Management: Don't count, measure

For 50 years quantification has been the rage in business and economics. Accountants have proliferated as fast as lawyers. Yet we do not have the measurements we need.

Neither our concepts nor our tools are adequate for the control of operations, or for managerial control. And, so far, there are neither the concepts nor the tools for business control - that is, for economic decision-making. In the past few years, however, we have become increasingly aware of the need for such measurements. And in one area, the operational control of manufacturing, the needed work has actually been done.

Traditional cost accounting in manufacturing does not record the costs of non-producing, such as the cost of faulty quality or of a machine being out of order. Yet in some plants these run as high as the costs that traditional accounting does record.

By contrast, a new method of cost accounting developed in the past 10 years - called 'activity-based' accounting - records all costs. And it relates them, as traditional cost accounting cannot, to value added. Within the next 10 years it should be in general use.

But we still will not have cost control in services: schools, banks, government agencies, hotels, retail stores, architectural firms and so on. We know how much a service takes in, how much it spends and on what. But we do not know how the spending relates to the work the service organisation does and to its results - one of the reasons the costs of hospitals, colleges and the post office are out of control. Yet in every developed country, two-thirds to three-quarters of total output, employment and costs are in services.

A few big banks are just beginning to implement cost accounting for services. Though results so far are quite spotty, we have found out a few important things. In contrast to cost accounting in manufacturing, cost accounting for services will have to be top-down, starting with the cost of the entire system over a given period. How the work is organised matters far more than it does in manufacturing. Quality and productivity are as important to cost in services as is quantity of output. In most services, teams are the cost centre rather than individuals or machines. And in services, the key is not 'cost' but 'cost-effectiveness'. But these are still only beginnings.

Even if we had the measurements we need for manufacturing and for services, we would still not have true operational control. We would still treat the individual organisation as the cost centre. But the costs that matter are the costs of the entire economic process. These are what the ultimate customer (or the taxpayer) pays and what determines whether a product, a service, an industry or an economy is competitive. A large part of these costs are 'interstitial' - incurred between, say, the parts supplier and manufacturer, and recorded by neither.

The cost advantage of the Japanese derives largely from their control of these costs within a keiretsu, the 'family' of suppliers and distributors clustered around a manufacturer. Treating the keiretsu as one cost stream led, for instance, to 'just-in-time' parts delivery.

Process-costing from the machines to the supplier's plant to the checkout counter in the store also underlies the rise of Wal-Mart. It resulted in the elimination of a whole slew of warehouses and of reams of paperwork, which slashed costs by a third.

But process-costing requires a redesign of relationships and changes in habits and behaviour. It requires compatible accounting systems where organisations now pride themselves on having their own unique methods, choosing what is cost-effective rather than what is cheapest and joint decisions within the entire chain as to who does what.

Similarly drastic are the changes needed for effective managerial control. Balance sheets were designed to show what a business would be worth if it was liquidated today. Budgets are meant to ensure that money is spent only when authorised.

What managements need, however, are balance sheets that relate the enterprise's current condition to its future wealth-producing capacity and budgets that relate proposed expenditures to future results while also providing follow-up information that shows if promised results have actually been achieved.

So far, we have only bits and pieces: the cash-flow forecast, for example. Now, however, some multinational companies are beginning to put these pieces together into 'going-concern' balance sheets and budgets.

But most needed - and totally lacking - are measurements to give us business control. We need measurements that are akin to the 'leading indicators' and 'lagging indicators' that economists have developed to predict the direction in which the economy is likely to move and for how long.

Big institutional investors, including some of the large pension funds, are working on such concepts and tools to measure the business performance of the companies in which they invest.

It may take many years, decades perhaps, until we have the measurements we need. But at least we know now what we need. Slowly, and still groping, we are moving from counting to measuring.

The author is a professor of social sciences at the Claremont Graduate School in California.

(Photograph omitted)