provide meaningful and relevant information for decision making. While the body of knowledge still exists there are few with real deep expertise in it. What happened to all the management accountants? They were essentially stripped out of mid-management in the 1980s because they were deemed largely irrelevant because executives believed that the system could now effectively tell the organization what to do via the automated cost data.
Two important points must be made about cost at this point. First, any measurement based on past activity is guaranteed to be wrong in the future. Assuming that past cost performance will be indicative of future cost performance in the VUCA environment is simply nonsensical.
Second and most importantly, good flow control actually yields the best cost control. If things flow well within a period, the previously described benefits of flow occur during that period. If those previously described benefits happen, then fixed (depending on the length of the period) and variable expenses are effectively controlled in combination with better volume performance. This will be reflected in the GAAP statements produced for that entire past period. Thus, emphasizing flow will actually be more effective even for cost accountants!
This leads us to an interesting yet simple rule about cost and flow, a corollary to Plossl’s Law:
When a business focuses on flow performance, better cost performance will follow. The opposite, however, is not the case.
It should be noted that embracing a flow-based focus is not license or a strategy to overspend on massive amounts of capacity, constantly employ overtime, and expedite everything. That is not a flow-based focus. Those tactics become necessary mainly because a company is not primarily focused on flow.
In Chapter 2 we will dive into this corollary in more depth. At this point, however, the conclusion should be relatively solid: if a business wants to manage cost performance it must first and foremost design and manage to flow performance. The mistake to use GAAP-generated cost numbers and metrics as operational tools is actually a self-imposed limitation by an organization’s management. But what can we use
