Dr. Eliyahu Goldratt's 1984 book "The Goal" is one of my favorites of all time. Entertaining, witty, and relatable, the book is a novel that follows a plant manager as he turns his plant around under the guidance of Goldratt's literary reincarnation. Superficially, it was a manufacturing book, but at a deeper level, it revealed our collective inability to measure the right things.

Goldratt took aim at many things throughout his long career. Cost accounting, just-in-case inventories, misinformed notions of efficiency, and so many more. My favorite was the attack on "product cost". Traditional managers are taught to measure contribution margin for each product, subtracting the cost of goods sold from the sale price. All variable costs for the product such as raw material, labor, burden, and rework are factored in. This seems like a comprehensive and holistic approach on the surface.

The problem with this rudimentary logic is that it doesn't account for excess capacity of the operation. Based on my moderately deep research on the subject, modern plants often have excess capacity along at least some of their fabrication and assembly routings. When this happens, orders for any product at a sale price greater than its raw material cost are profitable. Accounting for labor, burden, and other non-material costs associated with these specific orders is completely nonsensical. The people and machines are already available and no new investments are needed to produce.

This logic also holds true for service delivery. The cost to write a report when the firm has excess capacity is limited to the cost of the materials consumed. This might include paper, printer ink, and postage. Possibly not even that in the digital age. Labor cost, in this instance, is just "funny money" and managers who don't know how to sell their excess capacity are missing opportunities to profit.

I'm not saying that contribution margin analyses are worthless. Don't perform them in a vacuum; your capacity (and the market) should govern your measurements, not century-old cost accounting maxims.

Subscribe by adding "www.njrusmc.net" to your RSS/Atom reader!

All Blogs -- Main Page