Persuasion,
decision, commitment - The cost justification process
Problems
with current cost justification methods
Innovation and change can be resisted,
or unjustly decided against, for several reasons:
- Traditional cost justification methods are frequently
inadequate.
- The benefits and costs of many innovation and changes
require data for their estimation that are not available from conventional cost accounting
methods.
- Some employees have been ambivalent or hostile to certain
innovations (e.g., new technology) because they see it as a threat to their jobs.
- Certain innovations (e.g., new technology) need to be
integrated if their benefits are to be fully realised. This interconnectedness makes for
greater complexity and difficulty in planning.
So the story goes:
A manufacturing firm implemented an $18 million dollar
flexible manufacturing system that resulted in the reduction of the number of machines on
the shop-floor from 68 to 18, in the number of employees from 215 to 12, in floor space
needed for production from 10,300 sq. mt. to 3,000 sq. mt., in average processing time
from 35 days to 1.5 days. After two years, however, calculated total savings from the new
technology came to only $6.9M, $3.9M of which came from a one-time cut in inventory. Even
if the system continued to produce annual labour savings of $1.5M for the next 20 years,
the project's return rate would be less than 10% per year, well below the hurdle rate of
15% with a pay-back period of less than five years frequently used. These justification
methods obviously are missing the enormous savings in floor space, inventory, throughput
times, and number of employees, as well as the potentially huge competitive advantages
that were afforded by the new technology.
These outmoded cost accounting methods can lead to an
under-investment in many innovations and new technology. Although traditional methods of
cost justification have been rejected by many firms as being inadequate for dealing with
the costs and benefits of new computer-based technologies, more appropriate methods are
still under development and cannot be discussed here in any detail. However, we can
discuss several of the ways in which newer approaches differ from more traditional
methods:
- Quality, productivity, and profitability.
Technologies are considered for their effects on business outcomes such as quality,
productivity, and profitability broadly defined, rather than simple return on investment.
Newer methods consider the relationships between cost structure and volume requirements
(i.e., providing an established product(s) at a reduced price or an enhanced product at
current price could necessitate increases in capacity). Product mix opportunities are also
considered (e.g., ability to widen product range), as are the consequences for materials,
indirect labour, and overhead expenses.
- Technology as part of a system. Technologies are
considered as part of a system rather than in isolation. The adoption of a system of
integrated PCs is not the same as buying everyone a new electronic typewriter. In
manufacturing, workload and product mix are not considered as pre-specified because
estimates are not always accurate, equipment does not usually perform to specification,
and there is a difference between the performance of stand-alone and integrated
technology. In the banking industry, linking tellers with each other and with other
functions in a networked system, drastically alters the way these individuals, and the
banks in general, do business. Therefore, it is necessary for their cost accounting
systems to reflect these changes.
- Change is necessary. New methods do not treat the
status quo as an economically viable alternative. Regardless of industry, many companies
no longer have the luxury of staying the same. If a firm does not apply the best available
technology, someone else will in order to get into the market or to improve their existing
market share. As Henry Ford once claimed "If you need a new machine and don't buy it,
you pay for it without getting it." The correct alternative to new technology
investment should assume a situation of declining cash flows, market share, and profit
margins.
- Longer-term. New methods tend to emphasise longer
planning horizons. Older methods assumed current technology will have basically the same
value in the future, and that it will not be superseded by other technology. Long horizons
include expenditures across first cost, installation, operation, maintenance, training,
retro-fit, and retirement. Greater flexibility may allow technology a longer useful life
across generations of products or services. Also, some firms need to begin to plan for
technological obsolescence and replacement every few years. They must include these
assumptions in their start-up cost calculations, for example.
- Broad range of opportunity. New methods consider a
broad range of technological opportunities, both in terms of substitute and complementary
technologies. For substitute technologies, new methods should consider alternatives to
best-practice. The most fully automated system may not always best suit a firm's strategic
business objectives. For complementary technologies, methods should consider retro-fit
opportunities and potential leverage of introducing new technology at other locations.
Having once implemented a new technology, a firm will have gained considerable knowledge
and capability that can be brought to bear elsewhere.
- Unique characteristics. Traditional methods rarely
distinguish between products and services that compete on the basis of cost and those that
compete on the basis of unique characteristics valued by purchasers. It is in the
production and delivery of these latter types of products and services that we find the
greatest advantages of new technologies. Older methods of accounting which stress
efficiency, stability, and productivity do not reward managers since this type of
production system is best assessed on up-time, quality, and delivery.
- Human resource development. Traditional methods are
unable to measure the costs or account for the benefits of the skills, training,
education, attitudes, absenteeism, turnover, and moral of the workforce. These costs, or
benefits, must be accounted for and considered. If employees do not share a company's
goals, the company cannot survive as a first-rate competitor. If employees do not want the
new technology, it will not work.
In short, costs frequently are visible and relatively
easily translatable to financial measures. Whereas benefits are lead time away, extend
beyond our understanding and enable new horizons. Dealing only with concrete, knowable,
benefits denies the notions of innovation, diffusion and vitality.
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Holistic Management Pty. Ltd.