Be like Toyota: don't maximize profit, optimize your portfolio

Its a paradox. On a daily basis we live with two conflicting ideas: the concept of profit maximization on the one hand and portfolio optimization on the other hand.

On the one hand, many of us are business types who want to make more; perhaps we want to make as much as we possibly can. That makes us profit maximizers. On the other hand, we all have (underperforming) portfolios of stocks and bonds. And, while we hope to restore our net worth to what it was before the present recession (or whatever economic historians may finally decide to call it), we apply a different decision rule to our portfolio than we do to our businesses. Namely, we optimize our portfolio on one of two ways. If we are risk takers, we will optimize our portfolio to maximize returns, given our aggressive appetite for risk. If we are risk avoiders, we will optimize our portfolio to minimize the risk, given the financial returns we feel we must have. In neither case--risk seeking or risk averting--are we strictly maximizing profit.

Several years ago it dawned on me that Toyota is not a profit maximizer, despite its legendary hoard of cash (sufficient to buy Ford, GM, Daimler, and BMW at the pre-recession values). As far as I can tell--and I have been studying Toyota's financial control system for over 15 years--Toyota is an optimizer, not a maximizer. I would say that Toyota views its business as a system of investments--economists call them "real investments," because they are not investments in financial instruments like stocks and bonds. They are investments in brand, technology and intellectual property, business process, people, and relationships. Toyota optimizes its portfolio of real investments by minimizing the risk of achieving what it calls a "target profit." Target profit is defined as market price less target cost. Because in a competitive market there is limited control over market price, financial risk management at Toyota focuses on minimizing the risk of hitting its target cost. This is done in two ways: Target costing of new products prior to launch, and the "kaizen costing" of products after launch.

The combination of target profit, target costing, and kaizen costing is referred to as profit management. Note the choice of words: profit management, not maximization. The actual management of Toyota's financial targets is accomplished through the mechanism of hoshin kanri (or policy deployment). Through the processes of hoshin, Toyota optimizes its portfolio by establishing clear profit and cost targets that are then deployed systematically to all managers, including front line supervisors. At each level in the management hierarchy, managers prioritize their various improvement options to minimize the risks:

1. of failing to satisfy cusomters' material quality requirements in terms of form and function; 
2. of failing to deliver form and function at an attractive price;
3. of failing form, function, and price (in other words, value) just-in-time; 
4. of failing to achieve Toyota's target cost; and, consequently 
5. of failing to achieve Toyota's target profit.

Although this all may sound a bit complicated, it is really no different than what your stock broker does in picking a portfolio of stocks, assuming you as risk averse as Toyota.

The real news in this is that while leading schools of management continue to crank out graduates who are trained to maximize profit, Toyota has in fact created a brand new way to run a company. Namely, Toyota uses hoshin kanri to manage, not maximize, profit by minimizing the risk of failing to achieve targeted levels of quality, cost, and delivery.

The last time anything this big happened in the world of management thinking was Alfred Sloan's invention of the system of financial targets and internal audits that eventually became known as management accounting. Now that should give us all pause to consider....

Tom Jackson
Principal, Rona Consulting Group

Yogi Berra, healthcare, hoshin kanri, and management accounting

Recently I have been doing most of my shopfloor work in healthcare. To quote Yankee great, Yogi Berra: It's deja vu all over again.

Today I visited the IHI's (Institute for Healthcare Improvement) web site, where it's gifted President, Donald Berwick, advocates for evidence-based medicine and lean healthcare. It is already a veritable encyclopedia of best practices. And that's the problem.

The economic hypothesis behind this blog is that lean enterprise (in any industry) represents a new organizational form. An organizational form is defined as a particular type of information processing structure characterized in at least two dimensions: a) the degree of decentralization of decision-making; and b) a unique control system. Cf. Oliver Williamson, The Economic Institutions of Capitalism. General Motor's invention of the modern corporation represented an effective decentralization of decision-making, relative to the command-and-control structure of the railroads and the Robber Barons. Sloan's new divisional structure (Chevy, Buick, Cadillac, etc.) was coupled with his invention of management accounting (financial targets and internal audits), which kept GM's strong-minded divisional presidents in check. Lean enterprise closely echoes these two innovations. First, there is the radical decentralization of decision-making, represented by Toyota's iconic andon cord and, in healthcare, Virginia Mason Medical Center's patient safety alert system. Now for the second part: the control system. Move over management accounting.

Lean enterprise has a new control system, and this would be hoshin kanri, but not just any version of hoshin. It has to be Toyota's version, known to a small audience as "profit management." Toyota's implementation of hoshin in 1960-63 displaced management accounting and resulted in the creation of kaizen costing and target costing. Because of the thoroughgoing deployment of quality, cost, and delivery targets to all managers (front line supervisors included), and the unique structure of standard work and poka yoke on the other hand, front line employees perform audits of cost as well as quality in real time. At the same time, Toyota used hoshin to pioneer cross-functional teams, also known as matrix organization.

So how does this affect healthcare and why am I quoting Yogi Berra? For the last 20 years I have witnessed manufacturing leaders try to cherry pick the best practices of Toyota. They have all failed, some spectacularly. Now, the same process is happening in healthcare. Alas, most healthcare executives function based upon the same received wisdom that continues to inform executives in manufacturing: Alfred Sloan's GM. I believe that well-intentioned healthcare executives can, and probably will, cherry pick Berwick's encyclopedia--perhaps for 20 years. And the effect will be the same. Isolated islands of excellence, and a fundamental failure to reform.

What we need is a revolution in management thinking and education that will couple best practices (almost all of which depend upon radical decentralization and matrix organization) with the correct management control system: hoshin kanri / profit management. It is indicative of the typically fragmented thinking of Western-educated execs that, on IHI's otherwise splendid website, there is listed a short paper entitled, "Execution of Strategic Improvement Initiatives to Produce System-Level Results." The paper is yet another watered-down version of hoshin kanri, something akin to Six Sigma's Breakthrough Strategy. You will have to register to IHI's site and log in to download the paper (for free). But don't bother. Everything you need to know is in the title: "Execution of Strategic Improvement Initiatives..."

As a new management system, hoshin kanri is intended not only for the execution of strategic initiatives, but for the management of everything that moves. Managers who relegate hoshin to strategic initiatives treat it mainly as a powerful project management tool (which it is), but--whether they know it or not, and apparently they don't--in the service of GM's management accounting.

This is, of course, what went so horribly wrong with Six Sigma. It also explains Six Sigma's great popularity. It's so easy, compared to lean enterprise, because the executives don't have to bother with transforming the organization or, more to the point, their own thinking. Indeed, it was Six Sigma's focus upon good old cost reduction (not quality) that made it a big hit in the C-suite. By the way, healthcare seems to be replicating manufacturing errors in this department, too.

While management accounting suited the divisional structure of 1920s GM, it is unsuited for the radically decentralized and matrixed structures of Toyota, Canon, and other faithful adopters of lean enterprise. The conflict between hoshin and management accounting is well known to lean consultants, and is increasingly well documented by leading accountants (see, e.g., H. Thomas Johnson's and Anders Broms Profit Beyond Measure and Hope and Fraser's influential Beyond Budgeting). Among management accounting's many faults are its incredibly slow response times, the incorrect valuation of inventories, the peanut butter approach of overhead allocations, the abject failure to value human resource development, and, despite the decoupling of effect (financial results) from cause (systematic process improvement) its generally punitive approach.

To simplify my message for healthcare executives--or executives in any industry who have yet to realize: You can't sustain, let alone optimize "best practices" without a suitable control system. In other words, you can't have lean or total quality methods without lean and total quality management, otherwise known as hoshin kanri.

Also, to quote H. Thomas Johnson, you must "stop accounting."

Fear of flying

So--46 years after Toyota adopted hoshin kanri as its management system--why haven't American execs copped on to it? And this despite the huge, huge success of the Balanced Scorecard (or at least the success of Balanced Scorecard consultants), derived as the Balanced Scorecard was from Analog Devices' implementation of hoshin kanri... Not to mention the success of Six Sigma's Breakthrough Strategy, again derived from hoshin... Not to mention the successes, respectively, of the Baldrige Award or the Shingo Prize, themselves based upon a technique (the President's Diagnosis), again derived from hoshin... Und so veiter, und so veiter, etc., etc., blah blah blah.

One wonders...

Actually, I think I know why: the fear of flying.

Let me explain.

To quote Jeremy Hope and Robin Fraser, authors of Beyond Budgeting and fathers of the similarly named movement, the future is about "radical decentralization."

Radical decentralizaton means that, in the enterprises of the future (Toyota, for example), front line employees are trained and empowered to discover and fix defects in real time. Moreover, if upon discovery of a defect an employee is not, unaided, able to fix said defect, he/she is empowered to interrupt production--even stop a major manufacturing process or entire production line--to call managers to come running to assist. At Virgina Mason Medical Center, my partner Mike Rona extended this practice to healthcare in the form of a Patient Safety Alert system. (Brilliant.)

Well, what American or European or, for that matter, Asian-trained fast-track MBA would be willing--in his/her right mind--be willing to do that? In any industry, let alone healthcare? There is baked in to to the degrees offered by our schools of higher management education, shall we say, a fear of flying. Which is to say that there is a fear of letting go of power. As a result, while American, European, and even Asian companies may dabble with the Balanced Scorecard, Just in Time (JIT), Six Sigma, and even Total Productive Maintenance (TPM), there is never any real empowerment of the workforce.

It looks like empowerment; but it is not empowerment.

For empowerment--aka "radical decentralization"--to work, two things must be present. Or, as John Shook put it, "It takes two to A3." First, you need a genuine delegation of responsibility to the workforce. And indeed, the tools of JIT, Six Sigma, and TPM are all designed in precisely this manner. Only an empowered workforce can make JIT, Six Sigma, and TPM work the way they are supposed to. Second, you need a management control system that respects empowerment. This would be hoshin kanri, and not its half-baked cousin, the Balanced Scorecard. Instead of embracing hoshin kanri, our managers still cling to the control system designed by Alfred Sloan in the 1920s, a system which is still the core message of the curricula of our schools of business: partial decentralization (to divisional presidents, and definitely not to the proletariat) and control by means of management accounting.

And the Balanced Scorecard? I am reminded of the brightly painted, coin-operated airplane rides my mother, arms full of groceries, used to put me in on the way to her car.

I thought I was flying; but I was not flying.

How poignant.

Glimmers of hope, but no consummating fire

Hoshin kanri and the A3 system is how Toyota manages its vaunted production system. John Shook stated in Becoming Lean (Productivity Press) that hoshin kanri is as important as the production system. Well, we've been tying our best to adopt the production system for over twenty years. How long will it take the business world to adopt Toyota's management system?

Is history any guide?

In the 1920s, Alfred Sloan invented the modern corporation by decentralizing management into the divisions of Chevrolet, Buick, Cadillac, Fisher Body, etc. Each division had its own president. Sloan brought this new system under control by inventing the system of financial targets and internal audits that became what we know today as management accounting.

Despite the fact that Sloan practically put Henry Ford out of business in 1926, it took Ford twenty (20) years to adopt Sloan's new system. And even then he did it under pressure from his daughter-in-law. Schools of business were even slower than Ford. They revised their curricula to reflect Sloan's management system only in the 1950s. European managers were even slower--much slower. They didn't get with Sloan's program until the tail end of the 1960s!

In the case of hoshin kanri, which we might call the Toyota Management System, progress has been extremely slow. There are glimmers of hope, but no fire. Under the title of "the balanced scorecard," hoshin--or at least certain aspects of hoshin--became very popular for a time. The phrase, "balanced scorecard," is repeated frequently in board rooms and schools of business, but hoshin kanri has not been implemented or even understood. Meanwhile, another version of hoshin kanri has had some effect under the title of "breakthrough strategy," which is of course an element of Six Sigma. And of course there are all those prizes modeled after the Deming Prize: the Baldrige, the Shingo, etc. All of them employ hoshin kanri's technique of the "president's diagnosis," which engages top management in the regular assessment of organization fitness based upon well defined diagnostic criteria.

But none of it adds up. Very often, anyway. The Danaher Business System is a good replication of Toyota's system, as was Masland Corporation's COMPASS system, at least prior to Masland's acquisition by Lear Corporation. Hewlett Packard was a fairly early adopter, but abandoned hoshin kanri under the glamorous Carly Fiorina.

Alas, in the case of hoshin kanri the social learning curve may be even more brutal than in the case of Alfred Sloan's system. In Sloan's case, the technology adoption process took over five decades from the time the Sloan invented the system, and at least two decades from the time that schools of business adopted Sloan's system as the gold standard of management education.

It has now been over four and a half decades since Toyota invented the version of hoshin kanri that will eventually become management's new gold standard. Moreover, it is very clear that schools of business--with a very few exceptions (notably the Ohio State University, to a lesser degree the University of Michigan, Portland State University, and perhaps MIT)--have not yet reformed their respective curricula. And they all still teach management accounting as if it were still useful. I estimate that general curricular reform in schools of business is a decade away. If the rate of turnover in the higher echelons of management has not changed, then it may be roughly 30 years before the world's companies finally embrace hoshin kanri as the successor to Alfred Sloan's management system.

That's a very long time to wait indeed.

It's the economics, stupid.

This is a post about the economics of hoshin kanri.

Over ten (10) years ago, lean guru John Shook stated in Becoming Lean that hoshin kanri--Toyota's management methodology--is just as important as Toyota's just-in-time production. Why this is true is still not well understood. Alas, this is a function of our so-called higher education system, which has failed to equip the present generation of executives with sufficient economic reasoning skills to understand.

It all boils down to is a matter of writing complete contracts.

Okay, we're in deep here.


Your company is a bundle of contracts

Economists maintain that organizations are essentially a bundle or "nexus" of contracts. This is a fancy way of saying that organizations exist because people agree to work together, whether formally or informally. These agreements are called contracts. It is a certainty that without contract law no company could exist or function. Think of your formal contracts with customers, employees, and suppliers. In addition to formal, legal contracts there are, of course, all those informal "contracts" that govern how most companies function. We normally refer to this class of contracts as "organizational politics" and "corporate bureaucracy."


Most contracts suck

Technically speaking, the typical contracts in a normal business organization are "incomplete." This is to say that most contracts are full of holes. In other words, our contracts do not fully specify, well, a variety of things, including even very basic things such as:

• The parties to the contract (who is accountable?)
  
• The reasons for the contract (why are we doing this?)
  
• The terms or performance requirements of the contract (what am I to do?)
  
• The rewards of performance (what's in it for me?)
  
• The penalties of nonperformance (what happens if I don't show up?)
  
• The exact method of performance review (who's going to make me do it?)
  

As a practical matter, this means that we poor mortals who enter into such contracts are left guessing about what these contracts mean (okay, now what?).


We are really bad guessers

Economists agree that human beings, poor sods, are really bad guessers. Technically speaking, all-too-human brains are physically incapable of handling more than seven (7) information "chunks" at a time. Think of a chunk as an information hair-ball, in which related bits of information tend to stick together. (Hey, this is Nobel Prize winning stuff...) Research has shown than, if we are idiot savants, we may handle nine (9) chunks. Woo-hoo. I say this tongue-in-cheek because, on a daily basis, our normal range of function may be between 3 to 4 chunks. Sigh. This has fairly obvious implications for contract performance and enforcement. As parties to incomplete conracts, we will--no matter how hard we try--be slower to understand and perform. As managers (or external agencies) tasked with contract enforcement, we will be less likely to understand cause and effect relationships and therefore will be less likely to take correct decisions when contracts go awry. In other words the cost of contract enforcement will rise together with the degree of contract incompleteness. The relationship between the degree of contract competeness and contract performance is probably exponential, which is really scary.


A3s are a better (much better) kind of contract

The process of hoshin kanri, as spelled out in my book Hoshin kanri for the lean enterprise (Productivity Press) and again in Pascal Dennis's Getting the Right Things Done (Lean Enterprise Institute), is a matter of creating and enforcing a lot of A3s. A3s are also known as "team charters" and "charter" is just a fancy name for "contract." To be exact, the A3s of hoshin kanri formalize the many informal contracts of organizational politics or corporate bureaucracy. A3s are a better kind of contract namely because, being based explicitly upon the scientific method (in the form of the Deming Cycle of PDCA--Plan, Do, Check, Act) they are relatively complete. I would argue that they are far more complete than the "back channel" contracts (if you can call them contracts) of normal bureaucratic processes.... A good A3 contains a clear articulation of the problem; a clear articulation of the targets to be achieved; an explanation of the cause-and-effect relationships that have resulted in the problem; a strategy for improvement; a plan of action, including milestones and a list of accountable parties; and, finally, a clear method of review (i.e. contract enforcement).


Less guessing = lower cost of doing business

It stands to reason that a system--such as hoshin kanri--that is defined by relatively complete contracts will require less time and energy to enforce, whether through self-enforcement (i.e., people adhering to the agreements that they make voluntarily) or through external enforcement (i.e., through senior managers forcing people to do what they have said they will do). This is, economically speaking, why the "flat" organizations of Japan (which adopted hoshin kanri in the 1950s and 1960s) have far fewer (perhaps three (3) times fewer!!!) layers of bureacracy than Western organizations that still employ management structures and methods developed in the 19th (i.e., the railroads) and 20th (i.e., General Motors divisionalized system) centuries.

And this, my friends, is why General Motors--which invented the modern corporation in the 1920s, went bankrupt so very recently, and Toyota, which reinvented the corporation (between 1960 and 1963) has not.

It's all about economics.

Tom Jackson
Portland, Oregon