What Is Explicit Cost Dynamics?
June 2002 (SmartPros) Is it cheaper to make 15 units than five assuming that the same amount of labor is used in each case? Do you believe that efficiency and productivity increases lead to lower costs?
If you believe that it is cheaper to produce more or that productivity leads to reduced costs, you have been fooled by your cost management system. If labor remains the same, yet more materials are required to make 15 units than it takes to make 5, how can it be cheaper to make more? If a worker is more efficient, yet the salary paid to the worker is the same, how have costs gone down? Traditional accounting approaches such as ABC get this problem wrong, but Explicit Cost Dynamics gets it right, according to Dr. Reginald Tomas Yu-Lee, author of Explicit Cost Dynamics and Essentials of Capacity Management.
Explicit Cost Dynamics (ECD) is a cost management tool that focuses on ensuring that managers understand the impact of their decisions and actions on the bottom line and on their cash flow. To do so requires techniques that are in complete alignment with the bottom line and with how organizations generate cash. ECD ensures this alignment by not allocating costs to products and services and by mathematically modeling how revenues and costs are incurred.
What Is Different About Explicit Cost Dynamics
The difference between ECD and other approaches is that ECD completely avoids cost allocation. Cost allocation results in ratios such as costs ÷ units. Such ratios, however, create problems. These ratios have cost dynamics that are often the opposite of the bottom line cost dynamics. Managing the costs ÷ unit ratio allows one to believe that the more that is done, the less it costs. With a fixed numerator such as overhead, for instance, making more units causes the cost per unit to go down. This is totally the opposite of what the bottom line sees. The bottom line sees increases, as the overhead remains the same and more materials are consumed when making more units. The numerator is often the value tied to the bottom line, however, managers often try to manage costs by manipulating the denominator. If managers are making decisions using the ratio, and if the ratio is the opposite of the bottom line cost dynamics, what does this say about the chances for long term predictability and success?
Rather than allocate costs, ECD understands how costs are incurred. ECD defines costs as resources (capacity), actions, and items. ECD describes the cost dynamics of each as they appear on the bottom line, and allows managers to see the impact of decisions on the bottom line. If, for instance, more products are manufactured, ECD predicts the bottom line cost impact more completely and effectively than any other cost management technique that exists. ECD predicts a cost increase in this case and also reminds the manager that unless the units are sold, profitability and cash flow have been reduced by X and Y respectively.
What Is the Value of Explicit Cost Dynamics to You?
You will make better operational and financial decisions using ECD. ECD allows you to see the bottom line much more clearly, which will improve your decision making ability significantly, and keep you from falling prey to opportunities that overstate their benefits, sometimes by as much as 10X or 100X dollars. When implementing information technology solutions, for instance, where, exactly, will bottom line benefits come from? Implementing CRM without changing the level of capacity, the number of cost incurring actions, or the amount of materials purchased for specific situations will create no positive financial benefit. Increasing productivity has no direct impact on the bottom line. It increases the capacity to do value adding work. This leads to options for managers to decide what to do with the improvement. Should you focus on gaining more output? Should you focus on reducing the input by reducing the amount of capacity? There is also the option to do nothing.
In any case, ECD positions you to improve your ability to make decisions that have a direct bottom line impact. If you make decisions with any other tool, you might be making decisions that have the opposite effect as that which you ultimately desire.
Reginald Tomas Yu-Lee, Ph.D. is the president of The Yu-Lee Company, specializing in strategy, profit maximization, information systems, and operations management. Dr. Yu-Lee is the author of two books, Explicit Cost Dynamics and Essentials of Capacity Management, which was named one of the top books for 2002 by the Institute of Industrial Engineers. He can be reached directly at email@example.com. For information about The Yu-Lee Company, please visit www.yu-leeco.com2002 John Wiley & Sons. Republished with permission.