Adopting an economic viewpoint for running a business

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Figure 1

Businesses must develop a worthwhile means to accomplish their mission over time, and effectively manage the application of these means'. This essential capability involves effective execution of activities necessary to:

  • find and sign up customers
  • manage the resources necessary for development, production, and operations
  • organize those activities
  • perform the work necessary to accomplish those activities effectively
  • evaluate and improve how the 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:

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 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 intended value.

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 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.

All investments should be considered through the lens of the cost structure of its products and their services, and the business models which monetize these outputs over a competitive landscape, with realistic expectations of how tbe business is to be shaped by each endeavor going forward. To conquer the effects of products and markets in different stages of maturity, costs should be grouped into several high level categories, in order to account for uncertainty in each part of their product's lifecycle. These accounting structure should simplify the management of resources as new capabilities are designed, introduced, grow in usage, and reach a mature level of adoption within target business segment. An example of these groupings is depicted as blue boxes in Figure 1 above, consisting of:

  • inception - Customer development is performed and launch customers are selected. The business context, ways, and means by which these needs can be satisfied is defined. An endeavor to address these needs is scoped, alternative concepts are explored, and an opportunity evaluation and initial project plan is defined. The cost drivers of variability in these activities are understood.
  • elaboration - Alternative concepts and configurations are explored and evaluated. A subset of these options are refined into definitions of a solution 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 must be available that will credibly bound uncertainty to acceptable levels. The cost drivers for this to happen include the complexity and stability of the existing environment, and the fitness of the business and technical architecture to these situations.
  • construction -​ Work packages are developed and verified into functional, logical, and physical design elements  within the product's breakdown structure. The cost of developing each work package is a function of amount of new, changed, and deprecated features.
  • integration- Logical and physical designs 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.
  • transition- Operational configurations are fully deployed, delivered, and readied for use within each customer environment. A service level plan is established, 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.

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 is necessary to provide a reference point which reflects the situation had no costs been incurred, and no benefits were realized. This kind of representation is useful to show the future obligations implied by near-term commitments. Unfortunately, those with self interest in investment decisions inevitably are as subject to biases as everyone, and will tend to manipulate factors in directions they believe to be favorable from their points of view. Until a new product enters service (where measurable benefits can begin to accrue) the resources consumed by an endeavor may have provided better returns had they been allocated to alternative endeavors or investments. The diagram at the beginning of this article provides a conceptual depiction of the financial aspects of an offering over its design and service life. This representation aids consideration of alternative investments within a similar reference frame, and helps to determine whether adjustments to the business's strategies should be implemented.

Investors in for-profit businesses expect profits back from their investments that exceed the minimum acceptable rate of returns. 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 instincts 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.

Figure 2

Available cash is thus the lifeblood of businesses, and an important measure of the health for any business's portfolio, and is generated from the many alternative sources (over different time horizons) as depicted in Figure 2. Regardless of perspectives, there are limits to how much cash a business may be able to obtain or gain access to, whether through sales, borrowing, or tactical adjustments to working capital. 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.

In an ideal world, such new product development would be predictable and brief; the quality of construction would always exceed customer expectations; and 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 is effectively a hypothesis that investments will deliver sufficient value to the business and become self-sustaining within. All such bets are made with lofty expectations but uncertain payoffs.

Until delivery is actually achieved, only costs accumulate, and overruns push break-even points further and further into the future. 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 it hasn't been, gaps in performance can easily take longer to be noticed, since aggregation can dilute the signals broadcast. Industrial models of productivity can provide a stopgap basis until more effective estimation processes are developed.  By the time real data is available and recognized, it may be very difficult to avoid deterioration that accelerates nonlinearly. For example when we examine a robust estimate for a moderately complex development project of an embedded system, the relative effects that different factors have on performance can be studied. Such estimates helpfully demonstrate how confidence levels should be accounted for, given the productivity data that estimates are derived from.

Cost accounting strives to provide facts and data in support of such investor and owner decisions, so they can be traced to technical and business processes, and cost allocations​can be consistently captured across different elements of the business's products. Clear and consistent interpretations emerging from such governance are essential so that alternative courses of action can be evaluated and pursued even as changes to the business and technical environment unfold over time. Businesses are compelled by regulatory oversight to govern how this accounting is performed, such as prescribing the types of information in financial statements.

This value chain analysis can take many forms, such as:

  • activity-based costing (or ABC),  a methodology which assigns the costs of resources to the activities, products and services which consume them
  • transfer pricing, establishing rates for goods and services exchanged among controlled (or related) legal entities within an enterprise
  • theory of constraints (or TOC), a methodology which focuses on removing constraints on more efficient development and production
  • throughput accounting, which considers only the elastic costs associated with each batch of production.

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. Each accounting method must also 'settle accounts' periodically.  Because of these requirements, accounting systems struggle to provide meaningful accumulations of 'total project cost' that are immune to gaming

A common accounting mechanism allows certain kinds of major investments which 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.

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 biases 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. The 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 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, unless you have actually been counting them along the way.

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