Saturday, January 26, 2013

The Calculus of Cost 2

@remembermytweet and @tetradian explore the Types of Cost (Jan 2013).

Alex identifies a number of different types of cost, which as Tom points out are largely monetary costs. But what is a cost anyway?

An enterprise incurs a great deal of cost. and these can be broken down and classified in various ways. Accountants like to express all costs in monetary terms - so for example,  human effort is translated into labour cost.

But that only works if the enterprise is directly paying for the labour, in the form of wages or contractor bills. Wasting the customers' time doesn't count as a direct cost to the enterprise, although it may well have an indirect cost in terms of customer complaints and lost revenue.

We might also think of anxiety as a cost. As Seth Godin comments in relation to the airline industry, "By assuming that their customer base prefers to save money, not anxiety, they create an anxiety-filled system." Eleven things organizations can learn from airports (Jan 2013). See also my post on Anxiety as a Cost (Jan 2013).

Even for direct labour, the human cost may not be fully reflected by the wages and monetary overheads associated with employment. Many employees do unpaid overtime and incur other personal costs, and this is only visible to the enterprise accountants when it results in high levels of sickness and staff turnover.

So we need to remember the difference between a real cost and its monetary measure.

In most organizations, there is a constant pressure to contain and reduce (monetary) costs. Costs are associated with specific activities, specific resources, specific outcomes; and cost-cutting generally means identifying things that can be done cheaper or eliminated altogether. Which leads to an important discussion between enterprise architects (who understand the complex relationships between activities, resources, outcomes, and so on) and accountants (who understand how costs are allocated to these things).  A cost-cutting agenda can look very different from an architectural perspective, which balances local//global and short-term//longer-term.

Particular difficulties arise with shared resources, whose costs are often calculated and allocated using a fairly simplistic formula; this can significantly distort the investment case for shared infrastructure.

A simple accounting view of cost is that monetary costs follow simple arithmetic - addition and multiplication. Architects need to understand where this simple view breaks down, thanks to the economies and diseconomies of scale, as well as network effects and externalities. Perhaps one of the ways of measuring the monetary value of enterprise architecture is that when it is done well it increases economies of scale and reduces diseconomies of scale. So architects need to understand how costs interact - what I call the Calculus of Cost.

Related posts: Calculus of Cost (Aug 2009), Architecture as Jenga (Sept 2012),  On Business Architecture and Management Accounting (Nov 2012), Anxiety as a Cost (Jan 2013).


asplake said...

Hi Richard,

Your advice (without actually saying so) is to engage in a bit of Systems Thinking. OK as far as it goes...

With a title like "The Calculus of Cost" you could usefully cast the net a bit more widely in the search for alternatives to Cost Accounting. For example there's Flow Accounting, Beyond Budgeting, advice from the likes of John Seddon to pursue economies of flow over economies of scale. They might not replace Cost Accounting for all purposes but they certainly encourage you to approach the problem in different ways.


Mike Burrows (@asplake) said...

P.S. Regretting commenting using my Blogger profile. What a joke of a system!

Richard Veryard said...

Thanks Mike

In his article Why do we believe in economy of scale? (July 2010), John Seddon compares Henry Ford with Taiichi Ohno, saying "While Ford was concerned with unit cost, Ohno concentrated on total cost. He took the view that cost was in flow – how smoothly and economically the parts were brought together in the final assembly – not just the aggregation of unit costs."

I think what this means is that you only get economies of scale if you understand how everything fits together. Actually Ford probably understood this well enough, although a number of his successors possibly didn't.

Seddon concludes that "Economy of scale is a myth". I think this is a bit of an overstatement. Economies of scale are certainly possible under the right conditions. What Seddon rightly criticizes is the common naivety of imagining economies of scale will happen by magic, without paying due attention to architectural questions such as flow.