Tuesday, September 29, 2009

The meaning of profit management

Why is hoshin so powerful? People will tell you that it's the best way to get a company focused. No kidding!

But what does "focus" mean, apart from powerpoint slides that show all of our "arrows" pointed in the same direction.

It may be helpful to think of focus as the opposite of diversification. Diversification is what we do to minimize the risk in our portfolios of stocks and bonds. Diversification spreads the risk of losing on our investments as a whole by minimizing (at least based upon historical trends) the extent to which investment prices will go up or down together. We diversify because we are engaged in a game against the Market. To quote Peter L. Bernstein, the market is "a powerful opponent indeed and secretive about its intentions. Playing to win against such an opponent is like to be a sure recipe for losing. By making the best of a bad bargain—by diversifying instead of striving to make a killing—the investor at least maximizes the probability of survival." See Berstein, Against the Gods (New York: Wiley, 1996) p. 253.

Running a lean enterprise is in some ways the same as and in some ways different from financial investing. We can easily accept the idea the an enterprise represents investment in both real and intangible assets. The intangible assets of people and process are among the most important features of lean enterprises. And hoshin is the method by which those investments are chosen. But rather than diversifying our investments in people and processes, we focus. We can understand more clearly the meaning of focus by comparing it to the mathematics of diversification. Diversification requires us to minimize the correlation or covariance of the expected returns of investments within the portfolio. Focus requires us to do the opposite. To focus, we maximize the correlation of expected returns of investments in people and processes. Indeed, this is the whole purpose of "balanced scorecards" and the famous X-matrix.

Why would we diversify our portfolios of stocks and bonds and focus our portfolios of real investments in people and processes? The answer is: Our state of knowledge.

In the case of financial markets, we playing essentially against nature, the Market, about which we know only a little. The point to diversification is to avoid being taken by surprise. It's those surprises that prevent us from "betting the farm," i.e., from focusing on one stock a group of related stocks. In the case of lean enterprise, however, we know much more. Through QFD we know exactly what our customers want. Through hoshin we know our managers, employees, and suppliers rather well. We can afford to "bet the farm." In fact, to do anything less would be wasteful!

This becomes clear if we present this in mathematical form of modern portfolio theory, with a twist.

maximize COR (People, Process)

Subject to: Profit = X 

This says that we plan to maximize rather than minimize (that's the twist) the correlation among our investments in people and process, subject to a target profit, which we have arbitrarily set at X. In other words, we are going to choose investments in people and process that work together, the tighter the better.

This is new perspective on what Toyota calls "profit management." Normally, we think of profit management as consisting of its more familiar components, target costing of new products and kaizen costing of existing products. In most books about target costing and kaizen costing there is little discussion of hoshin and alignment (i.e., focus). That's a mistake. In this simple rewrite of Markowitz's portfolio theory, we can see what Toyota is really doing. Profit management really means that we are minimizing the risk of failing to hit a target profit. 

Moreover, the way in which we minimize that risk is to focus our portfolio, i.e., "bet the farm," on the most promising combination of people and processes, the combination that will deliver value to our customers. You've heard it before: Focus on the process, not the result. The result is but a constraint. It is given. It is the result of focusing on the right combination of people and process.

One last insight: Toyota is not a profit maximizer, at least in the short term. The company is clearly too risk averse. Like Markowitz's portfolio theory, this theory allows companies to maximize their returns (or profit), subject to some predefined tolerance for risk. In that case, the profit term becomes the "objective function," and the correlation term becomes the constraint. But we know that Toyota doesn't behave that way. 

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