Gemba Keiei, Chapter 6: The Blind Spot in Cost Calculation

Let’s start off with a bit of background on the Toyota Production System (TPS) and what has come to be called Lean manufacturing in the West. One of the pillars of TPS as envisioned and developed by Kiichiro Toyoda, Taiichi Ohno, and Shigeo Shingo is the idea of Just in Time production. This is not the same as the “just in time inventory” fad of the 1980s which for the most part left bitter memories of failed implementations and lingering beliefs that “we are different” or “it won’t work here”.

Just in Time is the design of production activity to be closely synchronized with customer demand according to the three principles of Takt Time, One-Piece Flow, and Downstream Pull. One of the major goals of Just in Time is to prevent the mother of the 7 wastes – overproduction – by making only what the customer needs, when they need it, in the right amount.

Taiichi Ohno began implementing TPS in the machining area of Toyota. Toyota in those days was working in a very traditional manufacturing way. The machining processes were vertically optimized in mass production mode. This resulted in the typical evils of batch & queue including low productivity, high inventory, and defects.

Taiichi Ohno begins the chapter by saying that there is a misconception in the minds of people who calculate cost. They believe costs can be lowered on the basis of volume produced without considering the actual customer demand. One of the challenges with kaizen and implementing Just in Time production is that traditional accounting rewards high equipment utilization, absorption of cost, and counts inventory as an asset. These things are in fact examples of overproduction (waste) that is driven in part by how we calculate cost.

Ohno says “Make only as much as the customer will buy. Don’t make things the customer won’t buy” but the cost accountants reply “What are you talking about? Of course it’s cheaper to make 20 than to make 10.”

Ohno recognizes that in terms of simple math what the accountants say may be true but says the reality of costs is not so simple. Here he introduces the famous three equations for cost. Mathematically they are the same. They are very different in terms of the point they bring across. The equations are:

1) Price – Cost = Profit
2) Profit = Price – Cost
3) Price = Cost + Profit

At first glance these all appear to be the same. Equations 1 and 2 are identical, only flipped horizontally. Equation 3 simply subtracts cost from both sides of the equation and is mathematically identical. However Taiichi Ohno stresses that the thinking behind each of these equations is fundamentally different, and that is something difficult for cost accountants to understand.

In the case of equation 1 the market is competitive and the price is set by the customer. If the market will bear a $1.25 selling price and your cost is $1.00 per unit then your profit will be $0.25.

In the case of equation 2 you need to make a certain profit, let’s say $0.25 per unit. So here you have to increase the value and increase the price so that if your cost is $1 you can now sell it for $1.25. You gold-plate it if you have to, says Ohno. If you can’t reduce the cost you have to increase the value so you can increase the price and get a better profit margin.

Taiichi Ohno illustrates this using a story from 1974 – 1975. An economist asked him why Toyota only sold cheap cars to the United States. Why not sell high value-added luxury cars that cost 10 times more, but only sell 1/10th as many?

In the case of equation 3 the math may be the same but the underlying thinking is different, says Ohno. If $0.25 is a fair profit and the cost per unit is $1, then you may set the selling price at $1.25.

However if the customer can purchase the same thing elsewhere at $1 then you can not set the price this way. This is typically something that governments will do to set prices in order to insure a “fair” profit to the producer, but markets (where customers make the choice) typically do not behave this way.

This is the classic “cost plus” (equation 3) of U.S. government contracts. In these cases often you must pass on the cost savings to the government when the contract is renewed. If your profit is $0.25 and your cost has been reduced to $0.50 through kaizen the new selling price to the government is $0.75. This is good for the taxpayer perhaps, but still not so market-driven.

Taiichi Ohno clearly states that he prefers equation 1. This is the only equation that allows for an increase in profits based on cost reduction. If the selling price remains at $1.25 and your cost is reduced as a result of kaizen to $0.75 now you can take a fair profit of $0.50.

“Costs do not exist to be calculated. Costs exist to be reduced.” Out of all of Taiichi Ohno’s famous quotes, this one is my favorite.

Even after seeing these three equations explained many times by my teachers and reading Ohno’s explanation in the original Japanese it’s easy to get tangled up in the math and confused. The most useful way to understand this perhaps is that 3 is the “cost plus” approach and that 2 is the “price plus” approach, and 1 is the “cost minus” approach. Most of us do business in a “cost minus” market. Even if you don’t there’s no harm in remembering that costs exist to be reduced.

2 Comments

  1. Yingming Zhang

    December 29, 2006 - 2:08 am

    “Costs do not exist to be calculated. Costs exist to be reduced.” This sentence means that the owner of company must focus on how to reduce the cost, rather than how to calculate the cost. Right?

  2. Jon Miller

    December 29, 2006 - 7:58 am

    That’s correct. Ohno says it’s more important to do kaizen to reduce cost than to use cost calculation to make decisions about the business. These decisions based on cost calculations can be false because of pitfalls (assumptions) of cost calculation that is based on economies of scale or forecast volumes.