Extra Point

March 2006

by Jack Tenney, Publisher

The Cost of Doing Business

I search for the perfect driver. Golfers, of course, think I’m talking about the latest mega-sized, melon-shaped, 10.5-degree lofted-launcher of the balata ball. Actually, I’m looking for the independent variable that explains why things happen in business.

As a group controller for a conglomeration of paper products manufacturing plants and their shared support activities, I was amazed to discover that the profitability driver was a support activity and not the manufacturing activity. There were three support divisions: trucking, power and maintenance. Each of those divisions “sold” its services to manufacturing divisions at “cost.” 

I put the terms “cost” and “sold” in quotes because it is virtually impossible to sell something at cost. Costs can only be known historically, and selling implies some market factors such as supply, demand, time sensitivity and the like. So ... what was actually happening was each of the support divisions was transferring its services at estimated costs. There was no bonus plan in place for managers of the support divisions to make a profit as there were for managers of the so-called profit centers.

Then a really weird thing happened. If the plan for the service underestimated the actual per-unit cost, the consuming division gained an advantage over its competitors that manifested itself in greater sales volumes and ultimately greater consumption of trucking, power and maintenance. The support groups made up their inadequate selling prices with volume.

Unfortunately, if the plan overestimated the actual per-unit cost for services, the consuming divisions needed higher prices for their goods, which decreased their unit sales and lessened their demand for services, which left the service divisions behind the power curve because they were unable to absorb their overhead.

Can you see the boom and bust cycles that resulted? That’s what happens in a controlled economy. If you don’t believe me, ask Fidel Castro.