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Managerial or Engineering Economics
Managerial economics or engineering economics deals with marginal rev-
enues, costs, and profits as shown in equation 2.1. The derivatives are for
any given level of production N, e.g., 100 units per day, and dn refers to an
incremental change in production.
Marginal Revenue
d Revenue
dn
sales pr
N
:
=
iice
Marginal Cost
d Cost
dn
materials
N
:
=
ccost plus genuinely variable labor
Marginal
:
Profit
d Profit
dn
Marginal Revenue
N
=
m
minus Marginal Cost
(2.1)
What I Learned about Business • 29
The phrase “genuinely variable labor” is important because cost
accounting systems generally treat all hourly labor as a variable cost.
The truth is that this cost is a fixed cost, just like that of the plant and
equipment, unless the business is paying overtime. The workers are
there whether or not they have value-adding work to do. In this exam-
ple, then, the only marginal cost consists of the $10 in materials. This
is why every unit the company can sell for $20 brings a marginal profit
of $10.
If, however, the company has no excess labor capacity and must pay
overtime to fill this order, the marginal cost is now $10 for the materials
plus $37.50 (at time and a half) for labor, for a marginal cost of $47.50. In
this case, the order should be rejected.
Another dysfunctional effect of overhead is the desire to make as much
inventory as possible to “absorb” it, i.e., distribute the overhead over as
many units as possible. This might even yield a favorable overhead vari-
ance (difference between standard and actual cost) for the product. This
looks good to cost accounting systems that treat inventory as a short-term
and, therefore, liquid asset, but this is the only place in which inventory
is an asset. Goldratt and Cox (1992) define inventory along with operat-
ing costs as undesirable performance indicators, i.e., less of both is better.
Throughput, or finished goods with customers who want them, is the only
indicator of which more is desirable.
We therefore conclude that Ford’s avoidance of the use of cost account-
ing metrics for actual managerial decisions is worthy of particular atten-
tion and emulation.
31
3
Starting the Real Business
This chapter begins with the identification of what Ford calls “universal
demand,” whose achievement comes from a product or service that meets
the needs of 95% of potential customers. These needs include high quality
and low cost as well as functionality. Ford stresses that, even in his day,
few people would buy without regard to quality. On the other hand, the
segment that would pay for special or extraordinary product features also
was very small, so it made no sense to meet that segment’s needs at the
expense of the 95%.
* * *
In the little brick shop at 81 Park Place I had ample opportunity to work out
the design and some of the methods of manufacture of a new car. Even if it
were possible to organize the exact kind of corporation that I wanted—one
in which doing the work well and suiting the public would be controlling
factors—it became apparent that I never could produce a thoroughly good
motor car that might be sold at a low price under the existing cut-and-try
manufacturing methods.
Everybody knows that it is always possible to do a thing better the second
time. I do not know why manufacturing should not at that time have gener-
ally recognized this as a basic fact—unless it might be that the manufacturers
were in such a hurry to obtain something to sell that they did not take time
for adequate preparation. Making “to order” instead of making in volume is,
I suppose, a habit, a tradition, that has descended from the old handicraft
days. Ask a hundred people how they want a particular article made. About
eighty will not know; they will leave it to you. Fifteen will think that they
must say something, while five will really have preferences and reasons. The
ninety-five, made up of those who do not know and admit it and the fifteen
who do not know but do not admit it, constitute the real market for any prod-
uct. The five who want something special may or may not be able to pay the
price for special work. If they have the price, they can get the work, but they
32 • The Expanded and Annotated My Life and Work
constitute a special and limited market. Of the ninety-five perhaps ten or fif-
teen will pay a price for quality. Of those remaining, a number will buy solely
on price and without regard to quality. Their numbers are thinning with each
day. Buyers are learning how to buy. The majority will consider quality and
buy the biggest dollar’s worth of quality. If, therefore, you discover what will
give this 95 per cent of people the best all-round service and then arrange to
manufacture at the very highest quality and sell at the very lowest price, you
will be meeting a demand which is so large that it may be called universal.
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