For those who took the blue pill, life will continue on blissfully, but they live with a significant level of risk. They’ll believe that activities, products, and services cost money. They will overcalculate benefit opportunities. They will invest in projects with a questionable cash flow ROI. They will quote the cost of an invoice or the cost to handle a customer service call. They will continue to make decisions that they feel are best for their organization even though the logical and mathematical evidence suggests they’re wrong.
For those who took the red pill, the business world will seem very different. There are three major areas where you will be able to outperform those who took the blue pill substantially. This is because you have a perspective on things that they don’t even know exists. These examples are as follows:
1. Understanding the dynamics and limitations of profit
2. Understanding the dynamics of cost reduction
3. Improving the return on investment and reducing the risk of investments
When you think about the cash dynamics of profit, two things become apparent. The first focuses on the current period. The revenue you make now must offset your current costC including the supporting infrastructure that enables further research and development for new products and services. It must also help support investments that will enable future growth. You will know if there are shortfalls and what you need to do about them.
Consider the pharmaceuticals industry. One big issue focuses on the cost to develop a new drug. There is relatively small costC involved in performing research and development for a new drug. While there may be transactional costs associated with creating the drugs, a good percent of the costC is tied up in the capacity infrastructure built up to support the research. You have expensive facilities and scientists. But ask yourself, if this same infrastructure existed, but for some reason, there were no drugs created, would the costC of the capacity change? No. You have research and development capacity consuming cash doing their jobs. The quantification of this consumption is costNC. The output may be a new drug, or it may be a failure. Ultimately, the key is to create drugs for the future that will create enough revenue to pay for future costC. Today’s drugs pay today’s costC. The key is to be efficient and make drugs that will sustain future cash requirements and growth.
This is a controversial point of view, but it is what the cash flow and math says. You spend money now to pay current expenses and on things that will generate revenues both now and in the future.
For companies dealing with pricing products and services, the focus is not on what something costs to make. This number is not real. Instead, you focus on pricing based on market value and sell to generate revenues to offset cash flow costs at a minimum. When you need a financial value to use as a cost, you use worth to represent capacity consumption, but you understand that it is not a cost. It is just a way to represent capacity consumption.
Second you’re not constrained by accounting. The focus is on the factors that affect costC, transactions and capacity, and you manage these. You know that when you manage capacity costs, you manage what gets allocated, which means you are affecting calculated costNC as well. You know how much money is coming into your company and leaving it, regardless of what the accounting statements tell you.
When it comes to cost management, having taken the red pill, you understand the only way to reduce real costs, costC, is to buy less or buy cheaper. You understand that efficiency only improves capacity use, and to gain a cash flow improvement, you have to put yourself in a position to buy less or cheaper capacity. CostNC does not really matter to you except when reporting for government or client purposes. You’ll not be bamboozled by consultants looking for you to spend big bucks on cash savings you know will not materialize. And you know how to align improvement opportunities directly with cash flow and how to quantify the improvement. Your cost management techniques are far superior to those who have taken the blue pill.
Many companies negatively affect the returns of their improvement investments and increase risk in three ways. First, they quantify the benefit opportunity incorrectly. Second, they do not project the savings correctly. Third, they do not go back to measure performance to plan.
Having taken the red pill, it is very clear what needs to be done to quantify benefits. When will you buy more or less capacity? How much will you buy? When will you get rid of excess capacity? How much money will you avoid spending as a result? You also understand the importance of transactions and the role they play when managing cash flow.
Tie this to your projected timing for the changes in capacity; you now have a projected cash flow timeline with clear requirements regarding what is necessary to achieve these numbers. Finally, you can close the gap between what you projected and what you realize. Your savings and improvements are tied to discrete decisions to add or subtract capacity and to what extent. You compare the assumptions to reality to make the necessary adjustments. You can approve projects based on the cash benefit of the project. This is not to suggest all projects are cash based, of course, but when cash is an issue and improved cash flow management is the objective, your analysis approach is very clear and weeds our poorly documented cost benefit analyses.
In the end, what I’ve offered is a simple way to look at your organization. Accounting math does not work. The output is unhealthy. It creates tomato sauce. You cannot go wrong when you are dealing with what is natural, whole, and simple. You cannot go wrong with the truth.