In Chapter 7, we talked about the differences between input, or static capacity, and output or dynamic capacity. One of the key differences is that you buy input, not output capacity. When you hire a manager, you are buying her time, not her decisions. This gives you access to her decisions, but you are not paying her on a decision-by-decision basis. Of course, when you buy input capacity, you must pay for it, creating the tie between input capacity and cash. Given the notion that most companies are fundamentally capacity based, it should follow that most of what the company pays for is capacity. If that is true, then the largest influence of cash, specifically cashOUT, is capacity. That makes understanding the relationship between capacity and cash dynamics and what levers you have to manage them critical. To reach the goal and to make money for the firm, you will have to get your arms around the cash dynamics of capacity. When you understand the dynamics, you will make decisions knowing, in foresight and more precisely, what the impact will be on cash. You will not be bamboozled by huge value propositions that have no basis in cash.
To create this understanding, I’d like to take you through the three key points to understand about the cash dynamics of capacity.
Point 1: Buying Input
As mentioned last chapter, when we buy input capacity, there is an exchange of cash for capacity. For instance, we exchange $60,000 salary for one year of work. This purchase and the terms set the stage for cashOUT.
One challenge to managing input is keeping it and the cash dynamics in the OC Domain. Capacity and the related cash dynamics belong in the OC Domain where they are created and are unperturbed by the subjectivity and arbitrary actions that are a part of the transformation into the Accounting Domain. Once the data are transformed into the Accounting Domain, you will lose insight into the cash and operational dynamics of capacity. As mentioned previously, when you consider a product cost, you have no idea, when looking at the cost, how much capacity you bought as a firm, or what you paid for it, which are critical to know from a cash perspective.
Point 2: Are Capacity Costs Fixed or Variable?
One key attribute, perhaps the most important one, is the notion that capacity costs do not change with use. Consider leased space. The $20,000 you pay for 5,000 ft2 of space does not change with how you use it or how much of it you consume. The same holds true for all other types of capacity. For instance, consider labor where a person is paid by the hour. If you agree to pay her $30 for an hour of work, that amount does not change with what she does in that hour. Whether the job entails making widgets, cleaning floors, processing invoices, hiring new employees or making executive decisions, what you pay her does not change with her level of consumption or output.
Let’s recap. I mentioned a laborer’s cash costs do not change with output. They are fixed with respect to output. I expanded this to all forms of capacity. If you agree with me on this, then we have a problem. In the Accounting Domain, direct materials and direct labor are considered variable costs. A variable cost, by definition in the accounting world, is a cost that varies with output. Long distance calls are variable cash costs. The cost of the call changes directly with minutes, and the more we speak, the more it costs. However, capacity is like the local call, not long distance. It doesn’t matter how many calls we make or how long they are, the costC cost is still $25.
This creates a major disagreement between cash and the OC Domain data and cost information in the Accounting Domain. Accounting says these costs vary and cash say they do not. This is an issue that companies, which deal with fixed and variable costs, must understand. The costs that vary are costNC, so while the cost may change in the Accounting Domain, the cash cost in the OC Domain is unaffected.
Capacity costs do vary, however, just not with output, which is the next point.
Point 3: Capacity Costs Only Change with Price or the Amount of Input Capacity Purchased
One thing I regularly hear from cost accounting advocates is that all costs vary. Well, yes, they do. Both costC and costNC vary. The question is, what do they vary with respect to? In the Accounting Domain, direct labor and material costs vary with output. In the OC Domain, they don’t. Why is that?
With capacity, you are not buying output, you’re buying input. As such, the amount you pay, costC is a function of how much input you buy and what you pay for it. For instance, if you buy eight hours of labor at $30 per hour, you spend $240. This is more, of course, than if you buy eight hours of labor at $25 per hour. Likewise, buying six hours at $30 is cheaper than buying eight hours at $25 per hour. Hence, capacity costs do vary, but not for the reasons accounting variable costs vary. When you buy more capacity the cashOUT increases, which is an increased cash cost to your firm. When you buy less or cheaper capacity, cashOUT decreases.
There are several key business implications of this when considering the cash dynamics of capacity.
1. All cash and capacity data are native to the OC Domain.
2. Increasing efficiency will not directly improve cash costs.
3. Isocash curve shifts are tied to how much capacity you are buying or the price you pay (Exhibits A-D in Chapter 3).
4. The only way to reduce costC from a capacity perspective is to buy less of it, buy cheaper, or both.
Native Data
As mentioned earlier, all capacity and cash data as they relate to cashIN and cashOUT, and the respective analyses belong in the OC Domain. Of course, cash data will be used in the Accounting Domain. How this happens is akin to database security. Many may have read access to certain data in a corporate database for their own analyses, but you don’t always want everyone to have write access and to change critical data that affect others. The Accounting Domain should have read access to cash data while OC Domain should have write access too, because that is where the data are being created. Likewise, improvement opportunities should be modeled in the OC Domain to capture operations and cash improvements as is documented in Chapter 17.
Improving Efficiency
We tend to believe that becoming more efficient when using capacity saves money. If we save time or increase output, we reduce costs. Let’s consider the $30 laborer. Assume she can create 15 units of output per hour. Now, let’s increase the amount of output to 20 then 25 then, ultimately, 30. What you will see in the Accounting Domain is that the cost per unit output decreases. It starts at $2 (15 units when using average costing where the cost is divided by output), moves to $1.50 (20 units), to $1.2 (25 units) to a final of $1 (30 units). What has happened is that you have moved down the same isocash curve as a result of being more efficient. The cost per unit may have decreased, but you’ve still spent $30 (Exhibit 8.1).
I often get the response, “Yeah, but I can sell more.” Can you? First, not all work output is salable. How do you sell a processed AP invoice, or an interview HR has, unless that is the business you’re in? Second, if the output is salable, the argument assumes there is demand for what is being sold. There may not be. Finally, if it’s sold, that’s a revenue increase, not a cost decrease.
Exhibit 8.1 Increasing output at the same cash level moves you down the isocash curve. Hence, while the cost per unit is lower in the Accounting Domain, the cash cost remains unchanged
As we will see and as Toyota experienced, by focusing on the means, being efficient helps you meet demand by spending less money.
Isocash Shifts
The only way to reduce cashOUT from a capacity perspective is to buy less or cheaper input. This can be illustrated by considering isocash curves. As you move along a single isocash curve, you are not changing cashOUT and, hence, costC. You are changing costNC which isn’t money by definition. To save money, you must shift to a lower isocash curve, where you will be spending less money. You can do this two ways. The first is by buying cheaper capacity; think of paying $25 versus $30 for an hour of labor. The second is buying less capacity; think of buying six versus eight hours of labor. In both cases, you will shift to a lower isocash curve, which will be reflected, cash-wise, as a lower cashOUT.
Reducing Costs
When reducing costs, the emphasis should be on reducing cashOUT, the rate cash leaves your firm. As suggested previously, this comes primarily from managing capacity and knowing how you’re moving on, and between isocash curves. The two situations mentioned next illustrate how to use efficiency improvements and isocash curves to reduce cashOUT. They are, to a limited extent, managing the means.
Situation 1
Let’s say you have three people doing a job and your company is in cost reduction mode. Each person can process five units of output per hour. Let’s say you lean the operation and now each person can now process eight units of output per hour. If demand is for 15, you now have the ability to meet that demand with less capacity; two versus three people. This positions you to buy less capacity and put yourself on a lower isocash curve (Exhibit 8.2).
Exhibit 8.2 Efficiency enables you to meet demand using less input
Situation 2
Now you’re in growth mode. You have the same three associates processing five units of output each. Once you exceed a demand of 15 units, you would need at least one more person. Every time you increase demand to a multiple of 5 or greater, you will need to hire another person. Now, let’s say you lean the process so they’re achieving eight per hour. Now you can hire based on multiples of eight. In the pre lean scenario, 40 units of output would require eight employees. In the post lean scenario, you just need five. The amount of cash required to meet demand should be less if you’re efficient and you take advantage of it by buying less capacity.
Being more efficient will not reduce cash costs. The cash cost, costC, function increases monotonically, suggesting the more you do, the cost will stay the same or increase, but it will not decrease. Efficiency enables improvements to occur. First, although your costs won’t go down, they will increase more slowly when managed effectively. Second, it creates options with respect to how much capacity you need to buy. Toyota could spend less, relatively speaking, because it did not need to buy excessive capacity to hide inefficiencies.