Cost and Value Behavior is Complex

Cost behavior

Well understood by good business managers

Optimizing performance requires understanding of the behavior of both cost and the value ... neither of which is simple. An optimization model that incorporates the many variables that are normal in human society and in sectors such as health is very complicated ... and does not work well unless there are large quantities of reliable data.

However, some of the behaviors are easy to understand ... but even the simple behaviors are not being documented well and knowledge about cost and value is primitive. It need not be ... and the TVM initiative in conjunction with initiatives like IMM will help to change this aspect of performance metrics.

Good managers use the available data to achieve the best possible results. Good managers respond quickly to what they see is happening way more quickly than an ex-post factor academic study.

What something costs is determined by technical considerations. A physical item is made up of materials that are processed in some way. To do this required people and production facilities and equipment … all of which have costs. It is a mechanical process to add up the costs of the various production activities to come up with the cost of the item.

Every element of cost varies in different ways with volume. Some component parts of the item will have a lower unit cost when the volume increases, but other parts might have higher costs as volume increases. Using less material may not reduce the cost when the production process is more difficult with a small item than a larger one … scrap may change the unit cost for the completed product depending on production capabilities and required quality.

Understanding the behavior of costs is the key to making program performance optimum. Matching the behavior of cost with all the other dimensions of operational performance makes it possible to get better results than might otherwise be expected. While elementary analysis is often based on simple relationships, efficient cost accountancy shows how low costs can be matched with high impact values for best results.

The behavior of cost is determined mainly by the system or process ... that is, the underlying science and technologies, and by the competence of the people involved and the decisions they make. Most students of cost accounting know about fixed and variable costs and know the simple breakeven chart ... but in practice everything varies, and the variations can be substantial.

Some elements of cost are a function of time. Staff are usually compensated based on a time rate … a monthly salary … an hourly wage. Some costs are based on some measure of activity … fuel consumption per mile for example. Some costs vary depending on external conditions … heating and air-conditioning costs vary depending on the weather.

The cost and profit of software applications

If a software application costs $1 million to develop plus $100,000 to deploy the first unit ... the unit cost is $1,100,000 million. If the second unit deploys for $50,000 then the total cost is $1,150,000 and the unit cost drops to $575,000. If the next 8 units cost $25,000 each to deploy the total cost becomes $1,350,000 and the unit cost drops to $135,000. After this the deployment cost drops to $100 each, and by the time 100,000 have sold the total cost is $11,349,000 ($1,350,000 plus $9,999,000) at a unit cost of $113.49. This is not an extreme case ... it is the basic business or economic model that has made modern IT such an important source of profit.

Very little … maybe nothing … is linear. Each element of cost has a different cost behavior … and together add up to an overall cost and value consumption behavior. The individual element behavior is a great help in understanding cost and the behavior of cost.

In TVM, the basic approach is to understand the way the system or process works, and use data to determine how costs relate to the system at a specific state ... and work from their to determine how costs are going to change as the system changes.

Value behavior

Maybe more complex than cost

Value usually has a different behavior. A medical intervention for a critical health condition that makes death likely without treatment has a value that is huge. How huge is subject to debate, but the value in social value terms is big. A medical procedure that makes one look a little more handsome is not in the same league as the one that saves life. And value may not relate simply to the way costs are incurred ... preventative care does not have immediate impact ... but in time its value emerges. This is addressed within TVM by the use of value chain analysis that links a series of costs with a series of values.

Value behavior is complex because most value is a function of many different elements … and the subjective aspect of value adds further uncertainty to the behavior. The important thing about this is that value has more impact on quality of life than anything else, and accordingly should be taken into consideration in every aspect of doing socio-economic activities of any type.

The complexity arises in part because each sector is dependent on other sectors, and value often only arises when several sectors together are needed for enabling improvement in value. In other situation the activity my take place with substantial money flows but not actually improve the situation to create the value. At the same time there is value associated merely with paying for the interventions. This health example illustrates this:

Health example

If I am ill and undergo some medical treatment and get better … the value situation improves substantially, while if the medical treatment does not make me well, the value increment related to my health situation is zero. Meanwhile there is value flow associated with the income and profits related to the medical interventions which may be substantial for the medical sector but pulled from the entities that that funded the interventions. True Value Metrics aims to understand all the value flows associated in any form of socio-economic activity.

Education is an important sector. Much of the value of society is derived from education and the ability to process knowledge … but the value behavior is complex. It costs money funds to educate a child … and many years. An educated person has better career prospects than someone without education and this is of great value to the individual if the individual is able to locate a job and gets the remuneration. In the case where there are little or no opportunities to use education, the value of the education is very much reduced relative to the situation where a job is available.

Education example

With no education or skills a person cannot do a well paid job. Without a job opportunity an educated person cannot do a well paid job. To get value for the individual there has to be the education and skill development and there has to be job opportunities … both!

The value chain behavior may be considered to be a derivative of cost and value behaviors. The factors that go into value chain decisions are related to costs and profit potential. With the application of TVM the value dimension should also get taken into consideration.

Outsourcing

Lower costs … a nearly same product or service … going into the same market … and the outcome is likely to be higher profits. This business model has been popular in the United States and other high wage countries for many years and is now the norm for multinational business. The value chain for this business model has a good profit profile … but the TVM value profile is poor because of worker impact and value destruction associated with losing jobs. There is value adding associated with the outsourcing enterprises … but the impacts associated with gaining jobs and losing jobs is part of the analysis.