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FOUNDATION INFORMATION THAT ENTERPRISES NEED We are just beginning to understand how to use information as a tool. But we can already outline the major parts of the information system enterprises need. In turn, we can begin to understand the concepts likely to underlie the enterprise that managers will have to manage tomorrow. From Cost Accounting to Result Control We may have gone furthest in redesigning both enterprise and information in the most traditional of our information systemsaccounting. In fact, many businesses have already shifted from traditional cost accounting to activity-based costing. It was first developed for manufacturing. But it is rapidly spreading to service businesses and even to nonbusinesses, for example, universities. Activity-based costing represents both a different concept of the business process and different ways of measuring. The primary techniques of cost accounting that are still in use were designed for mass-production activities. These traditional costing systems emphasize costing products for the purpose of valuing inventory. Inventory costs exclude the costs of many value-producing activities such as technology, marketing, distribution, and service. 342 MANAGERIAL SKILLS When cost accounting was developed over seventy years ago, labor cost in manufacturing was above 50 percent of total manufacturing costs. And manufacturing employment was over 50 percent of employment in U.S. industry. Both assumptions are no longer valid. Yet, traditional cost-accounting techniques continue to enjoy widespread use. The basic problem is not the technology but mentality. The ways of thinking about costing under traditional costing and under activity-based accounting are totally different. Traditional costing builds up cost from the bottom uplabor, material, and overheadand concentrates primarily on manufacturing-related direct and support costs, so called inventoriable costs. Activity-based costing starts from the cost objectthe product, service, customer, or distribution channel and asks, Which activities and related costs are used in carrying out the complete value-chain activities associated with the cost object? Users of the technique trace the costs of activities consumed by a product or service according to measures that reflect the quantity of activities used. Activity-based costing may be thought of as top-down, total costing. The cost that matters for competitiveness and profitability is the cost of the total process, and that is what the activity-based costing records and makes manageable. Its basic premise is that business is an integrated process that starts when supplies, materials, and parts arrive at the plants loading dock and continues even after the finished product reaches the end-user. Service is still a cost of the product, and so is installation, even if the customer pays. Activity-based costing can substantially lower manufacturing costs. Its greatest impact, however, is likely to be in services. In most manufacturing companies, cost accounting is inadequate. But service industriesbanks, retail stores, hospitals, schools, newspapers, and radio and television stationshave practically no accurate unit cost information. Activity-based costing shows why traditional cost accounting has not worked for service companies. It is not because the techniques are wrong. It is because traditional cost accounting makes the wrong assumptions. Service companies should not start with the cost of individual operations, as manufacturing companies have done under traditional cost accounting. They must start with the assumption that there is only one costthat of the total system. And it is, predominately, a fixed cost over any given time period. By assuming that all costs are fixed, service companies can shift to an emphasis on the customer, in other words to result control. For example, retail discounters, such as Wal-Mart and Costco, must assume that once the shelf space is installed, its cost is fixed, and management consists of maximizing the yield on the space over a given time span. This focus on result control has enabled these discounters to increase profitability despite their low prices and low margins. Information Tools and Concepts 343 Banks for instance, have been trying for several decades to apply conventional cost-accounting techniques to their businessthat is, to figure the costs of individual operations and serviceswith almost negligible results. Now they are beginning to ask, Which one activity is at the center of costs and of results? There is one answer: the customer. The cost per customer in any major area of banking is a fixed cost. Thus it is the yield per customerboth the volume of services a customer uses and the mix of those servicesthat determines costs and profitability. Just as the distinction between fixed and variable costs does not make as much sense in services, neither does the basic assumption of traditional cost accounting that capital can be substituted for labor in knowledge-based work. In fact, in knowledge-based work especially, additional capital investment is likely to require more rather than less labor. A hospital that buys a new diagnostic tool will not lay off anybody as a result. But it will have to add four or five people to run the new equipment. Other knowledge-based organizations have had to learn the same lesson. In some areas, such as research labs, where productivity is difficult to measure, we may always have to rely on assessment and judgment rather than on costing. But for most knowledge-based and service work, we should, within a few years, have developed reliable tools to measure and manage costs and to relate those costs to results. Thinking more clearly about costing in services and knowledge-based work should yield new insights into the costs of getting and keeping customers in businesses of all kinds. From Legal Fiction to Economic Reality Knowing the cost of operations, however, is not enough. To compete successfully in an increasingly competitive global market, a company has to know the costs of its entire economic chain and has to work with other members of the chain to manage costs and maximize yield. Companies are, therefore, beginning to shift from costing only what goes on inside their own organizations to costing the entire economic process, in which even the biggest company is just one link. The legal entity, the company, is a reality for shareholders, for creditors, for employees, and for tax collectors. But economically, it is fiction. Thirty years ago the Coca-Cola Company was a franchiser all over the world. Independent bottlers manufactured the product. Now the company owns most of its bottling operations in the United States. But Coke drinkerseven those few who know that fact could not care less. What matters in the marketplace is the economic reality, the costs of the entire process, regardless of who owns what. Again and again in business history, an unknown company has seemingly come from nowhere and in a few short years has overtaken the established leaders without apparently even breathing hard. The explanation always given is superior strategy, superior technology, superior marketing, or lean manufacturing. But in many cases, the newcomer also enjoys a tremendous cost advantage. The reason is often the same: the new company knows and manages the costs of the entire economic chain rather than its costs alone. Toyota is perhaps the best-publicized example of a company that knows and manages the costs of its suppliers and distributors; they are all, of course, members of its keiretsu. Through that network, Toyota manages the total cost of making, distributing, and servicing its cars as one cost stream, putting work where it costs the least and yields the most. Increasingly managing the economic-cost chain will become a necessity. Indeed, managers need to organize and manage not only the cost chain but also everything elseespecially corporate strategy and product planningas one economic whole, regardless of the legal boundaries of individual companies. A powerful force driving companies toward economic-chain costing will be the shift from cost-led pricing to price-led costing. Traditionally, Western companies have started with costs, put a desired profit margin on top, and arrived at a price. They practiced cost-led pricing. Marks & Spencer long ago switched to price-led costing, in which the price the customer is willing to pay determines allowable costs, beginning with the design stage. Until recently, companies that practiced price-led costing were the exceptions. Now price-led costing is becoming more common. The same ideas apply to outsourcing, alliances, and joint venturesindeed, to any structure that is built on partnership rather than control. And such entities, rather than the traditional model of a parent company with wholly owned subsidiaries, are increasingly becoming the models for growth, especially in the global economy. For many businesses it is painful to switch to economic-chain costing. Doing so requires uniform or at least compatible accounting systems in all companies along the economic chain. Yet, each one does its accounting in its own way. Moreover, economic-chain costing requires information sharing across companies; yet, even within the same company, people tend to resist information sharing. Whatever the obstacles, economic-chain costing is going to be done. Otherwise, even the most efficient company will suffer from an increasing cost disadvantage.

INFORMATION FOR WEALTH CREATION Enterprises are paid to create wealth, not, primarily, to control costs. Enterprises are not normally run to be liquidated. They have to be managed as going concerns, that is, for wealth creation. To do that requires three additional sets of diagnostic tools: productivity information, competence information, and resource-allocation information. Together with foundation information, they constitute the managers tool kit for managing the enterprise. Information Tools and Concepts 345 Productivity Information The second set of tools includes those that measure the productivity of key resources. The oldest of themof World War II vintagemeasures the productivity of manual labor. Now we are slowly developing measurements for the productivity of knowledge-based and service work. However, measuring only the productivity of workers, whether blue- or white-collar, no longer gives us adequate information about productivity. For that, we require data on total-factor productivity. That explains the growing popularity of economic-value added (EVA), even with all its complexities. EVA is based on something that has been known for a long time: what we generally call profitsthe money left to service equityis not profit at all and may be mostly a genuine cost. About this, there is no controversy. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit on its income statement. The enterprise still returns less to the economy than it uses up in resources. It does not cover its full costs unless the reported profit exceeds the cost of capital. Until then, it does not create wealth; it destroys it. By measuring the value added over all costs, including the cost of capital, EVA measures, in effect, the productivity of all factors of production. It does not, by itself, tell us why a certain product or a certain service does not add value, or what to do about it. But it shows us what we need to find out and that we need to take action. EVA should also be used to find out what works. It does show which products, services, operations, or activities have high economic productivity and add high value. Then we should ask ourselves, What can we learn from these successes? Another widely used tool to obtain productivity information is benchmarking comparing ones performance with the best performance in the industry or, better yet, with the best anywhere in the world. Benchmarking assumes, correctly, that what one organization does, any other organization can do as well. It assumes, correctly, that any business has to be globally competitive. It assumes, also correctly, that being at least as good as the leader is a prerequisite to being competitive. Together, EVA and benchmarking provide the diagnostic tools to measure total-factor productivity and to manage it. Competence Information A second set of tools for wealth creation deals with competencies. Leadership in an industry rests on being able to do something others cannot do at all or find difficult to do even poorly. It rests on core competencies that meld market or customer value with a special ability of the producer or supplier. How does one find out whether ones core competence is improving or weakening? Or whether it is still the right core competence and what changes might be needed? The discussion of core competencies has largely been anecdotal. But a number of highly specialized, midsized companiesa Swedish pharmaceutical producer and a U.S. producer of specialty tools, to name twoare developing the methodology to measure and manage core competencies. The first step is to keep careful track of ones own and ones competitors performance, looking especially for unexpected successes and for unexpected poor performance in areas where one should have done well. The successes demonstrate what the market values and will pay for. They indicate where the business enjoys a leadership advantage. The nonsuccesses should be viewed as the first indication either that the market is changing or that the companys competencies are weakening. This analysis allows for the early recognition of opportunities. By carefully tracking unexpected successes, a U.S. toolmaker found, for example, that small Japanese machine shops were buying its high-tech, high-priced tools, even though it had not designed the tools with them in mind or ever offered these tools to them. That allowed the company to recognize a new core competence: its products were easy to maintain and to repair despite their technical complexity. When that insight was applied to designing products, the company gained leadership in the small-plant and machine-shop markets in the United States and Western Europe, huge markets where it had done practically no business before. Core competencies are different for every organization; they are, so to speak, part of an organizations personality. But every organizationnot just businessesneeds one core competence: innovation. And every organization needs a way to record and appraise its innovative performance. In organizations already doing thatamong them several top-flight pharmaceutical manufacturersthe starting point is not the companys own performance. It is a careful record of the innovations in the entire field during a given period. Which of them were truly successful? How many of them were ours? Is our performance commensurate with our objectives? With the direction of the market? With our market standing? With our research spending? Are our successful innovations in the areas of greatest growth and opportunity? How many of the truly important innovation opportunities did we miss? Why? Because we did not see them? Or because we saw them but dismissed them? Or because we botched them? And how well do we do in converting an innovation into a commercial product? A good deal of that, admittedly, is assessment rather than measurement. It raises rather than answers questions, but it raises the right questions.