Dangerous Decision Rules of Thumb

In today’s data rich world, managers have little excuse to rely on “rules of thumb” except for habit and convenience; but these are surprisingly powerful forces. A history of success and survival creates confidence in rules of thumb, and often managers don’t recognize the fundamental changes that are occurring and apply the necessary thinking and creativity to create new performance measures. Let’s explore a few common “rules of thumb”.

Fixed and variable cost confusion:  When making a decision, what you care about is Avoidability -  which costs are and are not avoidable as a result of the decision, not whether the costy are fixed or variable. For example, you identify an improvement that cuts maintenance by 50% on a category of equipment. You have one technician doing that maintenance. That technician’s salary and benefits may be considered fixed or variable by your cost model. Does it matter? Realizing savings depends on how difficult it to hire such technicians, whether a qualified technician is willing to work part time, or whether you can move half the technician’s time to another task. Clearly the improvement should be implemented; it creates more up time and the potential for savings or redeployment of talent.

Profit as a percentage of sales:  This is a typical measure to evaluate product attractiveness, and it is simply wrong. First, it fails to consider return on invested capital, your business infrastructure, and production capability. Second, it normally only looks at gross margin (sales price minus product cost), which overlooks selling and marketing costs, order processing costs,  and usually post-sale support and warranty costs.

Overfocus on cost management: Cutting costs is a sure way to improve financial results; I’m a huge fan.  But a singular focus on cost reduction exacts a heavy toll on the morale and culture of an organization, even when characterized as operational excellence initiatives. Balance efficiency with a revenue focus where everyone is challenged to find new opportunities and markets for current products, valuable new product capabilities and characteristics for existing and new customers, and innovative ways to solve customer problems. Consider the positive impact of growth by differentiating products and services to customers willing to pay for different characteristics or services, more demand can be captured (see diagram).

Pursuing return on investment (ROI) the wrong way: ROI is a critical measure, but only when used responsibly. The goal behind ROI is to increase the return. Game playing executives pursuing poorly constructed performance bonuses at any cost often focus on minimizing the investment—a path to disaster and often the end of a manufacturer. In the U.S., capital markets have rewarded ROI improvement whether progress came from increasing the return or minimizing the investment with negative consequences for domestic manufacturing. Improving return should involve long-term thinking about items categorized as expenses for financial statements, but are really investments in the future, such as research and development, employee training, process improvement, and many data and information technology enhancements.

Overfocus on product cost: Creating operational improvements is essential, but product cost is not the only important cost information for a manufacturer—it is simply the most available. Customer costing can provide highly valuable insights. Customer behavior drives a wide variety of organizational costs. Frequency of orders, returns, changes, requests for customization, etc., all have a significant effect on manufacturing and warehousing costs. Beyond the factory, difficult or complicated customers consume management, sales, order processing, credit and collections, and customer service support time and effort. Many of these costs are not included in product cost or are allocated non-causally by an overhead driver. Most customer-driven costs are simply included in selling, general, and administrative expenses where they are poorly categorized and hidden from management analysis.