10.

THE COST-ORIENTED ECONOMICS TRAP

Saving on expense may be an upside of tech innovation and investment, but the real goal should be creating value.

—JOHN MCMANUS¹

“The numbers give us no choice,” the CFO declares. “It’s obvious that if labor costs in another country are very much lower, it will be cheaper to outsource the work there, even if the workers there are somewhat less productive.” Agile managers in public corporations are often confronted with such declarations. The argument can be even more compelling in software development than manufacturing because in a virtual world, the reasoning goes, geographical location doesn’t matter: Software can be shipped in an instant from wherever it is developed to wherever it is needed. “The numbers are clear—we must offshore.”

But where do the CFO’s numbers come from? And what are their underlying assumptions? If Agile managers come to such discussions with no more than the self-evident premises of the Agile Manifesto, it will be like coming to a gunfight without a weapon. To prevail in such settings, Agile managers need a certain amount of understanding of financial accounting and its tools, the assumptions underlying the numbers, and their relationship to Agile management.

Agile managers need to understand the preoccupation of traditional economics with cutting costs. Ronald Coase won the Nobel Prize in Economics for his 1937 article explaining that firms exist because they reduce transaction costs.² The theory made sense when products were essentially commodities. But as the economy steadily shifts from commodities to complex differentiated or personalized products and services, and as power in the marketplace shifts from seller to buyer, adding more value to customers at lower cost has become steadily more important than internal efficiency.

The phenomenon is particularly striking in software. A few decades ago, when firms were dealing with big and slow-moving monolithic systems, it made sense to focus on efficiency. Today, as unit costs approach zero, storage space is almost infinite, and systems operate and interact almost instantaneously, competitive advantage rests almost entirely in what value can be added.³

Yet CFOs continue to emphasize cost-cutting, because it can appear to improve short-term profits and so boost the current share price. CFOs often come to the table with proposals for short-term gains that are not in the long-term interests of the corporation or its shareholders. Consider for instance the sad story of Dell Inc.

The Case of Dell Inc.

Dell is a multinational computer technology company based in Round Rock, Texas, that develops and sells computers. One important part of its story is told in The Innovator’s Prescription, by Clayton Christensen and colleagues.⁴ Several decades ago, Dell discovered that it could lower the cost of production by asking a Taiwanese electronics manufacturer, ASUSTeK, to make simple circuit boards inside a Dell computer. As a public corporation, Dell could go to Wall Street and show how offshoring would lower Dell’s operating costs and remove some manufacturing from its balance sheet. Both Dell and ASUSTeK were happy with the arrangement. It was a win-win for both firms.

Then one day, ASUSTeK came to Dell with an interesting proposition. They said in effect: “We’ve been doing a good job making these little boards. Why don’t you let us make the motherboard for you? Circuit manufacturing isn’t your core competence anyway and we could do it for much less.”⁵

Dell accepted the proposal because it made sense from a perspective of making money for shareholders in the short term: Dell’s revenues were unaffected and its profits improved significantly, as it could save money by eliminating the staff who had previously worked on the task. On successive occasions, ASUSTeK came back and took over the motherboard, the assembly of the computer, the management of the supply chain, and the design of the computer. In each case, Dell accepted the proposal because Dell’s revenues were unaffected and its profits improved significantly, as it cut back on the costs of its own staff. However, the final time ASUSTeK came back, it wasn’t to talk to Dell. It was to talk to retailers and tell them that they could offer their own brand or any brand PC for 20 percent lower cost. As The Innovator’s Prescription concludes:

Bingo. One company gone, another has taken its place. How did it happen? There’s no stupidity in the story. The managers in both companies did exactly what business school professors and the best management consultants would tell them to do—improve profitability by focusing on those activities that are profitable and by getting out of activities that are less profitable.⁶

This sequence of decisions, the authors say, made sense from Dell’s point of view because the return on each of the decisions on outsourcing was high. At each step, Dell’s revenues were unaffected and its profits improved significantly. The end result? ASUSTeK became Dell’s formidable competitor, while Dell was reduced to hardly more than a brand, having lost the technical expertise it needed to innovate and grow its business.

The good news in the story is the sequel: In the end, Dell didn’t quite die. But it had to take itself private, and fundamentally reinvent itself, in order to get back to delivering high-quality products that delight customers. The move is having some success. I can even report that when I had to replace my PC recently, I surveyed the market and discovered that the PC best corresponding to my particular needs was made by Dell. So Dell didn’t die, but its near-death experience with offshoring was a costly one.

The widely accepted implication of the story is that the calculations made by Dell “dictated” that it offshore manufacturing. Yet a closer look at the numbers shows that this just isn’t so. If Dell’s managers had examined more closely what was involved in assuring Dell’s future—by continuing to delight its customers—they would have realized that not only would they be steadily losing their capacity to grow the business, but they would actually be killing the business. Contrary to what Christensen and his colleagues say, there was stupidity in the story. Dell was not practicing “good management.”

Given hindsight, we can see that Dell should have included in its calculations the costs and risks of running long-distance supply chains in foreign countries; the likely closing of wage differentials between the countries; the declining proportion of labor in the total costs of production given increased automation; the cost of knowledge and expertise being lost; and the cost of creating a competitor (ASUSTeK) that could make a better product at lower cost and so lower the margins that Dell would be able to charge in the future. The cost of crippling its future business was enormous, and it was missing from the calculation.

The calculation of costs, risks, and benefits based on a narrow view of costs, particularly labor costs, assumes that the firm’s ongoing business will continue and grow and that any other costs are insignificant. If Dell had correctly assessed the full opportunity costs and risks of its actions, the calculation would have revealed the business disaster that was unfolding.⁷ While analysts sometimes blame the tool being used for the outcome, they should rather blame the mindset applying the tool, which fell into the trap of cost-oriented economics.

Mastering the arduous task of calculating rates of return might seem tedious to Agile managers when compared to the thrill of building cool new products that delight customers. But often, it’s in these tedious details that the battle for the future of Agile management is being lost—or won. If Agile managers don’t make the effort to understand the nitty-gritty of the numbers and the financial analysis, they will be easily bulldozed by those who claim: “The numbers make us do it!” and, “Numbers don’t lie!”

Let’s also keep in mind that the problem with numbers and numbers-people isn’t numbers. Traditional management was wrong about many things, but it was right about one thing: the importance of measurement. Peter Drucker repeatedly said that it was hard to improve something if you can’t measure it, while also noting that in some areas, reliable measures were lacking.⁸ The main trouble with measurement comes when managers measure the wrong thing. The problem with bean counting isn’t the act of counting, but rather the mistake of counting beans. Managers need to be counting the elements that drive the business—customer outcomes, not merely outputs—and also using their judgment where good measures are lacking.

Here, as in other areas, what’s key is the management mindset. A mindset that is set on extracting value from a corporation for the shareholders will come to different conclusions from the numbers, compared to a mindset focused on creating monetizable value to customers.

The Urge to Offshore

Take the decisions of U.S. public corporations on issues of offshoring over the last several decades. Whole industries have been shipped overseas in pursuit of short-term cost savings. For the last several decades, it became a lemming-like rush.

As one Fortune 500 executive told me:

The decision to go to China was driven almost exclusively by the financial analysts, who told management they couldn’t support a “buy” recommendation if the firm had no plans to be in China. Since the executives who make the decision are compensated with hefty stock options, it wasn’t long before corporate was offering Mandarin lessons. These people understand the long-term implications of these decisions perfectly well, and they’re very sympathetic to the poor b*****ds who will come after them and have to sort this mess out—after their options have been exercised, of course. The unholy alliance between the analyst community and executives heavily incentivized by stock options—given cover by the simplistic apologia of cost accountants who coo about labor savings in China but forget about the six-figure travel expenses—helps explain why manufacturing has left.

Incorporating the full cost of offshoring is still a pervasive issue in business today. In analyzing proposals, firms must get beyond rudimentary cost calculations focused on the cost of labor and instead consider the total cost and risk of extended international supply chains over time. There’s an app for that: It’s called the Reshoring Initiative. It has a website with an analytical tool enabling companies to calculate the full risks and costs of offshoring. It’s called the Total Cost of Ownership Estimator.⁹ And happily, it’s free.

The Estimator poses a series of questions. What’s the price of the part from each of the destinations? How far away is it? How often are you going to travel to see the supplier? How much intellectual property risk is there? How long do you think you are going to make it? It uses the answers to calculate twenty-five different costs that add up to the Total Cost of Ownership.

“Many companies that offshored manufacturing didn’t do the math,” Harry Moser, an MIT-trained engineer and founder of the Reshoring Initiative, told me. “A study by the consulting company, Archstone, showed that 60 percent of offshoring decisions used only rudimentary cost calculations, maybe just price or labor costs, rather than something holistic like total cost. Most of the true risks and costs of offshoring were hidden.”¹⁰

“Often what firms find,” says Moser, “is that whereas the offshoring price is perhaps 30 percent less than the U.S. price, all these other costs add up to more than 30 percent. If they are willing to recognize all of them, then they can see that it may be profitable to bring the work back.”¹¹

Why did so many smart managers make the same mistake? It’s not a lack of mathematical capability. Their decision making was driven by the rush to generate short-term profits—or at least appear to be generating them—so as to raise the stock price.

A contributing factor was the belief that offshoring manufacturing to emerging markets would eliminate labor problems that were arising because of the top-down bureaucracy in U.S. firms. By offshoring production, firms were not only seeking to lower their production costs, they were also checkmating unions by removing jobs from this country. These considerations have led many managers to ignore the cliff they are driving their firms over.

A Permanent Loss of Expertise

Sadly, the cost of offshoring goes beyond the consequences for individual companies. Decades of such decision making have led to massive outsourcing of manufacturing and left U.S. industry without the capability to invent or manufacture the next generation of high-tech products that are key to growing the economy, as noted by Gary Pisano and Willy Shih in their classic article “Restoring American Competitiveness.”¹² The authors showed how the United States lost its ability to develop and manufacture a slew of high-tech products, in many cases using technology that had been invented in America. For instance, Amazon can’t manufacture a Kindle in the USA today, even if it wanted to. The expertise no longer exists in the United States.¹³

Pisano and Shih continue:

So the decline of manufacturing in a region sets off a chain reaction. Once manufacturing is outsourced, process-engineering expertise can’t be maintained, since it depends on daily interactions with manufacturing. Without process-engineering capabilities, companies find it increasingly difficult to conduct advanced research on next-generation process technologies. Without the ability to develop such new processes, they find they can no longer develop new products. In the long term, then, an economy that lacks an infrastructure for advanced process engineering and manufacturing will lose its ability to innovate.

Pisano and Shih gave a frighteningly long list of technologies “already lost”—some of them invented in the United States—along with a list of industries “at risk” that is even longer and more worrisome.¹⁴

Yet some firms are coming back to the States. For instance, Charles Fishman reports in The Atlantic that GE spent some $800 million to reestablish manufacturing in its giant facility—that was almost defunct—at Appliance Park in Louisville, Kentucky.¹⁵ In 2012, GE opened an all-new assembly line to make cutting-edge, low-energy water heaters and high-tech French-door refrigerators.¹⁶

And a funny thing happened when GE decided to bring manufacturing of its innovative water heater back from the “cheap” Chinese factory to the “expensive” Kentucky factory. “The material cost went down. The labor required to make it went down. The quality went up. Even the energy efficiency went up. GE wasn’t just able to hold the retail sticker to the ‘China price.’ It beat that price by nearly 20 percent.”¹⁷

Fishman also reported that “time-to-market has also improved, greatly. It used to take five weeks to get the GeoSpring water heaters from the factory to U.S. retailers—four weeks on the boat from China and one week dockside to clear customs,” he writes. “Today, the water heaters—and the dishwashers and refrigerators—move straight from the manufacturing buildings to Appliance Park’s warehouse out back, from which they can be delivered to Lowe’s and Home Depot. Total time from factory to warehouse: 30 minutes.”¹⁸

Bringing industries back home is also leading to important discoveries. Thus, GE’s water heater was designed in Louisville, but made in China. When GE took over the manufacturing, it discovered that its own designs involved a tangle of copper tubing that was difficult to weld together. “In terms of manufacturability, it was terrible,” Fishman noted one GE executive saying.

So, GE’s designers got together with the welders and redesigned the heater so that it was easier and cheaper to make. By having those workers right at the table with the designers, the work hours necessary to assemble the water heater went from ten hours in China to two hours in Louisville.

“For years,” Fishman writes, “too many American companies treated the actual manufacturing of their products as incidental—a generic, interchangeable, relatively low-value part of their business. If you spec’d the item closely enough—if you created a good design, and your drawings had precision; if you hired a cheap factory and inspected for quality—who cared what language the factory workers spoke? . . . It was like writing a cookbook without ever cooking . . . there is an inherent understanding that moves out when you move the manufacturing out. And you never get it back.”¹⁹

What is only now dawning on American companies, Lou Lenzi, head of design for GE appliances, told Fishman, is that when you outsource the making of the products, “your whole business goes with the outsourcing.”²⁰

Explaining Agile Management to a CFO

While CFOs have certain weaknesses, lack of confidence in cost-oriented economics typically isn’t among them. Prudent Agile managers need to come to discussions with CFOs and their staff with as much advance information as possible about the CFO’s mindset and should exercise caution in attacking fundamental assumptions up front.

Agile managers should thus begin from a thorough understanding of the responsibilities of a CFO—and their legal limits. CFOs are required by law to carry out financial accounting in accordance with generally accepted accounting principles (GAAP) issued by the Financial Accounting Standards Board. These rules are enforced by the Securities and Exchange Commission (SEC) and other local and international regulatory agencies and bodies. CFOs have no option but to implement those rules. However, the laws also have limits: For instance, there is no legal requirement to apply the rules of cost accounting.

Within the overall financial accounting framework, CFOs have some latitude in the choice of the accounting system that forms the basis for the required periodic financial reports. The accounting systems of the different companies, and sometimes even different parts of the same company or organization, can thus vary somewhat.

Many firms embrace cost accounting and its preoccupation with identifying and reducing costs, particularly labor costs. Individual CEOs and managers may do their best to support Agile management, to encourage innovation, and to go the extra mile for the customer. But the powerful undertow of the cost-accounting framework creates a continuing risk that CFOs will be missing the point of Agile management, whose principal goal is adding value at lower cost, not just cutting costs.

Throughput Accounting

The challenge here is to get a traditionally minded accountant to start thinking beyond cost accounting and focus on the corporation’s true purpose of generating value to customers and end-users at lower cost. In many situations, Agile management results in more value from less work and hence ultimately lower costs. However, if the CFO is not paying attention to value, the savings may be hidden.

Many accountants agree that cost accounting itself is problematic. But in a slow-moving profession like accounting, it has proved difficult to reach agreement on an alternative accounting system.

A step toward such a system was developed by Eliyahu Goldratt for managing factories and is known as throughput accounting.²¹ It’s a way for an organization to keep track of the velocity at which products and services move through an organization.

Throughput accounting isn’t a total solution for Agile management, but it’s an improvement on cost accounting. It can be used by a firm in its internal accounting to incorporate customer value, even though for external reporting, a public corporation will still have to follow generally accepted accounting principles.

If the CFO understands throughput accounting, an Agile manager is on the way to having a sensible discussion about the value of lean and Agile management. The CFO will already understand the importance of thinking through what adds value to the customer, not merely, “How can I cut costs?”

The follow-on conversation can be about the cost of work in process, the risk of delay, the importance of establishing a steady flow, and the customers’ unmet needs. You might draw a chart that compares iterative work cycles to work carried in a traditional “waterfall” fashion, as shown in Figure 10-1.

Agile management provides value to clients at the end of each short cycle. By contrast, the waterfall approach proceeds according to a single elaborate plan, including all the specifications. Steadily mounting costs are incurred in the expectation that when all the pieces come together, the investment will pay off.

Even a traditionally minded cost accountant should be able to see from Figure 10-1 the risk involved in spending more and more with no interim return. And unless the environment is totally static, and the work totally predictable, the risks of a delay or a technical glitch occurring are significant. With so much invested with no return, any delay can be disastrous. Earlier delivery of value improves revenue and reduces risk, as shown in the example from Ericsson discussed in Chapter 1.

Moreover, Agile management focuses effort on the features, products, and services that customers and end-users actually use and value, as opposed to features that are included in specifications “just in case” and that users may never in practice get around to using. In this way, Agile systematically reduces costs by eliminating low-value work.

Figure 10-1. Comparison of cost/revenue patterns of Agile and waterfall implementation.

Thus, even accepting the perspective of cost-oriented economics, a powerful case can be made for Agile management over the traditional waterfall approach. Nevertheless, victories of this kind will remain isolated and tactical unless and until there is a deeper understanding of the shift from a cost-orientation to Agile’s value-driven perspective.