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:
- of failing to satisfy cusomters' material quality requirements in terms of form and function;
- of failing to deliver form and function at an attractive price;
- of failing form, function, and price (in other words, value) just-in-time;
- of failing to achieve Toyota's target cost; and, consequently
- of failing to achieve Toyota's target profit.
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....
Principal, Rona Consulting Group