CALCULATING THOSE HIDDEN COSTS:

Throughout this semester, we are going to be analyzing different businesses that provide a wide range of products to a wide range of customers. Even though the companies that the consulting groups will encounter will have different operation processes and management approaches, all of them will be (at some point or area) small businesses.

Due to their size or management approach, this companies rely greatly on their day to day sales and profits. In most cases, traditional managers don’t have their time well managed so they don’t have much time to worry about long term planning or long term investments that could help them increase their profit margins in the future (that is one of the areas SEAM concentrates in). On the contrary, they spend most of their time concentrated in the day to day business. Of course, I’m not implying that this entrepreneurs don’t care about the future of their creations, but that they believe that through the creation and production of good quality products that will satisfy the needs of its customers they will always have a profitable business, (even though great products and satisfied customers are very important to a company, its just not enough in a time of constant and rapid change). .

Because of this, it is going to be of great importance in our consulting work to be able to quantify the profit gained by eliminating hidden costs so that they will be able to see and understand how much economic benefit there will be. (This can be seen in the SEAM Overview).

But in addition to this, some of the companies we will study are going to have future investments in mind. Investments that are going to be either on their planning stage or in their implementation stage. And because we are going to apply the SEAM approach, we will not only be improving their day to day activities, but will also try to improve their strategic plans (if there are any or if they want to create any).

Here we have to take into account that just as most hidden costs are not reported to management through traditional accounting systems, the creation of potential gain also has costs linked to it that are not always reported. This is because investments, (as well as costs), have both a tangible and an intangible part.

For example, if a company is going to create a new production process, the tangible part of the investment will be constituted mainly by machinery and plant remodeling. This is usually well quantified in financial statements, unlike the intangible part of the investment that is conformed by time spent by employees in training, time spent by management receiving consultant advice or assisting supervisors or other employees. Sometimes, this hidden costs are higher than tangible costs. This is why is very important to take them into account when planning a future investment and its budgeted profit.

Not taking them into account may lead to two possibilities: a lack of intangible investment. (for example, the implementation of a new process without the right training. This can lead to inadequate use of equipment or lack of quality) or it can lead to sanctions to middle managements for not respecting the approved budget or required profitability (ignoring the intangible portion of the investment will create future hidden costs that will not only reduce profitability, but also increase costs trying to correct them).

Of course, if some of the companies we are going to study have investments planned, this kind of analysis of their future ventures will most likely increase their value, making them less attractive to the owner of the company. In the same manner, if some of the companies under our study this semester are now starting to plan future investments and have only a rough view of their future possible costs, this kind of study will probably discourage the owners from their ideas.

So, is very important for us, as consultants, not only to quantify the hidden costs of a future investment, but also to let the managers know (or remind them) that this extra amount of money has to be considered a "the creation of potential gains as hidden performance", instead of other investment costs.

That’s right, "potential gains as hidden performance". This, even though is hard to visualize, will save money in the long run. Taking this into account when planning a future investment will most likely increase the project’s profit, and decrease it’s total cost and payback period because they will practically eliminate the possibility of having future economic consequences due to future dysfunctions (creators of hidden costs) in the new projects. Dysfunctions like the ones we are going to be identifying in existing processes.

Of course, small business managers will better understand or visualize this after we have quantified their company’s actual hidden costs, (in most cases, small business management wont be aware of the existence of them).

But in addition to quantifying all the "potential gains", we must also quantify and show management in the best possible and simple way the economical benefits that the intangible investment will give the company. Unfortunately, this is not an easy task, because this are possible problems that could happen in the "future", in other words, we have to quantify an error that hasn’t happened yet.

From my experience, there are different ways of doing this. If the investment is going to improve an existing process, the data can be inferred from the actual hidden costs identified in the actual process.

If the investment is for a new process, one way of getting the information is by presenting costs that other companies have experienced due to errors or mistakes, (this is very hard to accomplish unless the consultants have the required data and the time to analyze it). Another way (and probably easier) is by simulating future possible scenarios of production problems or human errors. In most cases, this will be easy to calculate because once the consultant has some time of having started he consulting visits, data on salaries, down-time costs (by processes or machines), re-production cost (based on time or material quantity), and unsatisfied customer costs (either by customer or by average sale per customer), will be available (this is the same information we are going to use to calculate the actual hidden costs).

In Las Cruces New Mexico, a small business is planning to improve one of it’s existing processes due to quality problems the company is having during production..

During the first and second visits of the consulting group (from the Small Business Consulting class of NMSU), the manager explained them that they have been experiencing problems in a specific area of the production process. To eliminate this problem, the head of production decided to make a quality control study of this specific process. After finishing the study, he suggested that the best way to improve the process is by acquiring new sophisticated equipment to replace the manual labor that is being used in the present. The following tables were presented:

New equipment $30,000.00

Installation costs $5,000.00

Improved Performance (per year): 22,000.00

Among many other things, the consultant team agrees to analyze this situation and present their recommendations at the end of their study.

After a couple of months, the students discover that even though the new equipment will improve the efficiency of the production process, it won’t solve the problem as a whole, because there are hidden costs linked to the actual process and to the new investment. To explain their findings to the manager, they present the following information:

Training of the employees in the use of new machine (2 pers). $5000.00 ($2500.00 per person)

Training of managers in the adequate supervision of the new equipment (2 persons) $5000.00 ($2500.00 per person)

Time to define new quality standards and responsibilities $2000.00

New equipment $30,000.00

Installation costs $5,000.00

This kind of presentation offers only part of the information. Even though it is not wrong, is not telling the manager the whole story because its adding only part of the hidden cost effects the investment will have on the company.

This presentation informed the owner of the company of the hidden costs linked to the investment, (intangible part). The good thing about this presentation is that the owner was informed of very important costs that were not taken into account in the first information given to him. This new part of the investment has to be considered in order to avoid future dysfunctions and future hidden costs.

The bad thing of this presentation is that is not letting the company know off all the benefits that this new investment (if done right) will mean to the company in an economic sense.

After a couple of months, the students discover that eventhough the new equipment will improve the efficiency of the production process, it won’t solve the problem as a whole, because there are hidden costs linked to the actual process and to the new investment. To explain their findings to the manager, they present the following information:

Training of the employees in the use of new machine (2 pers). $5000.00 ($2500.00 per person)

Training of managers in the adequate supervision of the new equipment (2 persons) $5000.00 ($2500.00 per person)

Time to define new quality standards and responsibilities 2000.00

New equipment $30,000.00

Instalation costs $5,000.00

Products damaged during movement in production*** $10,000.00 66% $6,666.66

Time wasted in maintenance due to careless product handling*** $6,000.00 80% $4,800.00

Cost of Reprocessed products*** $3,000.00 50% $1500.00

***This information that was gathered throughout the consulting visits.

Visible costs $35,000.00 Visible performance: $22,000.00

Hidden Costs $12,000.00 Reduction of hidden costs: $12,966.00 + Increased level of customer satisfaction

According to the report given to the owner by the head of production , the investment would have a pay back period of 19 months.

According to the consulting report of Situation A, the pay back period was of 26 months.

According to the consulting team of Situation B, the payback period was of 17 months.

In this hypothetical case, it can be clearly seen that its not only important to report the hidden costs linked to future investments, but that the consulting team has also the obligation of presenting the hidden performance of the investment, (an analysis that is more difficult to achieve).

Even though Situation A report is correct, in terms that it provides management with the necessary information to make the investment and avoid future hidden costs, the lack of information on the benefits it will provide, makes it less attractive.

Last, is through the Situation B report (last one) that the manager gets the most information related to this investment, and (in this case), is the most attractive report in the economic perspective.

 

 

All the information related to SEAM was extracted from:

1. Savall, H; Zardet, V. and Bonnet, M. RELEASING THE UNTAPPED POTENTIAL OF ENTERPRISES THROUGH SOCIO-ECONOMIC MANAGEMENT. France. 2000.

 

2. Website of Dr. David Boje http://business.nmsu.edu/~dboje/sbc/