Businesses must develop an effective means to accomplish their mission over time, and effectively manage the deliveries of their development and production systems. These essential capabilities involves effective execution of the activities necessary to:
discover and connect to customers
manage the resources necessary for activities in development, production, and operations
organize these activities into effective flows
perform the work necessary to accomplish those activities quickly and efficiently
evaluate and improve how this work is being performed, and
enhance the effectiveness of running the business overall
Even the owner of a lemonade stand needs to attract seed money (or a sponsor) to cover pre-launch expenses; once launched, enough capital must continue to be attracted to warrant continued investments in labor and materials for operating expenses. In parallel, the means of production must be established, maintained, and evolved at a steady pace for growth to occur, or at a minimum, for mere survival. Herbert Simon, computing's first economist, describes the steep path this involves in his book, Sciences of the Artificial:
The idealization of human rationality is enshrined in modern economic theories, particularly those called neoclassical. These theories are an idealization because they direct their attention primarily to the external environment of human thought, to decisions that are optimal for realizing the adaptive system’s goals (maximization of utility or profit). They seek to define the decisions that would be substantively rational in the circumstances defined by the outer environment.
Economics exhibits in purest form the artificial component in human behavior, in individual actors, business firms, markets, and the entire economy. The outer environment is defined by the behavior of other individuals, firms, markets, or economies. The inner environment is defined by an individual’s, firm’s, market’s, or economy’s goals and capabilities for rational, adaptive behavior. Economics illustrates well how outer and inner environment interact and, in particular, how an intelligent system’s adjustment to its outer environment (its substantive rationality) is limited by its ability, through knowledge and computation, to discover appropriate adaptive behavior (its procedural rationality).
The question of maximizing the difference between revenue and cost becomes interesting when, in more realistic circumstances, we ask how the firm actually goes about discovering that maximizing quantity. Cost accounting may estimate the approximate cost of producing any particular output, but how much can be sold at a specific price and how this amount varies with price (the elasticity of demand) usually can be guessed only roughly. When there is uncertainty (as there always is), prospects of profit must be balanced against risk, thereby changing profit maximization to the much more shadowy goal of maximizing a profit-vs.-risk “utility function” that is assumed to lurk somewhere in the recesses of the entrepreneur’s mind.
In real life the business firm must also choose product quality and the assortment of products it will manufacture. It often has to invent and design some of these products. It must schedule the factory to produce a profitable combination of them and devise marketing procedures and structures to sell them. So we proceed step by step from the simple caricature of the firm depicted in the textbooks to the complexities of real firms in the real world of business. At each step toward realism, the problem gradually changes from choosing the right course of action (substantive rationality) to finding a way of calculating, very approximately, where a good course of action lies (procedural rationality). With this shift, the theory of the firm becomes a theory of estimation under uncertainty and a theory of computation—decidedly non-trivial theories as the obscurities and complexities of information and computation shift.
Achieving this fiscal acumen requires those with a fiduciary responsibility to intelligently juggle priorities and allocate resources properly across the many demands which compete for those resources. This requires business intelligence of sufficient fidelity and relevance for the above to occur across many large organizations, to empower all employees to act in the business's interests as well as their own.
The importance of this information is highlighted by Lawler, Mohrman and Ledford in their landmark 1995 publication, Creating high performance organizations:
Without (..) information about business performance, it is difficult for individuals to understand how the business is doing and to make meaningful contributions to its success. In addition, participation in planning and setting direction is impossible for employees to make good suggestions about how products and services can be improved and about how work processes in their area can be done more effectively. Finally it is also difficult for employees to alter their behavior in response to changing conditions and receive feedback on the effectiveness of their performance and that of the organization. In the absence of business information, individuals are usually limited simply to carrying out prescribed tasks and roles in a relatively automatic bureaucratic way.
Any established business is likely to have many different projects in their portfolio. Each effort is likely to be at different stages of maturity in each product's lifecycle. The attention and perspectives of the stakeholders of these projects vary over their period of performance. As a result, portfolios are effectively bundles of focused bets. Each bundle presents collections of risks and rewards, with outcomes that may or may not be realizable or deliver the value intended by the original sponsors.
In such aggregations, success will depend on many factors, including the stability of requirements, the amount of effort that can be focused on each activity, and how well the work is performed. Amazon is a classic example of such a bundle, which is one of the reasons their customers viewing them with which a broad spectrum of aggregated love and scorn. When viewing work in these bundles, each project competes with their peers within the bundle they are a part of and offers different value propositions, bargaining positions, and margins for the shaping of the business and alignment with its environment with both evolving over the time. James Grier Miller, in his book Living Systems, described the push for economic analysis in this context:
All adjustment processes have their costs, in energy of nonliving or living systems, in material resources, in information (including in social systems a special form of information often conveyed on a marker of metal or paper money), or in time required for an action. Any of these may be scarce. (Time is a scarcity for mortal living systems.) Any of these is valued if it is essential for reducing strains. The costs of adjustment processes differ from one to another and from time to time. They may be immediate or delayed, short-term or long-term.
How successfully systems accomplish their purposes can be determined if those purposes are known. A system's efficiency, then, can be determined as the ratio of the success of its performance to the costs involved. A system constantly makes economic decisions directed toward increasing its efficiency by improving performance and decreasing costs. Economic analyses of cost effectiveness are equally important in biological and social science but much more common and more sophisticated in social than in biological sciences. In social systems such analyses are frequently aided by program budgeting. This involves keeping accounts separately for each subsystem or component that carries out a distinct program. The matter-energy, information, money, and time costs of the program in such analyses are compared with various measures of the efficiency of performance of the program. How efficiently a system adjusts to its environment is determined by what strategies it employs in selecting adjustment processes and whether they satisfactorily reduce strains without being too costly. This decision process can be analyzed by a mathematical approach to economic decisions, or game theory. This is a general theory concerning the best strategies for weighing "plays" against "payoffs," for selecting actions which will increase profits while decreasing losses, increase rewards while decreasing punishments, improve adjustments of variables to appropriate steady-state values, or attain goals while diminishing costs. Relevant information available to the decider can improve such decisions. Consequently such information is valuable. But there are costs to obtaining such information. A mathematical theory on how to calculate the value of relevant information in such decisions was developed by Hurley. This depends on such considerations as whether it is tactical (about a specific act) or strategic (about a policy for action), whether it is reliable or unreliable, overtly or secretly obtained, accurate, distorted, or erroneous.
Investments should thus be considered through the lens of the cost structure of an endeavor - the production function of products, services, and capabilities - and the business models which monetize these outputs over a competitive landscape. Candidate investments must be reconciled with realistic expectations of how the business will realistically be shaped by each capability increment going forward.
To properly account for the effects of products and markets in different stages of maturity, these costs and benefits should be grouped into several high-level categories, to account for the inherent uncertainty characteristic of lifecycle phases. These accounting structures should simplify the effective management of resources as new capabilities are designed, introduced, grow in usage, and reach a mature level of adoption within targeted business segments.
Figure 1 provides a conceptual depiction of the financial aspects of an offering over these phases in its design and service life. This representation suggests consideration of alternative investments within a similar reference frame to aid in determining whether adjustments to the business’s strategies should be implemented. Unfortunately, those with self-interest in investment decisions inevitably are subject to biases and thus will manipulate factors in directions they believe to be favorable from their points of view. Until a new product enters service (when benefits begin to accrue) the resources consumed by an endeavor may have provided better returns had they instead been allocated to alternative endeavors or investments.
The cumulative cost of these activities is depicted by the green dashed line in figure 1. A dotted red line is used to represent the aggregate capability available to users, as the product is launched, gains acceptance, achieves maturity, and declines in usage over the product’s lifecycle. A baseline business plan for a representative environment before and after realization must be available to provide a reference point that reflects the situation had no costs been incurred, and no benefits were realized. This kind of representation is also useful to highlight the continuing future obligations that may be implied by near-term commitments.
Capability development phases
An example of these groupings is depicted as blue boxes in Figure 1 above:
Inception - Customer development is performed and launch customers are selected. The business context, intentions, and ways and means by which these needs can be satisfied are defined. An endeavor to address these needs is scoped, alternative approaches are explored, and an opportunity evaluation and initial approach are defined. The cost drivers of variability in anticipated activities are considered.
Elaboration - The details required for realization are explored and evaluated. The available options are refined into definitions of a vision, requirements, and high-level architecture, within a planning baseline of the product breakdown structure. Each option is evaluated for technical and business feasibility. A down-selected set is then further elaborated into work packages, statements of work, and defined specifications so the resulting architectural elements can be concurrently realized. In parallel, mitigation options are outlined that will credibly bound uncertainty to acceptable levels. The cost drivers for this realization include the complexity and stability of the existing environment and the fitness of the business and technical architecture for these situations.
Construction - Work packages are initiated and results are verified for functional, logical, and physical design elements within the capability’s structure. The cost of developing each work package is a function of the amount of new, changed, and deprecated features which must be incorporated into the increment.
Integration- Logical and physical design elements are woven together and refined into cohesive solutions. The cost of this activity is typically driven by the quality of these design elements and the clarity of their requirements and design definitions.
Production- Physical elements of realization are sufficiently stable for replication in larger quantities. Costs are often driven by whether an effective means of late-stage customization for distinct operational configurations is in place. Note that in the PIANOS model, the above can all be considered production, when connected with the associated fields of that model.
Transition- Operational configurations are fully deployed, delivered, and readied for use within each customer environment. A service level plan is established for ongoing support. The cost driver for this activity is established by the effectiveness of upstream processes.
Sustainment- Services are provided as described in the service level plan, including support, training, troubleshooting, maintenance, and enhancements;
Upgrades- Periodic technology updates and modernization activities are performed to assure continued utility and acceptable operational performance within the bounds originally authorized.
Investors in for-profit businesses expect profits back from their investments that exceed the minimum acceptable rate of return. According to Mike Cowell, getting to cash flow neutral ((when the green line crosses the red one in figure 1) is thus an essential survival instinct for a business to develop:
What causes most businesses to fail is running out of cash. In putting together a financial plan for your startup, the primary goal is to determine when or even if the business will get to cash flow neutral. This is the point when there is the same amount of cash coming into the business as is going out...
Cash flow is the lifeblood of your business. The cash flow statement allows you to see what your cash balance will look like month to month through the duration of your plan. When looking at this statement, keep in mind you need to keep a substantial amount of cash on hand at all times as a safety buffer. It is not unusual to keep at least six months of operating expenses on hand in the form of cash. Most businesses fail because they run out of cash before they achieve positive cash flow.
There are always limits to how much cash a business will be able to gain access to, whether through sales, borrowing, or tactical adjustments to working capital. Available cash is thus the lifeblood of businesses and serves as an important measure of the health for any business's portfolio. This cash is generated from the many alternative sources (over different time horizons), as depicted in Figure 2.
Each business needs these reserves to invest in new product development and buffer the affordable capacity of the business against the cyclic demands placed on its resources. Once a particular product has matured in the marketplace, it becomes possible to re-purpose those resources away from mature product lines towards future ones, though achieving this goal is a long-term play.
New product development is the seed corn for future products. Ideally, this process would be predictable and painless; the quality of construction would always exceed customer expectations; wasteful activities would occur so infrequently and have such little impact that the drain they present could be ignored.
Unfortunately, in the real world, development inevitably takes longer than forecast, risks become issues which quickly drain available resources, and quality compromises result in traveled work, cost overruns, and dissatisfied customers. As a result, each endeavor requires placing and winning a series of bets. Each product in its embryonic beginnings can therefore be characterized as a hypothesis that investments will deliver sufficient value to the business to provide a self-sustaining source of revenue for the future. All such bets are made with lofty expectations but uncertain payoffs.
Until realization is actually achieved, costs inevitably accumulate, and overruns push break-even points further and further into the future, extending the continual risk of plan continuation bias further. When seen from this lens, each product development (ad)venture exerts a tax (or drag) on a business's resources with an expectation that these investments will result in worthwhile payoffs over a longer time horizon. Uncertainty must be factored into resource forecasts over this timeframe so that the range of likely performance is appropriately characterized. If uncertainty hasn't been properly accounted for, or discipline wanes, gaps in performance can easily take longer to be noticed, since aggregation can dilute the signals available to those paying attention. Industrial models of productivity can provide a stopgap basis until more effective estimation processes are developed.
By the time data is available and understood, it may be very difficult to avoid deterioration that can accelerate nonlinearly. For example, when we examine the robust estimate produced for a moderately complex development project for an embedded system (see below), the relative effects that different factors have on performance can be studied. Such estimates helpfully demonstrate how confidence levels should be accounted for using the productivity data that estimates are derived from.
Resource expenditures are typically managed separately as direct and indirect costs. Negotiations are often necessary to pro-rate these indirect costs to organizations and infrastructure across the business's direct base. Each planning cycle must accommodate 'carryovers' of expenditures made in a prior accounting period but not paid until the current period is underway. As a result, each accounting method must also 'settle accounts' periodically. Without such reconciliation, accounting systems struggle to provide meaningful accumulations of 'total project cost' that are immune to gaming by those who wish to obfuscate outside interference.
A common accounting mechanism allows certain kinds of major investments that exceed an established threshold to be treated as capital expenditures. These are distinguished from annualized expenses by their multi-year distribution. Additional resources in addition to this capital investment are often necessary to acquire or prepare an asset for use, to repair or improve it for a new application, or to extend its service life. If the asset retains most of its value over an extended period after the year of acquisition, the costs may be depreciated over time and retained on the businesses' balance sheet. If an asset has no material value shortly after its initial acquisition, it is instead treated as an item that is expensed in the accounting period in which the work was performed.
In Knowledge and Decisions, Sowell discusses how challenging this can be, since accounting for operating expenses using unit costs and marginal costs are quite different:
When people casually speak of "the" cost of producing something, they usually mean the average cost - that is, the total cost of running the enterprise divided by the number of units of output it produces. But for actual decision-making purposes at any given time, the incremental cost is more crucial. The total cost of running an airline obviously includes the cost of airplanes, but in deciding whether or not to make a particular flight, what matters at that point is whether the incremental cost of that flight will be covered by its incremental value to the passengers, as revealed by what they are willing to pay for it....
An airplane idle on the ground during a particular time has a very low cost in the economic sense of cost as a foregone alternative. If a plane that would otherwise remain in a hangar overnight is instead brought out at midnight to fly a party of vacationers to a nearby resort, the cost of this short flight that does not interfere with its other schedule of flights is much less than the "average" cost of an airplane flight. In this case, the incremental cost of the flight is little more than the cost of fuel and a flight crew, since the plane itself is there for another purpose anyway.
The allocation of indirect costs attempts to walk a fine line between concepts that legal theory describes as fairness and efficiency. Different stakeholders typically benefit at different times, and to different degrees, from applying these two concepts. Let's define efficiency as that which maximizes aggregate welfare, and fairness as a morally defensible treatment of or distribution among stakeholders. Achieving both goals can be quite difficult and usually requires compromises to be formed. Such compromises require trust to be developed. It can be far easier to just grant one class of stakeholder access to resources to pursue their grand vision, despite the opportunity cost that may represent to others.
Literature on complex adaptive systems has suggested that bottom-up approaches to pursuing fairness and efficiency create structures that are more resilient to volatility. Other studies have found that the bottom-up activity-based costing approach is more agile and less limiting than the top-down theory of constraints approach. Clearly, a balance must be struck.
Many of these accounting methods focus primarily on costs, rather than on assuring that claimed benefits are actually realistic and can be achieved under nominal circumstances. The problem with cost-focused methods is they have a built-in bias towards cutting costs and reducing expenses, rather than providing more selective shaping of investments, in concert with more effective accountability.
Enhanced collective returns are often available by reallocating existing resources from currently assigned work to pursue longer-term, more credible opportunities. A newly engineered must enter service before its non-recurring costs can be properly accounted for as unit costs across the product's lifecycle. The costs incurred for supporting different configurations will still need to be fairly assigned to the particular party who required those features. Profit centers and cost centers are both alternative accounting methods to achieve such a strategy, though incorporating such changes usually requires a considerable period of adjustment before the revised allocations can be fairly and efficiently distributed, and the quality of the data will be adequate for decision-making across candidate future scenarios.
Ideally, tradeoffs between alternatives should be performed consistently across projects and endeavors, by converting benefits to dollars using consistent and credible assumptions, meaningful measures of effectiveness, and active risk management. In practice, accounting systems may not provide data in the form needed for a meaningful analysis of alternatives. In this context, productivity measures are essential tools to stamp reality onto this ideal canvas, and to evaluate organizational performance as a whole. The underlying units of measure should be tied to the 'real' completion of each job, rather than just a checkmark on a schedule (which often obscures a large iceberg of remaining work).
Until a business can make credible projections of its lifecycle costs and what benefits can be expected from its products and services over realistic forecasts of the future, the yield recoverable from investments may be quite uncertain. Without a credible story of how such investments will pay off, this environment may make it increasingly challenging to secure the investments required for sustaining endeavors of significance over time. For this reason, cash surpluses should be channeled into productive uses of capital for long-term business perpetuation, such as investments to improve efficiency, accelerate the capture of new sources of revenue, and improve focus on the bottom line. While sunk costs can never be recovered, neither is it wise to bet that the cards will turn in your favor, presuming you have actually been counting them along the way.
