Part III: "You are a totally worthless, soon-to-be-eliminated-thus-no-longer-non-variable cost."

(excerpted from The Pipeline)

“So – what do we mean by the term “productivity”?”, asked the intrepid, results-based consultant. “How do you increase productivity? What does it mean to become more productive?”

Do you always ask the same question differently?”, asked the CEO. “Or – do you just ask different questions the same way?”

“The question was about productivity”, she said, ignoring the interruption. “Any thoughts?”

“Well, if adding production capacity is a “more-for-more” proposition, I suppose improving productivity would be a “more-for-less” proposition”, said the second superintendent. “Or, at least, a “more-for-the-same” proposition.”

“Not bad”, she said. “So – what does this “more-for-less” idea look like? How do you measure productivity?”

Turning to the CEO, she smiled and said, “Don’t wear yourself out.”

The CEO smiled and replied, “Productivity is the relationship between what is produced and what has to be consumed in order to produce it.”

“That’s right”, she said, continuing the list.

MEASURES OF PRODUCTIVITY

“From any managerial standpoint – operations, manufacturing, production, or otherwise; from any industry standpoint – auto manufacturing, homebuilding, or any other industry; from any enterprise standpoint – Toyota, RB Builders, or anyone else; from any expert or business leader standpoint – Peter Drucker to Eli Goldratt to Taiichi Ohno, the conventional, accepted formula for calculating Productivity is Revenue divided by Operating Expense.”

She moved back to the erasable board at the front of the conference room, selected the blue erasable marker, and wrote:

PRODUCTIVITY = REVENUE/OPERATING EXPENSE
PRODUCTIVITY = OUTPUT/INPUT

“Less commonly, you will also find productivity expressed as the ratio between the “input” and the “output” of a process”, she said. “Either one will do, but the first formula fits best with the correct understanding of what it means to “make money”. We will talk about that later.”

She continued, “Under either formula, productivity is about what is produced and what is consumed. The “what is produced” part is pretty clear; we understand what is meant by “output”. What about “input”? What is it that is consumed? Is it an asset, or is it a resource?”

“Assets are converted or transformed. Resources are consumed”, said the CFO. “Inputs are expenses, just like the first formula.”

“That’s right”, said the intrepid, results-based consultant. “It is an expense. But – what type of expense is it? Is input a fixed cost – like Operating Expense or overhead – or, is it a variable cost?”

Turning, she wrote:

VARIABLE COSTING

“Earlier, you used the terms “direct, variable cost” and “indirect, non-variable cost” to describe cost behavior”, the CFO said. “I could quibble that direct/indirect and variable/non-variable refer to different characteristics dealing with objects and behavior. But – I agree – that ties with the idea that consumption of a resource would make input an indirect, non-variable cost, as opposed to direct, variable costs, which are really more like contra-assets associated with our work-in-process. In fact, those direct, variable costs don’t even become expenses until after we close the job out.

“Like a lot of other homebuilding companies, RB Builders has not clearly separated those costs, but there are clear advantages to variable costing.”

“I agree”, said the CEO.

“What about us?”, asked the second superintendent. “The argument can be made that the cost of a superintendent is a direct cost, but clearly not a variable cost. The same could be said about construction interest, albeit for different reasons. So – what am I?”

“You are an incredibly valuable resource that happens to be a non-variable cost”, said the CFO. “But – you”, he said, looking at the first superintendent and grinning. “You are a totally worthless, soon-to-be-eliminated-thus-no-longer-non-variable cost.”

“I agree”, said the CEO.

The intrepid, results-based consultant put the erasable marker down, and waited until the laughter died down and she again had everyone’s attention.

“We have talked – briefly, at different times – about how costs are classified”, she said. “We mentioned it in the discussion about the cost of the pipeline. It is part of managerial accounting, more a part of the business principles and disciplines you will be learning than the production principles and disciplines you have been learning.

“We will address it further, down the road, because it does impact so many areas of management. For now, it will be enough for you to just remember this: In order to understand productivity and production capacity, you must understand how costs behave, and how you manage those costs on the basis of that behavior.

“Control your direct costs, because they vary in accordance with Revenue. Leverage your indirect costs, because they are more-or-less fixed, and you incur them regardless of how well you utilize those resources.”