Last week I posted a column on cost accounting. But I didn’t say it was about cost accounting, and nearly eight hundred people read it. Let’s try a (ahem) “scientific” experiment, starting with this announcement: This column is about cost accounting too. I’ll share the readership numbers with you next week!
Among the first things we teach students of business operations are the cherished principles of incremental cost (cost resulting from an action taken, minus costs that would have resulted had the action not been taken), opportunity cost (cost relative to the next best alternative), and sunk cost (past, irrecoverable, and hence irrelevant costs). This is as it should be, because these are among the few rational criteria for making decisions. We serve our students badly, though, by failing to discuss the organizational dynamics of the three cost types.
Consider the venerable liberal arts college that created a new business school. The overhead items – library, registrar, classrooms and offices – were already in place or substantially so. No additional central administration personnel had to be added at first, only faculty and staff for the new school. The cost of these positions, plus the modest marketing budget, were more than offset by the new b-school’s tuition income in the second year of operation. There was every indication that enrollment, and tuition, would grow. What could be more desirable?
Shortly after the school’s creation, the college’s provost decided it would be a good idea to embark on a cost-allocation exercise. Provost and CFO decided on a “fair” formula that allocated central administration overhead according to each school’s use of office, classroom, and laboratory square footage. Suddenly, the business school, still ramping up its enrollment, didn’t look so good. It more than covered its incremental cost, but barely paid back its allocated cost in the current year. Its newly hired dean had been promised the full attention of the college’s fundraising office. After all, the b-school’s revenue was “free” in terms of incremental cost, and who wouldn’t want more of that? After the cost-allocation project, however, the college’s president decided one of its older, better-established schools deserved a higher fundraising priority.
The business school had been launched on an incremental-cost logic, and operated under an allocated-cost logic. As a result, it never reached its full potential. The dean resigned.
Now let’s peek through the window of a company that was stagnating, its stock price growing too slowly to excite Wall Street. All its units were profitable, but the CEO decided to jettison the least successful unit and refocus the firm’s energies on the remaining “core.” General and administrative (G&A) costs were mostly Human Resources, corporate marketing, and other activities that enabled the firm – that enable any firm, really – to engage in business; these were not activities that specifically supported the profit centers. Thus, little G&A cost went away as a result of the divestiture.
The remaining business units’ performance, burdened by an increased allocation of G&A, was further depressed. The next lowest-profit unit was shut down, a move that made sense to the CEO on an incremental cost basis, and.… You can see where this company was going. Like the storied frog in the slowly heating pan of water, it incremented itself right out of (a profitable) business.
This company called its G&A “fixed costs,” and the units’ profits “contribution to fixed costs.” This created a mentality that assumed G&A costs could not be reduced (and created an implicit disadvantage vis a vis the firm’s Japanese competitor; the usefully negative Japanese term for “fixed costs” translates as “costs that do not vary with level of production”). Was there unproductive deadwood in the corporate office? There was, but not enough to sink the company, and not enough even to comprise the biggest part of the company’s problem.
No, again the problem was a decision made on incremental-cost logic, with its consequences suffered in an allocated-cost world. This company could have been saved by a radically different strategy, for example, raising capital for a spin-out IPO of a profitable division. Alternatively, hiring a more competent (though expensive) central executive team might have enabled an economic centralization of functions now executed in diverse units.
Another firm (and you might recognize aspects of GM-Saturn or the IBM PC in this illustration) started a new business unit as a skunkworks. Located away from the firm’s other operations, its startup budget carried on the books without allocated burden, the skunkworks was allowed to stand or fall on its own incremental feet. This company’s problems began when the skunkworks succeeded. It couldn’t stay a skunkworks forever; its technology would be a new part of all the firm’s future products. It had developed enough business momentum to carry its share of allocated costs. It had also grown a different culture and generated jealousies among executives in the established divisions of the firm. Re-integration of the skunkworks employees and their operation could shake the whole company apart.
What are the lessons for teaching Operations Management and Operations Research (“OR”)?
o We must be frank that most OR methods are for the exceptions, and accounting methods are for the norm. Solving the OR problem is not the end of the process. OR-oriented managers must be able to see the process through to a conclusion in an implemented environment. This is not just “change management.” Accounting is valuable because its methods almost never change, enabling it to give consistent, if not always really accurate, longitudinal information to the financial markets. OR must find ways to make a positive difference even in largely unchanging environments (though these are rarer nowadays).
o Conversely we must teach how, when markets are turbulent and technologies shift – that is, when almost everything is an exception – OR can assert itself as the firm’s pre-eminent adder of value.
o We should co-teach with organizational development faculty, when they can help convey that different organizational forms (e.g., skunkworks) comprise the decision alternatives in an OR problem, and what the consequences of these forms can be.
o We must teach the interface between OR and strategy. What do we do when we are optimizing ourselves right out of business? When should the frog swim around in the pan, and when should it jump out of the pan?
o Though we are mathematicians, we must be sensitive to the nuances of ordinary language. Phrases like “fixed costs” or “economic externalities” are loaded with unwanted connotation. They should be used sparingly, or better, replaced.
o We must convey to students that OR people contribute by seeing things, like opportunity cost and sunk cost, that accountants don’t see. Let’s use class time to show students how to see such things.
Cases in point of the latter: Companies’ efforts to “fully utilize capacity” can fly in the face of the sunk cost principle. Owned factory capacity (for example) is already paid for; that money is gone, whether the factory is used or not. Capacity utilization is not the right question! The right questions are future-oriented: whether the factory should be sold, or whether a new product will be most effectively manufactured in the factory or elsewhere. Who would worry about whether the factory is “utilized”? Only a manager who is preoccupied with avoiding blame for having bought that useless factory in the first place.
The dean of a graduate school, whose enrollment was shrinking, decided to cut back on adjunct faculty and increase the teaching workload of the core faculty, to “better utilize capacity.” She thought this would make her look good at the next Provost’s Council meeting. The results:
· Core faculty were assigned courses in subjects they knew nothing about. Students noticed. Enrollments declined further.
· Core faculty were prevented from engaging in the research and community involvement that could have raised the profile of the university and, with luck, stemmed or reversed the enrollment decline.
· A new load of x courses for y professors meant xy courses had to be offered in the semester course bulletin. There were not enough students to fill this number of courses. Many courses didn’t “make,” and were cancelled during the first week of classes. Students were irritated. Faculty were frustrated. Morale declined and the school gained a reputation for being disorganized.
· The specialized expertise of adjunct faculty, so valuable to the students, was no longer available.
The dean did not understand that core faculty are sunk costs – and that adjunct faculty for elective courses are free, both in incremental cost and allocated cost. With no benefits and a small, shared office, overhead cost for adjuncts is negligible. If a course “makes,” it more than covers the incremental cost of the adjunct; if the course doesn’t make, it is cancelled (zero cost) or converted to supervised independent study (small cost, but still profitable).
Another case: A colleague of mine left a string of imploded organizations behind him. Was he a destructive influence? On the contrary, his former co-workers invariably described him as the “glue” in each of these firms; he had held fundamentally unstable organizations together, imparting a sense of common purpose that enabled those around him to be productive, even when he was not personally producing revenue. By not making a direct financial contribution, he was easily marginalized in each organization. Six months after his departure, however, the opportunity cost of his absence would be obvious, as morale and revenues plunged.
My colleague’s contributions to his employers’ social cohesion were not visible on accounting statements. (Indeed, he didn’t even know how he did it. He was a “leader” without a leadership title.) I dream of an OR that can, perhaps by leveraging social network theory, devise a principle that will recognize real contributions like his, make them visible, measure them, and prevent avoidable organizational meltdowns.