When financial results don’t meet
expectations, senior executives
face five dreaded words that
have become much too common: “We
need to cut costs.” Those expectations
might have been set according to shareholders’
requirements, past performance
or metrics that seemed attainable at the
time. Explanations aren’t always crystal
clear. Regardless, the mandate goes
out for every department to “do their
share,” whether by cutting travel, training,
maintenance, engineering, marketing or
people. Those who hit their targets are
heroes, while the naysayers are labeled
as whiners.

Budgets are set; reality sinks in later.
Lower-level managers wonder how
they can run the business with reduced
resources, but they have no choice.
They’re forced to cut costs in order
to meet their tightened budgets. The
accountants are happy. But wait – the
year’s end brings an unpleasant surprise:
The top-line growth, revenue or profit
is not there. The senior executives are
scrambling for answers; they did not
even hit last year’s revenue. The pipeline
is weak and market share is falling. The
knee-jerk response is to enact more cuts,
and even deeper this time.

It’s said that the definition of insanity
is doing the same thing repeatedly and
expecting a different result. Unfortunately,
not only does this scenario play
itself out in every major industry, but it
is considered to be “prudent and responsible”
managerial conduct.

While cost cutting can be disappointing
for the company’s bottom line, there
may be even more dire consequences. As
illustrated by the October 2006 Chemical
Safety Board’s findings related to
British Petroleum’s (BP) 2005 Texas City
Refinery Explosion, serious operational
disasters can result from cost-cutting.
The explosion killed 15 people and injured
180. BP has set aside $1.6 billion in claims
to families alone. Despite the company’s
protestations that it did not understand
the basis for some of the safety board’s
claims, an 11-member panel led by former
Secretary of State James Baker concluded
that, according to media coverage
of the news, “Cost-cutting at BP was
brutal. At the Texas City refinery, total
maintenance spending fell 41 percent from
1992 to 1999, while total capital spending
fell 84 percent from 1992 to 2000. On top
of those cuts, BP challenged its managers
to reduce costs an additional 25 percent
after the company’s merger with Amoco
in 1998.”

In the wake of the Baker report, BP’s
CEO John Browne announced that he
would retire 18 months early. He had been
the leading proponent of the company’s
entrepreneurial culture and decentralized
philosophy. BP also issued a statement
that laid the lion’s share of the blame for
the explosion on lower-level workers and
supervisors. However, the Baker report
found that “BP’s refineries are understaffed
and that employees did not report
accidents and safety concerns because
they feared repercussions or thought the
company would not do anything about
them. Audits were focused on making sure
that refineries were legally compliant,
rather than ensuring that the management
systems were making the refineries safe.”

Why did BP make management decisions
that put the company at such risk?
Did it think it was doing the right thing
by acquiring old refineries, consolidating
and gaining “synergies”? What numbers
could have been generated to promote the
belief that cost cutting was prudent, necessary,
even possible?

Certainly the BP example is not an isolated
incident. From Ford to Pfizer, cost
cutting is back in vogue on a grand scale.
But these measures sometimes compromise
the health of the enterprise and
its long-term viability. In the future, will
executives and board members be held
criminally liable for these types of decisions,
as they have been with other financial
improprieties? Are there other ways
to satisfy shareholders that don’t involve
risky cost cutting?

The answer is, yes, there is, but it
requires a new paradigm for the modern
enterprise. This article will explore
the weaknesses in current approaches
to financial accounting and offer a new
strategy for making better decisions.

The Limitations of Financial Acounting for Decision Making

Let’s assume that the capabilities of people,
equipment maintenance, technology,
supply chain and distribution channels
are integral to the health and viability of
the enterprise. Could these costs we are
cutting actually be investments with a
value and, therefore, a return (ROI)? Not
according to financial accounting, they
aren’t. These expenses are generally
considered “costs.” Although the Financial
Accounting Standards Board and
the International Accounting Standards
Board have several projects directed at
formulating a new conceptual framework
for financial accounting and for handling
“intangible assets” such as those listed
above, the reality is that rules change
very slowly. Modern financial accounting
was born in a time when financial and
physical capital were sources of competitive
advantage. Now estimates show that
80 percent of the U.S. economy’s value is
derived from intangible assets and largely
unaccounted for by financial accounting,
according to a February 2006 Business
article.

Financial accounting practices are
based on theory. The mark of a good
theory is that it can describe what is happening,
explain why it is happening and
predict what will happen next. Because
financial accounting takes such a limited
view of a company’s assets, its measures
support the idea that a reduction in
expenses will lead to improvements in
profitability. If, however, these “expenses”
are really investments in intangible
assets, then these reductions are, in fact,
“de-capitalizing” the business. The result
is less ability to create value – less output,
less revenue.

Most operating managers do recognize
that cost cuttings and downsizings can
sometimes sacrifice critical capabilities.
They know that the equipment is not
always being maintained to perform at
its optimal level. They understand the
risk. So why then don’t the numbers back
them up? Are these managers just soft or
can they see something financial accounting
can’t?

The Managerial Challenge – A New Paradigm

Managers need to make decisions based
on theories and numbers that illuminate,
not obfuscate, what is actually happening
in the business. Boards and senior executives
need to provide sound explanations
for those decisions to their employees,
their shareholders and their customers.
This requires a new paradigm – a strategic
framework and analytic techniques
that describe and predict the returns they
will actually achieve with the investments
they make every day (such as human
capital, physical plant equipment, facilities,
and technology such as processes
and IT).

The remainder of this article presents
core concepts of a framework developed
by ProOrbis. It’s usually discussed in the
context of improving productivity (the
asset concept of ROI); however, as risk
and value are flip sides of the same
coin, the framework will be explored
here from a decision-making standpoint
that addresses both risk and value
improvement.

A New Paradigm

For
an enterprise to understand its tangible and intangible assets, there are three
key requirements:

• Classification – definition of all investments
  and sources of value in an enterprise;
• Integration – connection of all elements
  into one integrated model; and
• Link to Value – a model that produces
  value and can be measured.

By putting assets in this context, the investments and the value they create
are causally linked, giving the model its predictive power. The framework has
some specific definitions of terms and analytic concepts to meet these three
requirements.

First, organizational capability is everything the organization “can
do” with its assets. There are three core assets – physical capital
(PC), including all tangible assets; technology capital (TC), including product
technology, R&D, information technology and process technology; and human
capital (HC), including employees and contract staff (see Figure 1). In this
model, an asset – tangible or intangible – is any productive means
the organization materially controls that can be used to create value. There
are some intangible assets, such as brands, channels, customer relationships,
intellectual capital, knowledge management, networks and the like. These assets
were created by the three core assets in the past, but can be used over and
over again.

Core assets are combined into production functions (see Figure 2) that are
designed to take inputs, such as raw materials, and generate valuable outputs,
called throughputs, which are the company’s offerings (products and services).

Core
assets are not purchased to be resold directly. They are purchased to be used
by the organization to develop its products and services. As a result, they
derive their value from the value of the products and services they are used
to create. Therefore:

Throughput – Input = Value of the Core Assets

This form of valuation assumes the
company is a going business concern, as
opposed to the value placed on assets
when a firm is going to be shut down.
Liquidated assets are only worth what
you can sell them for, not what you can
make with them. Going-concern valuation
involves the combination of assets and
the way they are intended to be used to
create value.

Since the assets in combination create
the value (T-I), then the return on the
asset investments of the enterprise (ROI)
can be calculated:

Throughput – Input = Value of the Core Assets
Investment in Human, Physical and Technology Capital = Return on Investment

All assets in an organization are used
either to create throughput or to manage
assets (asset management systems), as
shown in Figure 3. For example, you need
the HR department in order to manage
your human capital. The right number of
people with the right skills for your business
do not simply appear; they have to
be acquired and managed. Therefore
there is no “overhead” or “fat to cut.”
These assets and the asset management
systems that create them also have an
investment and, therefore, an ROI.
Risk, such as has been discussed
in this article, is like negative through-
put.

Risk is defined as the potential
for assets to perform in a way that
destroys value. For BP, lost production,
fines and claims to families were, in
essence, subtracted from the value
created by the refinery. One wonders how
much BP could have invested to avoid $2
billion in destroyed value. What would the
ROI have been on those investments –
10-to-1, 1000-to-1 or 10,000-to-1? Viewing
those cost reductions as de-capitalizations
is what will shift the conversation
from “how much money did we save?”
to “how much value did we destroy?”

Making Better Decisions

Managers can use this paradigm to
improve decision making in several ways.

• Putting Investment in the Context of
  Value and Risk. This entails reframing
  asset “costs” as investments needed
  to create value and then determining
  the effect on the value (T-I) when those
  investments are reduced. The effect
  will include both value impacts and any
  resulting risk. The new goal will be to
  improve value to investment ratios, not
  just lower costs.
• Taking a Comprehensive Approach.
  Managers must consider a decision’s
  impact on the entire enterprise, including
  the assets, inputs and throughputs
  (value and risk), to predict a real outcome.
  When faced with any single asset
  reduction, they should consider the
  impact on the other two assets in the
  production function. The intended and
  unintended results will be more obvious.
• Making Decisions in the Right Order.
  By beginning with value, then formulating
  the needed capabilities and identifying
  the requirements for assets and
  asset management, decisions are fed
  with the proper data. Making decisions
  “out of order” turns an opportunity into
  a constraint. For example, if a manager
  cuts training “costs” (a human capital
  asset management investment), there
  may be a decline in production (capability)
  due to less competent human
  capital (asset). Instead the manager
  should start with the design of the work
  process that delivers the required production
  (capability) and determine the
  requirements for human capital performance
  (asset). From there the manager
  can decide upon the right investment in
  training (human capital asset management
  investment).
• Making Decisions Transparent and
  Actionable. By articulating the comprehensive
  nature and the causal relationship
  between decision-making factors,
  managers make their rationale more
  easily accessible to broader audiences,
  including shareholders, employees,
  customers and the community. This
  builds credibility for the decision and
  gives managers a command of the facts
  required to execute the change. Transparency
  in decisions and their relationship
  to outcomes creates a clear path
  that people can understand, engage in
  constructively and reasonably support.
• The Hidden Advantage – Productivity
  for Growth. This article has discussed
  the serious liabilities of mislabeling
  critical investments in organizational
  assets as “costs.” Return on investment
  (ROI) is another word for productivity.
  By optimizing the relationship between
  value and investment, significant
  resources are freed up, as companies
  discover new ways to remix assets to
  create higher-return production functions.
  For industries expecting significant
  growth such as nuclear utilities,
  scarce resources can be redeployed to
  new operations and create opportunities
  for real growth.

The remarkable benefit of following this
paradigm is the way it allows an organization
to solve its intractable problems. Is
it a silver bullet? No, but it’s certainly
clear that the current paradigm is not
working. With everything to gain and not
much to lose (remember our definition of
insanity), this shift in perspective might
be worth exploring.

References
1. DiFrancesco, Jeanne, “Managing Human Capital as
a Real Business Asset,” IHRIM Journal, March 2002;
“Human Productivity: The New American Frontier,”
National Productivity Review, Summer 2000.
2. M andel, Michael, Steve Hamm, and Christopher J.
Farrell, “Why the Economy Is a Lot Stronger Than
You Think,” Business Week Online, February 13,
2006.
3. Cummins, Chip, “U.S. Cites Cost Cuts’ Role in
BP Refinery Blast,” WSJ.com, October 31, 2006.
4. “Cost-cutting led to BP Refinery Fire, Report Concludes,”
PBS Online, November 1, 2006.
5. Timmons, Heather, “Poor management and costcutting
hurt safety at BP, report finds,” International
Herald Tribune, January16, 2007.
6. Cummins, Chip and Mollenkamp, Carrik, “BP’s Next
Slogan: ‘Beyond Probes’,” WSJ.com, February 7,
2007.