Newtonian Economics IX - Part I for distribution


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Newtonian Economics IX - Part I for distribution

  1. 1. NEWTONIAN ECONOMICSAn Introduction to the Science of Integrated Business PlanningBy Robert C. Whitehair, PhDConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 1
  2. 2. Part I – Formal Concepts and SuchConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 2
  3. 3. Table of ContentsIntroduction .................................................................................................................................................. 4The Need for Integrated Business Planning .................................................................................................. 8 Evaluating the Explanatory and Predictive Power of Economic Science .................................................. 9 The Need for an Integrated Perspective for Decision Analysis............................................................... 14Integrated Business Planning Basic Definitions .......................................................................................... 20 Enterprise ................................................................................................................................................ 20 Enterprise Diagrams................................................................................................................................ 20 Basic Elements of Enterprise Diagrams .................................................................................................. 22 Purchase .............................................................................................................................................. 23 Inventory ............................................................................................................................................. 23 Conversion .......................................................................................................................................... 23 Sales .................................................................................................................................................... 23 Financial Report .................................................................................................................................. 23The Law of Universal Marginal Economic Analysis – The Basis for the Science of Decision Making ......... 25 Opportunity Value versus Marginal Value Implications ......................................................................... 31The Three Laws of Integrated Business Planning ....................................................................................... 33 First Law of IBP ........................................................................................................................................ 33 Second Law of IBP ................................................................................................................................... 36 Driver-Based Analysis.......................................................................................................................... 37 Infinite Degree of Freedom ................................................................................................................. 41 Third Law of IBP ...................................................................................................................................... 42Summary of Part I ....................................................................................................................................... 49Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 3
  4. 4. Introduction“Do you know who Isaac Newton was?”I asked my young daughter that question because her third grade class was being introduced to physics.The first page of her homework packet had a silhouetted image of a man sitting under an apple tree so,before she could respond, I said, “He was the guy who invented the apple.”My daughter tilted her head to one side, smiled knowingly and said, “Daddy! Don’t be silly! IsaacNewton didn’t invent the apple. He invented the apple pie!”Regardless of the disputed nature of Sir Isaac Newton’s relationship with apples, there is certainty withrespect to Newton’s cultural significance – he is without question one of the most influential people inhuman history. While Newton is well-known for many contributions, his biggest impact has not beenwith respect to any single branch of science or mathematics but to mankind’s general view of reality. Byestablishing an understanding of the causal mechanics of the universe, Newton completely transformedhow we think and ushered in the Age of Enlightenment. Today, almost 300 years after his death,Newton is still relevant and his approach to understanding the physical sciences has a similar potentialfor transforming how we think about another branch of science – economics.Prior to Newton, humanity’s view was that the machinations of the universe were controlled by anunknowable power, by an omnipotent being or beings. Observable phenomena such as floods,avalanches, and falling apples were caused by the whims of supernatural entities. Science and theologywere one and the same.Newton revolutionized how we see the world and human existence. Instead of unknown, mysteriouspowers dictating our daily lives and determining our fate, Newton gave us an understanding of naturalforces and a framework for understanding their interactions such that, today, we can explain allobservable phenomena in causal terms as well as manipulate nature and bend it to our will.The causal reasoning Newton pioneered has imbued us with such a deep reliance on rational analysisthat we no longer look to the supernatural as a means of explaining or predicting phenomena. Ourreliance on rational, causal explanations has become so deeply ingrained that when we do encounterthe mysterious, we dismiss it because we know that inevitably our understanding of the causal forcesinvolved will soon reduce it to the mundane.Basically, Newton gave us the ability to understand and explain why things happen in causal terms andto predict what will happen in terms of the same causal relationships.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 4
  5. 5. More specifically, Isaac Newton articulated principles that we now refer to as the Law of UniversalGravitation and the Three Laws of Motion. These laws are the foundation of Newtonian Physics.Newtonian Physics, which is commonly referred to as Classical Mechanics, is still widely used on a dailybasis. In 1969, humans walked on the moon. Newtonian Physics was used by the engineers, scientistsand technicians who made it possible. Newtonian Physics is used to design airplanes. When they don’tfly, Newtonian Physics determines why. Without Newtonian Physics, we would not have automobiles,pitching machines, skyscrapers, satellite television or the Golden Gate Bridge.But this is old news. You probably studied about Isaac Newton at some point and you probably had theexact same silhouetted image of a man sitting under an apple tree on your homework package. Youprobably even know some good jokes about apples.And you probably do not care.More than likely, unless you work for NASA or design airplanes, you do not see any connection betweenIsaac Newton and the pressing issues that dominate your daily activity. More than likely, you are farmore interested in recent financial crises, the plummeting value of your home, whether or not you willhave a job in six months, and a wide variety of other anxieties.Isaac Newton may seem an interesting fellow, but you may see little economic value for you, personally,in further study of his life or work.However, before moving on to other, non-Newtonian topics, you might want to consider a fewobservations: - No one really seems to understand why the recent financial crisis happened or how to fix it. - It is very unusual for a “modern” economy to go more than 10 years without a debilitating financial crisis. - Financial systems are, seemingly, wildly out of balance but the dire predictions for what should happen because of these imbalances are not being realized. Conversely, events that are initially perceived to be inconsequential are proving to have profound global significance. - Economists are incapable of both explaining what has happened and accurately predicting what is going to happen. Economists still cannot agree on an explanation for the cause of the Great Depression of the 1930’s let alone the more recent “Great Recession” of 2008. - Large companies have invested $billions on tools for planning and financial analysis yet still cannot determine how decisions will affect financial performance. - Extraordinarily large, profitable companies go bankrupt. How is this possible? Especially considering how much they have invested in planning and analysis software? - For virtually any and every economic decision of consequence, there is no clear, well-defined course of action that every stake-holder agrees upon. How is it possible that for some, a specific decision is the only sure course for avoiding disaster while for others, that same decision will be the cause of unfathomable calamity?Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 5
  6. 6. These observations are interesting because of the extent to which they illustrate the sharp contrastbetween Newtonian Physics and modern economic science. Similar to the state of natural science inIsaac Newton’s time, today’s economic science bears more resemblance to a theological system of beliefthan to a principled system of known cause and effect capable of explaining observed phenomena andpredicting future consequences. Economists can be overly sensitive and will take umbrage at thiscomparison, but we only need to consider the ongoing debate regarding fiscal versus monetary stimulusto see elements of truth in it.But this book is not about alienating economists. It is about empowering you. Consider the following: - What if you could accurately forecast the financial and operational consequences of key business decisions faced by your organization? - What if you could consistently make these calculations with a precision comparable to the analyses generated by aircraft engineers? - What if you could accurately anticipate, and prepare for, a business competitor’s response? - What if you could increase your organization’s profits by 3% - 8% of sales? Effectively doubling, tripling, or quadrupling profits? - What if you could demonstrate a plan for balancing the US Federal budget deficit without raising taxes? - What if you could help members of your local community understand the implications of allocating funding to schools? - What if you could show how to reduce unemployment? Or provide affordable universal healthcare? Or establish a workable social safety net? Or prove to your children that there is, indeed, such a thing as, “too many stuffed animals!”By this point, it may not surprise you to learn that analogies to Newton’s Law of Universal Gravitationand his Three Laws of Motion can be used as the foundation for a new form of economic analysiscapable of addressing these issues and many more. This new form of analysis is called IntegratedBusiness Planning™ and will be referred to as “IBP.” IBP makes it possible to understand, explain andpredict the behavior of economic systems in causal terms and to perform financial analyses withunprecedented accuracy and precision. In effect, IBP represents a new economic science. Thefundamentals of IBP are defined in this book and are presented along with example analyses andpractical applications.Before diving into specifics, some clarifications are in order.First, it is important to note that in the context of IBP, the word “planning” should be interpreted in itsbroadest possible sense to mean “any kind of decision making.” IBP should not be thought of as anarrow approach to any specific analysis such as “budgeting” or “performance management.” Instead,it should be thought of as a foundation for every form of economic analysis including:Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 6
  7. 7. - Planning o S&OP o Operational Planning o CPM o Strategic/ CapX Planning o Treasury/ Cash Flow Planning - Budgeting - Cost Analysis o Standard Costing o Activity Based Cost Analysis o Detailed Unit Cost Analysis - Scheduling and Sequencing - Price Optimization - Competitive Analysis - Root Cause, Differential, Sensitivity and Risk Analyses - Predictive Analytics - Managerial Accounting - Deming AnalysisSecond, the concepts presented here represent an enormous amount of work involving a wide range ofcontributors. They are not the casual musings of a small group of individuals. The original academicresearch was supported by multiple government agencies as well as several large, internationalcorporations and well-respected academic institutions. Successful commercial applications of IBP havespanned over 100 different industries and thousands of analyses and have conclusively demonstratedthe potential value and decisive competitive advantage IBP can deliver.Finally, the principles of IBP and example analyses will be demonstrated using a commercially availablesoftware application called Enterprise Optimizer® (EO) from River Logic, Inc. Spreadsheetrepresentations will also be used to illustrate IBP concepts but the mathematical analyses required inIBP are beyond the capability of a spreadsheet tool. For the purposes of the analyses presented here,an educational version of EO is sufficient and can be found on the River Logic web site, Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 7
  8. 8. The Need for Integrated Business PlanningThis book is about a new approach to economic science called IBP. Given that it will require time andeffort to understand IBP, the natural question to ask is, “What is wrong with the current economicscience?”In general, economic science, or simply “economics,” is intended to analyze decision making. Itspurpose is to help us make good decisions. Ideally, for a given situation, economics would enable us tomake the best possible decision. Economics is especially relevant to questions involving production anddistribution of goods and services.As with every science, economics has many branches. The two most prominent branches aremacroeconomics and microeconomics. Macroeconomics addresses issues of broad scope, especiallythose relevant to entire economies such as inflation and unemployment. Microeconomics addressesissues pertaining to individual agents in an economy such as corporations.IBP encompasses both micro- and macroeconomic science.This chapter is not intended to serve as a replacement for a textbook nor is the purpose to criticallyevaluate every aspect of economic thought. Instead, the evaluation sought here is to determinewhether or not modern economics provides analytical capabilities comparable to Newtonian Physics.The evaluation will be made in terms of two narrowly defined questions: - Does modern economic science have explanatory and predictive power comparable to Newtonian Physics? - Does it provide an adequate context for integrated, systemic analysis?Ultimately, the relevance of any science is based on its ability to solve problems we want solved. Theimportance of Newtonian Physics is rooted in the vast extent of the solutions it has fostered. Modern lifewould not be possible without Newtonian Physics.Thus, determining the extent to which economic science is comparable to Newtonian Physics will enable usto evaluate its suitability for use as the basis for business management solutions. If IBP does, in fact, have thepotential to transform economic science in a fashion comparable to the manner in which Newtonian Physicstransformed 17th century natural science, then we can assume IBP has the potential to similarly foster a newset of powerful solutions that will enable a new era of economic prosperity.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 8
  9. 9. Evaluating the Explanatory and Predictive Power of Economic ScienceBelow is a picture of the Rialto Bridge in Venice, Italy. It is made out of stone and was completed in1591. The Rialto Bridge is an indispensable part of the Venetian logistical system. Prior to the currentstone bridge, there was a wooden bridge. In 1444, the wooden bridge collapsed under the weight of alarge crowd. It was rebuilt, but, in 1524 it collapsed again.The 1444 collapse was directly related to a lack of understanding of Newtonian Physics. The bridgeengineers of the time did not understand the forces acting on the bridge or their magnitude. As a result,they were unable to predict that the bridge would collapse if it were to be occupied by too many people.In fact, their lack of understanding was such that they did not address the problems correctly when theyrebuilt the bridge. Consequently, it collapsed again in 1524. They finally solved the collapsing bridgeproblem with the stone structure that still stands today.The Golden Gate Bridge is shown below. It was completed in 1937. It is far more ambitious than theRialto Bridge in terms of structural tolerance for forces due to traffic flow, weight, current, wind, etc.The rebuilt Rialto Bridge functioned for approximately 80 years before it again collapsed. The GoldenGate Bridge has functioned exceedingly well for approximately 80 years and it is still satisfying all itsdesign requirements including withstanding earthquakes. It is useful to compare the performance ofthe two bridges; Without Newtonian Physics, the modest Rialto Bridge failed. With Newtonian Physics,the awe-inspiring Golden Gate Bridge succeeded.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 9
  10. 10. Using these bridges as metaphors can help us evaluate the status of modern economic science. Whilewe can clearly see that physical science has advanced since the 16th century, what can we say abouteconomic science? Has the economic science of today progressed to the same extent as physicalscience?An emphatic, “Yes!” is an understandable initial response. From a comparative perspective, it mightseem clear that today’s economy is based on a science better represented by the science of the GoldenGate Bridge than the primitive science of the Rialto Bridge. Surely today’s economic science representsan advance over 16th century economic science comparable to the advance in physical sciencerepresented by Newtonian Physics over 16th century physics. From the perspective of the 16th century,our modern economy is truly a marvel. Per capita production, income, and consumption have increasedmany fold. While problems undeniably exist, the world has never experienced such wealth, luxury andgeneral bounty.But is this initial response correct? Has economic science really advanced to the same extent as physicalscience? Even if we stipulate that today’s economy is more advanced than the economy of the 16thConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 10
  11. 11. century, we need to understand the extent to which our economic advances are the result of advancesin economic science. We need to ask the question, “Does our ‘advanced’ economy necessarily implythat our economic science has advanced as well?”It is helpful to note that there were actually two Rialto Bridges completed in 16th century Venice, neitherof which was engineered using Newtonian Physics. The first, a wooden structure, collapsed. Thesecond, a stone structure, is still in use today. Although the stone bridge was not designed with thebenefit of Newtonian Physics, 16th century engineers overcame design problems by significantlyoverbuilding it to meet tolerances far beyond anything it might ever be expected to encounter.Although this approach does not represent the best use of resources, it does satisfy the requirementsfor producing a bridge that does not collapse and it is a useful heuristic design technique that has beenemployed countless times.So, upon further reflection, perhaps it is the stone bridge that is the best metaphor for today’seconomy? Perhaps the advances represented in today’s economy are not the result of advances ineconomic science but are the result of heuristic management techniques that are applied in such a waythat we have merely “overbuilt” our economic infrastructure such that we now have a “stone economy”that is more robust than the “wooden economy” that preceded it but that is not as advanced as a“Golden Gate economy.”Given the ambiguous result of the metaphorical analysis, let us look at the question more formally.From a formal perspective, scientific theory has several well-defined characteristics that we can use toaddress the metaphorical question. Specifically, a scientific theory must explain observed phenomenaand predict consequences. For now, let us formalize the question we seek to answer as:Does modern economic science have explanatory and predictive powers comparable to NewtonianPhysics?In the late 1920’s and through the 1930’s, the world experienced a period commonly referred to as theGreat Depression. Can our economic science explain what caused the Great Depression?If you go to and search for books on the Great Depression, you will get at least 2,000 hits.If you scroll through just a few of the titles, you will find that many of these books explicitly address thecause of the Great Depression. Unfortunately, you will find a great deal of inconsistency andcontradiction in the explanations. For example, there are some who define the cause in terms ofmisguided steps to return the world to a monetary gold standard. There are others who lay the blameon decisions by nations to move off the gold standard. The economic scientists in these opposing campsroutinely use impolite language to refer to those of differing opinions so it is unlikely that the alternativeperspectives can be reconciled into a consistent view.A cursory review of the titles found on Amazon quickly identifies at least 10 sharply contrasting views onthe cause of the Great Depression. Those 10 different explanations are from just the first two pages ofhits and include “sunspots.”Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 11
  12. 12. Although economic science can, at some level, explain the cause of the Great Depression, the results ofthis test are discouraging in the sense that the various explanations should at least be consistent if notidentical. But this approach to evaluating economic science’s explanatory power might beunreasonable. The macroeconomic view taken might be too broad in scope. Instead, let us focus on amore practical, microeconomic application - explaining why large corporations fail.Every year in the United States, hundreds of thousands of companies fail and declare bankruptcy.Focusing on a few of the largest corporate failures in US history, we have: - Lehman Brothers, bankruptcy filed on 9/15/2008, assets: $691B - Washington Mutual, bankruptcy filed on 9/26/2008, assets: $327.9B - Worldcom, bankruptcy filed on 7/21/2002, assets: 103.9B - General Motors, bankruptcy filed on 6/1/2009, assets: $91B - CIT, bankruptcy filed on 11/1/2009, assets: $71BNow let us ask the question, “Can economic science explain why any of these corporations failed?”Starting with the top of the list, using the Amazon approach, you will find the failure of Lehman Brothershas multiple explanations including: - Colossal failure of common sense - Betrayal - Financial market manipulation - Lack of government oversight - Excessive government oversightAgain it is clear that there is no consistency in the explanations. In fact, several are quite obviouslycontradictory. Certainly, there is no consistency in explaining the cause in terms of economic science.The same is true for all the other bankruptcy examples.In contrast, if you go to and search for the article, “List of bridge failures,” you willfind a table listing bridge failures. For each incident in the list, there is a field specifying the cause of thefailure. For example, the Green Island Bridge in Troy, NY collapsed on March 15, 1977. The cause isspecified as, “Flooding undermined the lift span pier resulting in the western lift tower and roadbedspan of the bridge collapsing into the Hudson River.” For every instance of bridge failure, there is aclear, unambiguous causal explanation.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 12
  13. 13. It would seem that modern economic science has failed the “explanatory power” test. We will forgodeclaring a definitive conclusion for the moment and instead take up consideration of “predictivepower.”What is the predictive power of modern economic science?Ronald Reagan was the President of the United States from 1981 to 1989. Under his administration, theUnited States budget deficit ballooned to historical highs. According to modern economic science, largebudget deficits inextricably result in an increase in price inflation.Unless, of course, they do not. Economic science also predicts that inflation is a function of monetarypolicy – how much money is pumped into, or removed from, the economy by the central bank.So, in summary, economic science predicts that the result of President Reagan’s large budget deficitsshould be an increase in the rate of price inflation unless the budget deficit is offset by a tightening ofmonetary policy.Price inflation actually decreased during President Reagan’s administration. Therefore, economicscience would predict that monetary policy was tightened.It was not.Ronald Reagan’s administration ran huge budget deficits while at the same time the Federal Reserveimplemented a relaxed monetary policy. Economic science predicts that this situation should lead toincreased price inflation. Again, price inflation went down during the Reagan administration, from over11% in 1981 to under 2% in 1987.More recently, late in the first decade of the 21st century, the US government increased the annualbudget deficit to over $1,000,000,000,000. (In case you lost track of all the zeros, that number is onetrillion dollars.) Simultaneously, the Federal Reserve dropped interest rates to historical lows.And that is what caused the rampant price inflation of 2010.Only, there was no rampant price inflation in 2010. The biggest concern in 2010 was price DEFLATION!(Quick! Go check what your house is worth!)It would thus appear that modern economic science’s predictive power is on an equal footing with itsexplanatory power.If you have any remaining doubts, consider the following. During “earnings season,” anxious businessanalysts join conference calls to hear publicly traded companies announce their latest results. A hugepercentage of the announcements are “surprises.” In the third quarter of 2010, over 88% of theannouncements constituted “surprises.” If the predictive power of economic science was on a par withNewtonian Physics, an “earnings surprise” would be a far less common event.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 13
  14. 14. By now, the point should be clear – modern economic science has limited power as a tool forexplanation and prediction. It does not really matter how this compares with Newtonian Physics, thepoint is that economic science can, and should, be advanced and improved.Although it is reasonable to conclude economic science has not advanced in a manner comparable toNewtonian Physics, it may not yet seem relevant to you. The discussion has focused on abstract issueslike money supply and inflation and, if you still have a job and your house is still worth more than yourmortgage, these issues may not seem relevant to the economic issues you face daily.As mentioned at the beginning of this chapter, the relevance of any science is based on its ability toproduce solutions. Clearly we have seen that the explanatory and predictive power of moderneconomic science is not comparable to Newtonian Physics. The obvious implication is that moderneconomic science is inadequate for solving problems that are relevant to you. These problems thatmodern economic science fails to solve include; - Successfully managing the financial performance of companies - Designing effective supply chains - Efficiently managing a department of a company - Correctly pricing a product - Anticipating market demand and competitive response - Predictive modeling for budgeting - Managing the national economy to minimize unemployment while maintaining negligible price inflation - Many, many more…In contrast, IBP addresses all these issues by establishing a scientific basis for principled approaches todesigning, engineering and managing solutions to economic problems. The next section discusses a keyelement of the principled approach, the need for an integrated perspective for decision analysis.The Need for an Integrated Perspective for Decision AnalysisEngineering is the process of using scientific knowledge to design, build and manage solutions.Conventionally, we think of engineering in terms such as “mechanical engineering,” “electricalengineering,” or “aeronautical engineering.”Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 14
  15. 15. As with all other sciences, economic science is broadly used as the basis for a wide range of solutions.However, we usually do not think in terms of “economic engineering.” The reason for this is that theword “engineering” suggests a level of precision and robustness that does not exist in solutions basedon current economic science. As a consequence of the failure of its explanatory and predictive power,solutions based on economic science are universally heuristic in nature. This issue is addressed formallyin subsequent chapters. For now, you can think of the word, “heuristic” as implying, “unreliable andinaccurate” and it is important to understand that, because of this heuristic nature, it is not possible toaccurately predict the performance of any solution based on current economic science. In someinstances, solutions might have positive benefits. Under other circumstances, those exact samesolutions might have negative consequences.Again, specific details will be addressed formally in subsequent chapters. For now we will focus on onespecific, conceptual issue – the need for an integrated perspective for decision analysis.As a basis for discussion, consider a small company, the Candy Company, that makes candy. The CandyCompany has a department, “Procurement,” that buys ingredients; a department, “Production,” thatproduces finished candy products; a department, “Sales,” that sells candy; and a “Finance” departmentthat manages the company’s money.The Procurement managers have been told to minimize the cost of the ingredients. The Productionmanagers have been told to maximize capacity utilization. The Sales managers have been told tomaximize unit sales. The Finance managers have been told to minimize cost and maximize the return oncapital. Each of these managers uses one or more solutions to support their decision analysis processes.These processes are managed independently of one another.Before further consideration of the Candy Company, let us revisit the bridge metaphor. Imagine we hadthree groups of engineers building a bridge. The first is responsible for aesthetics and is told to makethe bridge visually appealing. The second is responsible for maximizing the traffic flow over the bridge.The third has been told to minimize the cost of materials. The result of their efforts is shown in thefigure below.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 15
  16. 16. For maximum impact, it is hoped that you will agree the resulting bridge is a mess. If you do not, pleasenote that due to inadequate attention to basic design principles, the bridge collapsed due to the weightof a flock of pigeons roosting on the left-most tower.The point is simple and obvious. It is not possible to design a bridge by decomposing the process intoindependent activities that have no interaction with one another. No competent engineer would everengage in a process where the decision analysis associated with a project was managed in such a way.Instead, design, engineering and management processes must be coordinated based on a unifyingobjective they are all attempting to achieve.How can the person designing the trusses determine how to distribute the compression forces from thesuperstructure if the person designing the superstructure is doing so independently? And what aboutthe forces from the roadbed? How much traffic is the bridge intended to support? What is the averagetraffic per day? Per hour? What is the expected maximum weight it is expected to support?If you want a bridge to function successfully, the people designing, building, and operating it must do soin an integrated, coordinated way. It would be foolish for engineers to try to make design decisionsabout a bridge in isolation.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 16
  17. 17. Yet, that is the definition of modern economic analysis.Today, decision support solutions invariably take a silo approach where activities within a silo areevaluated independently of activities in other silos. Returning to the Candy Company example, theProduction managers have been told to maximize capacity utilization. There is no reason to believe thatthe decisions that result in maximizing capacity utilization will be consistent with the objectives of theProcurement managers who have been told to minimize the cost of the ingredients. For example, if aProduction manager succeeds and increases capacity utilization, it is likely that this will result in anincrease in procurement costs. Such a scenario is common in industries where inputs have upwardsloping cost elasticity curves, or “cost response functions.” In other words, if the cost of an inputincreases with the quantity consumed, increasing capacity utilization can increase procurement costs.An example of such a cost response function is shown in the figure below. The price of the inputmaterial is shown on the Y axis and the quantity purchased is shown on the X axis. In most processmanufacturing industries, the general shape of the cost function shown in the diagram is considered thestandard shape of all cost response functions. One of the reasons for this can be easily understood interms of transportation cost. With each incremental unit of input, the transportation cost per ton ofinput increases due to the fact that all the locally available input material has been consumed and it isnecessary to bring in the additional material from sources that are further away.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 17
  18. 18. Similarly, the objective of the Sales managers, to maximize unit sales, is likely to conflict with theobjective of the Finance managers who have been instructed to maximize profit. In general, sellingmore units requires dropping price. As we have already seen, increasing production is likely to increasecost. Therefore, the obvious strategy of a Sales manager – to increase unit sales by dropping price – willhave the unintended consequence of increasing cost and, almost certainly, the ultimate impact will befelt in terms of reduced profits.These problems exist even within a department or division. Consider the following figures thatrepresent process steps in a supply chain. Each of the steps constitutes a silo in which decisions aremade independently of decisions in all other silos. Conventionally, each manager is given a mandate tominimize the costs within their silo.The typical result is shown in the figure below. Each silo manager responds by pushing cost out of theirsilo. Though not always the case, it often happens that the net effect is to increase overall cost.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 18
  19. 19. The “integrated” aspect of IBP is formalized in subsequent chapters but its importance is such that it ispresented here at a conceptual level. This is a theme that will be stressed throughout this book. Thegoal of IBP is to integrate all decision making in a single, unified perspective. Unfortunately, in mostcases, this is not a practical goal. Because of this, “integrated” decision analysis should be understood tomean analysis that spans multiple decision silos.Ultimately, the critical consideration is that, in order for economic science to achieve the predictive andexplanatory power of Newtonian Physics, the analysis must take a more integrated perspective thancurrent economic science supports.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 19
  20. 20. Integrated Business Planning Basic DefinitionsThe purpose of IBP is to establish an economic science with explanatory and predictive powerscomparable to Newtonian Physics. In so doing, IBP will establish a principled design, engineering, andmanagement framework for a new generation of high-value solutions.This chapter defines key elements that will be used to formally define the science of IBP and theengineering methods it enables.EnterpriseNewton defined the Law of Universal Gravitation and the Three Laws of Motion in the context of themotion of objects in the physical universe. Their purpose was to establish a foundation for explainingobservations and predicting consequences of actions. Newton expressed observations and predictedconsequences in terms of force, mass and velocity.IBP is defined in the context of the enterprise and is intended to be used to explain observations ofenterprise behavior and to predict the consequences of enterprise activities. Enterprise activities willfrequently be referred to as “decisions” or “actions.” These three terms will be used interchangeablythroughout this book. In this context, an enterprise is an organization of process activities that can bemapped to measurable operational and financial consequences. In IBP, observations and predictedconsequences will be expressed in terms of process activity, material/ energy balances, and financialresults.Examples of an enterprise include companies organized for commercial purposes, a department orfunction within such a company, a government or government agency, a service organization such asthe Red Cross or a hospital system or a school, a regional or global economy, a supply chain, or acompetitive market.Enterprise DiagramsAnyone who has studied physics is familiar with “free-body diagrams” such as the one shown in thefigure below. Free-body diagrams show the relative magnitude and direction of all the physical forcesConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 20
  21. 21. acting upon an object in a given context. The arrows in a free-body diagram reflect the magnitude anddirection of the forces acting on the object. Each force arrow in the diagram is labeled to indicate theexact type of force.The example diagram depicts four forces acting upon an object. Any number of forces can berepresented by a free-body diagram. The only rule for drawing free-body diagrams is to include all theforces that are acting on an object in the given context.IBP uses an analysis approach analogous to free-body diagrams called enterprise diagrams. An exampleof an enterprise diagram for a steel mill is shown below. Enterprise diagrams show the flow of all theprocess activities associated with an enterprise in a given context. In effect, an enterprise diagramshows the financial and operational forces acting on an enterprise in a given context. Enterprisediagrams will be used to explain IBP concepts and to perform IBP analyses. The direction of the links inan enterprise diagram represents the flow of process activity. There can be any number of objects andlinks in an enterprise diagram.Interpreting enterprise diagrams is intuitive. In the steel mill example, “Hot Strip” is being purchased,stored in inventory, and processed in a “Pickling Line.” “Pickled Strips” can then flow in one of fourdirections; to a “Cold Reverse Mill,” to “Galvanization,” to a “Tempering Mill,” or to a “Finishing Line.”Pickled Strips that are galvanized are subsequently processed in the Finishing Line. Pickled Strips thatare processed in the Cold Reverse Mill can then flow to Galvanization, to “Batch Annealing,” or to theFinishing Line. Eventually, “Finished Inventory” can flow to one of three markets, “North,” “South” and“West.”The steel mill model contains a freestanding object called, “Financial Report.” In this enterprisediagram, the financial consequences of the process activities are mapped to the Financial Report object.Enterprise diagrams are used throughout this book to demonstrate concepts, to capture knowledge andto perform analyses. In general, enterprise diagrams are intuitive to build and interpret.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 21
  22. 22. Basic Elements of Enterprise DiagramsConceptually, enterprise diagrams are based on network flow models that are widely used inmathematics and engineering. Network representations are commonly used in mathematical analysis ofbusiness processes in the fields of Operations Research and Management Science. They are popularbecause they are easy to learn and intuitive to understand and because it is commonly accepted thatany business process can be represented with a network flow model. Network representations consistof two simple elements, nodes and links. Some nodes are customized to represent the beginning of aflow through a network and are referred to as source nodes. Other nodes are customized to representthe termination of a flow and are called sink nodes.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 22
  23. 23. Nodes are commonly referred to as “objects” and that convention will be used throughout this book.Enterprise diagrams are a specialization of network representations. Enterprise diagrams consist of fourtypes of process activity objects; purchase, inventory, conversion and sales. In addition, a fifth type ofobject called a financial report is used to represent financial consequences. A very important aspect ofenterprise diagrams is that the objects and links have semantic meaning relevant to enterprises.The objects used to define enterprise diagrams, as well as their semantic meanings, are defined in thefollowing subsections. Using these simple objects and links representing flow between them, it ispossible to construct an enterprise diagram of any organization.PurchasePurchase objects are a variant of source nodes in network models and are used to represent the processof acquiring something from outside the enterprise. Purchase objects are so named to clearlydifferentiate the intuitive semantics they imply from generic sources nodes.InventoryInventory objects are intermediate nodes used to define materials and physical storage. Inventoryobjects can be used as source and/ or sink nodes in enterprise diagrams to indicate process flows thatbegin with existing inventory or that terminate with ending inventory.ConversionConversion objects are intermediate nodes used to represent the transformation of a flow of material aswell as the delivery of services and the use of resources in the transformation process. The semantics ofconversion processes are such that it is necessary to differentiate these intermediate nodes fromInventory objects. Conversion objects can also be used as source or sink nodes.SalesSales objects are a variant of sink nodes and are used to represent output sold and delivered tocustomers. Sales objects are so named to clearly differentiate the intuitive semantics they imply fromgeneric sink nodes.Financial ReportFinancial Report objects can be used as source, intermediate and sink nodes for financial flows. Inenterprise diagrams, process activity is mapped to Financial Report objects. It is very important to noteConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 23
  24. 24. that Financial Report objects are not merely used to report consequences. They are integrated in theflow of process activity and financial consequences and can be used to constrain both.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 24
  25. 25. The Law of Universal Marginal Economic Analysis – The Basis for theScience of Decision MakingHank Morgan was the superintendent of a manufacturing enterprise. He understood the principles ofNewtonian Physics and Classical Mechanics quite well. In Mark Twain’s novel, “A Connecticut Yankee inKing Arthur’s Court,” Hank is magically transported back in time to the 6th century. In the story, HankMorgan leverages his superior knowledge to become “Boss,” take over medieval England, and transformit to his liking. Because of his superior knowledge, he is able to defeat all his enemies, achieve greatrenown, and be held in high esteem.It‘s fun to imagine being in a similar situation – one in which you have knowledge that gives you adecisive competitive advantage over everyone else. It goes without saying that you would use suchpower only for good! If you understand the concepts presented in this chapter, you will have such knowledge. The decisivecompetitive advantage you will gain will be dramatically improved decision making. This chapter willhelp you understand why so many enterprise planning decisions turn out to be mistakes, how to avoidmaking similar mistakes, and how to correctly evaluate alternative courses of action in order to makethe correct decisions.In general, the purpose of economic analysis is to serve as an aid in decision making by evaluating thepotential merit of each alternative course of action. Today, all economic science is based on the conceptof the marginal analysis, or the marginal value, of decisions where, “Marginal analysis, quite simply,balances the additional benefits from an action against the additional cost.” (From microeconomicwebnotes by Dr. Robby Rosenman, School of Economic Sciences, Washingtion State University.)Mathematically, the marginal value of an action A, “MVA” is defined as: MVA = (incremental benefit of A) – (incremental cost of A)This is the universally accepted definition of marginal value. It is used in virtually every economics textbook and it is the basis for all existing analytical tools and is especially relevant to the concept ofContribution Margin.It is, unfortunately, problematic. The nature of the problem corresponds closely to issues Isaac Newtonfaced.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 25
  26. 26. Newton’s Law of Universal Gravitation is the centerpiece of Newtonian Physics and it directly addressesproblems in the widely accepted theories of his predecessors and contemporaries. It is helpful to reviewhow Newton resolved those issues because his approach is directly relevant to IBP.Have you ever heard of Johannes Kepler? Prior to Newton, Kepler defined Laws of Planetary Motion.He was a remarkable individual of immense intellect. You could easily make an argument that he wasone of the greatest scientists and mathematicians of all time. But there aren’t any amusing anecdotesinvolving fruit that anyone remembers about Kepler. His silhouette doesn’t appear on the cover of anyhomework packets. Very few people remember ever hearing his name. The reason no one remembersKepler is because his Laws of Planetary Motion were flawed in ways analogous to the flaws in theprevailing definition of marginal value.Kepler’s Laws of Planetary Motion are impressive in that they come very close to predicting themovement of planets. One of the issues is that their utility for explaining the root cause of planetarymotion, and, more importantly, the motion of any large object, is negligible. The other issue is thatalthough they are pretty good, they are not accurate enough to be used for predictive modeling. Theirpredictions for planetary motion are incorrect in ways that cannot be adjusted in some standardmanner.The figure below is a graphical representation of Kepler’s laws. Like Newton, Kepler defined three laws,but his laws only define the relationship between each planet and the Sun. Kepler’s laws do not definethe relationships between each planet and all the other planets. This is an important point. But evenmore importantly, Kepler’s laws only explain how the planets move, they do not explain why. His lawscannot be used as a foundation for a system of causal analysis. In other words, Kepler’s laws have nopredictive or explanatory power.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 26
  27. 27. Newton’s Law of Universal Gravitation corrected flaws in Kepler’s approach and established a basis forcausal analysis that is still used today. Newton’s approach differed from Kepler’s in that it first definedthe causal mechanism – gravity – that explained observed phenomena and then predicted expectedbehavior as a causal effect of gravity. A critical aspect of the Law of Universal Gravitation is that itdefines the interactive force between every physical body and every other physical body.Thus, there are two critical flaws in Kepler’s system – it does not provide for systemic considerations andit makes no provision for causal explanation. The problems with the definition of marginal value areidentical to those of Kepler’s system.More specifically, the definition of marginal value does not take into account the relevant context of thesystem in which benefits and costs are being determined.Consider the following situation in the context of the Steel Mill depicted in the enterprise diagramshown in the previous figure. Assume sales are being made of a range of products including PickledStrips and Cold Reverse Strips, both of which have been tempered in the Tempering Mill. In addition,assume the Tempering Mill is at maximum capacity. What is the marginal value of selling one more tonof Pickled Strips that have been tempered?Based on the prevailing definition of marginal value, this would be:marginal value = revenue(1 ton of tempered Pickled Strips) – cost(1 ton of tempered Pickled Strips)This may seem reasonable but consider the shortcomings of Kepler’s approach. He did not take intoconsideration the effect planets have on one another. His system defines planetary motion solely interms of the Sun and each individual planet. Because of this, predictions of planetary motion based onKepler’s laws are incorrect. Predictions of financial consequences made using marginal analysis (orcontribution margin) are incorrect for the same reason!Furthermore, marginal value calculations are incorrect in ways that cannot be corrected using somestandard method. They are not incorrect in a directional manner such that you could say, “marginalvalue calculations are always a bit too high” or “marginal value calculations are always a bit too low” or“marginal value calculations are always within 5% of actual.” Instead, all we can say is that marginalvalue calculations are incorrect. They might be too high, they might be too low, they might be negativewhen we think they are positive, and they might be incorrect by a significant amount or only by a smallpercentage.With respect to the Steel Mill, in order to determine the marginal value of selling one more ton oftempered Pickled Strips, we need to understand the implications not only in terms of the cost andbenefits of that specific action, but also in terms of the impact it will have on other activity. Since theTempering Mill is at maximum capacity, if we sell one more unit of tempered Pickled Strips, we will nothave enough capacity to process all the other activity that was occurring in the Tempering Mill. For thepurpose of this example, let us assume this means we have to reduce the amount of Cold Reverse StripsConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 27
  28. 28. we temper by one ton. This means we will need to reduce the sales of tempered Cold Reverse Strips byone ton and forfeit the marginal value of that action.Now we can recalculate the marginal value of selling one more ton of tempered Pickled Strips byadjusting for the loss of the marginal value of one ton of tempered Cold Reverse Strips:marginal value = revenue(1 ton of tempered Pickled Strips) – cost(1 tone of tempered Pickled Strips) - marginal value(1 ton of tempered Cold Reverse Strips)The potential magnitude of this problem can be understood if we instantiate our example with someactual numbers. For the sake of argument, assume the revenue from selling one more ton of temperedPickled Strips is $300 and the cost of selling one more ton is $200. Given this, selling an additional ton oftempered Pickled Strips has a marginal value of $100 and might appear to be a fortuitous event. Butwhat if the marginal value of selling a ton of tempered Cold Reverse Strips is $50? Then the net value ofthe fortuitous event drops by 50%. i.e., we have to subtract the marginal value of Cold Reverse Strips,$50, from the marginal value of tempered Pickled Strips, $100, leaving a net of $50.Even worse, what if tempered Cold Reverse Strips have a higher marginal value? What if their marginalvalue is $300/ ton? In this case, the marginal value of selling an additional ton of tempered PickledStrips is not $100 – it’s $100 - $300 = -$200, or negative two hundred dollars!This example was intentionally simplified. In real enterprises, production rates can vary dramaticallyand this can exacerbate the problem of determining marginal values. For example, what if theproduction rate for tempering Cold Reverse Strips was much faster than that for tempering PickledStrips? What if the rates differed by a factor of three? In this case, in order to make an additional ton ofPickled Strips, the Steel Mill has to make THREE fewer tons of Cold Reverse Strips. If we assume themarginal value of the Cold Reverse Strips is only $50, we again end up with a negative marginal value:$100 – (3 * $50) = -$50.By expanding the definition of marginal value to include consideration of the systemic impact of anaction, one of the problems with the prevailing definition of marginal value is corrected and we gain anintegrated perspective. This is analogous to one of the issues Newton addressed in Kepler’s systemwhen he defined gravity as a force that exists between all bodies, not just between the Sun and anindividual planet.It is extremely important to note that, in general, building a suitable mathematical representation ofinteracting systemic effects is an extremely difficult task. For the vast majority of IBP analyses, it will notbe necessary to build the mathematical representations manually nor will it be necessary to have adetailed understanding of the specific mathematical techniques and manipulations used. The importantpoints to know and understand are the key concepts. For analysis, software built specifically for IBPConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 28
  29. 29. analysis will be used and it will not be necessary to understand the mathematical details any more thanit is necessary to understand how electrical circuits work on silicon chips in order to use a pocketcalculator to calculate mortgage payments.The second issue that needs to be addressed is causality.Kepler only mapped out how planets move. He never addressed why they move in a manner that couldbe used for general purpose analyses of physical systems. Kepler’s system is incapable of explaining whythings happen in a causal way or accurately predicting consequences. The same is true for the definitionof marginal value.In terms of our Steel Mill example, we need to understand the causal factors underlying thedetermination of marginal value. More specifically, when we force one more ton of tempered PickledStrips to be sold, what caused us to make and sell one less ton of tempered Cold Reverse Strips?Perhaps we could have expanded capacity in the Tempering Mill by adding an overtime shift? Or maybewe could have increased the process rate in the Tempering Mill? Perhaps we could have purchased aton of tempered Cold Reverse Strips from a competitor and substituted it for our own production?In IBP, we address causality through the mathematical optimization of an objective function. In thecase of the Steel Mill, the decision to make and sell one less ton of tempered Cold Reverse Strips wascaused by the optimization of the objective function, “maximize profit.” In other words, the decision tomake and sell one less ton of tempered Cold Reverse Strips was the decision that maximized the SteelMill’s profit. If we had instead added an overtime shift or pursued any other option, it would haveresulted in a smaller profit. In general, any objective function can be used provided the terms in theobjective function can all be measured in the context of the enterprise. For example, any of thefollowing can be used as objective functions: - Optimize (or maximize) profits - Optimize (or maximize) cash flow - Maximize unit sales - Optimize profits subject to minimum sales growth of 2% - Maximize unit sales subject to minimum cash flow requirementsWe can now define the Law of Universal Marginal Economic Analysis in terms of the OpportunityValue™ of an action, A, as well as all activities B and C where A’s impact on B results in a decrease inbenefit and where A’s impact on C results in an increase in benefit.For action A, the Opportunity Value, “OppValA”, is calculated as: OppValA = OPTobj ((marginal benefit of A) – (marginal cost of A)Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 29
  30. 30. – (Sum (OppValB for all actions B displaced by action A) + Sum (OppValC for all actions C enabled by action A)) Where OPTobj is a mathematical optimization function subject to the objective function “obj”.In other words, the Opportunity Value of activity A is the optimal, net economic impact of A, taking intoconsideration all the systemic implications A has on every other possible activity in the enterprise.The above definition is mathematically precise. If it seems unintelligible, the textual definition issufficient for all further purposes. For the remainder of this book, we will make little explicit use of thisformal definition for one very simple reason – it is heinously difficult to compute manually. Instead, theanalyses presented here will be generated by River Logic’s Enterprise Optimizer software application.For most practical purposes, it will be necessary for IBP analysis to be performed on software specificallybuilt for that purpose. It is not technically feasible to use applications such as spreadsheets, simulationtools, OLAP tools, or statistical analysis packages to perform IBP analyses. To understand why this is,please note that the definition is self-referential; the Opportunity Value of A is defined in terms of theOpportunity Value of B, and the Opportunity Value of B is defined in terms of the Opportunity Value ofA. In order to solve problems of this type, it is necessary to solve a system of simultaneous equations(or “system of equations”). While it is possible to manually build and solve systems of equations usingtools such as spreadsheets, it is only practical to do so for small problems. IBP problems can easilyrequire millions of equations with millions of variables in each equation. Such problems are well beyondthe scope of conventional analysis tools.The “matrix method” is a commonly used approach for solving systems of equations that is well-suitedfor IBP analyses. Because of this, IBP practitioners often use the phrase, “the matrix” to describe themathematical representation of an IBP problem.For clarity, the phrase Marginal Economic Analysis will be used to differentiate the analyses performedin IBP from the conventional definition of marginal analysis. Similarly, Opportunity Value will be used todifferentiate the result of IBP analysis from conventional marginal values and contribution margins.In summary, all modern economic analysis and all decision science is based on a definition of marginalvalue that is flawed in the sense that it does not take into consideration systemic implications nor doesit support causal explanations. As such, it cannot be used to explain enterprise behavior or predictfuture consequences. The Law of Universal Marginal Economic Analysis addresses these flaws anddefines Opportunity Value in such a way that IBP analysis can provide causal explanations of enterprisebehavior and accurately predict the consequences of a decision.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 30
  31. 31. Opportunity Value versus Marginal Value ImplicationsOver 40 text books were reviewed during the preparation of this book. Every one of them used adefinition of marginal value that is virtually identical to the one used here. In addition, every one ofthese text books defined contribution margin in terms of marginal value.If you are a business manager, executive or analyst, you are familiar with contribution margins andmarginal value and you have probably calculated or used them in a business process. If you read andunderstood the passages above, you might be thinking some or all of the following; - “I am not sure I understand – is this really suggesting that the computation of marginal value is incorrect?” - “This cannot mean what I think it means – this is suggesting that the very basis for all economic analysis is incorrect. How can that be possible?” - “I have been using contribution margin to make decisions for many years, does this mean I have been making decisions based on incorrect information?”In a sense, the answer to all these questions is, “yes.” However, we need to keep in mind that we aredealing with a definition. Definitions should not be thought of as “correct” or “incorrect.” Instead, theyshould be evaluated in terms of whether or not they are useful. Therefore, the correct question to ask isthis, “When is the definition of marginal value or contribution margin useful?”Think of this question in the context of Newtonian Physics. You could argue that Newton, like Kepler,was wrong. Albert Einstein, among others, demonstrated that Newtonian Physics is “wrong” in thesense that it is not the best available model for explaining and predicting the behavior of the physicaluniverse. Even Newton realized the representation of the universe he defined was merely a model ofreality and not reality itself and he consequently spent many years adjusting and improving his theorieson the structure of the natural world.So the question is not whether or not Newtonian Physics is “correct.” The question is, “When isNewtonian Physics useful?”With respect to marginal value and contribution margin, they do have uses. These uses will be discussedin subsequent chapters and include validating enterprise diagrams, making long-term pricing decisions,and reporting financial results for past activities.This leads us to the statement of the first of several General Principles that will be presented.General Principle I – All decisions are about the future.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 31
  32. 32. Given this general principle, it is clear that any form of analysis used to support decision making must bebased on some form of accurate, predictive modeling. This is a key point and its importance cannot beoverstated – marginal value and contribution margin should not be used as the basis for any form ofdecision support related to planning as defined here. In contrast, IBP has very powerful predictivemodeling capabilities and is well-suited for use as the basis for an extremely broad range ofmanagement solutions.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 32
  33. 33. The Three Laws of Integrated Business PlanningA long-standing goal of economic research is the development of empirical methods comparable toNewtonian Physics. To date, progress has been made but it has been limited and it has failed in terms ofadequately providing a foundation for building solutions.The Law of Universal Marginal Economic analysis addresses a critical shortcoming by defining a basis forcausal explanation and predictive analysis. In Newtonian Physics, gravitation can be thought of as theprime mover that explains why there are forces and how to determine their magnitude. OpportunityValue plays this role in IBP by explaining why there is enterprise activity in terms of economic forcesdefined by an objective function.In this chapter, the Three Laws of Integrated Business Planning are presented. Each is directly analogousto the corresponding Newtonian law of motion. These laws complement the Law of Universal MarginalEconomic Analysis and establish a basis for designing, engineering, and managing solutions. InNewtonian Physics, the Three Laws of Motion define the analytical framework that is ClassicalMechanics. The Three Laws of IBP establish a corresponding framework for economic analysis of theoperational and financial forces acting on an enterprise at a micro- or macroeconomic level.First Law of IBPNewton’s First Law states that every physical body remains in a state of rest or uniform motion unlessacted on by an external force. The purpose of this law is to establish a frame of reference forsubsequent analysis. So, for example, a frame of reference might be, “my daughter is holding myfavorite coffee mug,” and the analysis might be, “what will happen if she drops it?”The IBP analog is,First Law of IBP: enterprise process and financial activity will remain constant unless acted upon by anexternal process or financial action.As with Newton’s First Law, the First Law of IBP establishes a framework for analysis by establishing abasis for validating IBP models and frame of reference for evaluating changes to the enterpriseassociated with decisions or actions of some kind.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 33
  34. 34. Consider again the Steel Mill enterprise diagram. How do we know if it is correct? How do we testwhether or not it is an accurate representation of the process activity and financial consequences of theactual Steel Mill?The First Law of IBP is stating that we can establish a frame of reference for further analysis by validatingthe enterprise diagram against actual data taken from a historical period. In other words, the historicalperiod can be thought of as a “constant” and we can use the enterprise’s actual process and financialactivity to calibrate the enterprise diagram such that it produces identical results.Examples of the validation process for an enterprise diagram will be given in subsequent sections. Aswill be discussed, the actual validation process is more involved than what is suggested here and willinclude sensitivity analyses and other validation methodologies. The key point, however, is thathistorical data can be used to establish a frame of reference for IBP analysis.The First Law of IBP is also stating that, once the frame of reference is established, it can be used toanalyze decisions. Again, we use the words, “decision,” “action” and “activity” interchangeably to meaneffectively the same thing – a change to the enterprise. It is important to stress that the First Law of IBPdoes not indicate what kind of subsequent analyses can be performed. In fact, the First Law of IBP doesnot in any way limit the kinds of analyses that can be performed.This is an important aspect of IBP analysis. There is no restriction on the analyses that can be performedrelative to the changes acting on an enterprise. For example, in terms of the Steel Mill enterprisediagram, potential IBP analyses can include all of the following: - What is the impact of increasing sales in the North region? - What would happen to finances if prices drop 10%? - What would happen to operation process activity if we limit the value of WIP we keep in inventory? - What would the impact be if we replaced the current Tempering Mill with new technology? - What is the best way to allocate $100M of capital? - How should we respond to a competitor’s price reduction in the North market? - Any and every combination of the above…The unrestricted nature of the analyses that can be performed with IBP may be counterintuitive forusers of existing methodologies or tools such as spreadsheets, statistical or simulation packages, orOLAP tools. Using spreadsheets as an example, in order to analyze a particular decision, it is necessaryto build a specific model. If a different decision is analyzed, it will be necessary to build a completelynew spreadsheet model. In terms of the questions above, a spreadsheet model capable of analyzing thefirst question will be inappropriate for analyzing capital expenditures.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 34
  35. 35. In contrast, in IBP, a single enterprise diagram can be used for unlimited types of analyses. Any decisionthat is represented in the context of the enterprise diagram can be analyzed. It is not necessary tochange the enterprise diagram to accommodate any particular analysis.The distinction is that IBP is a science; it is not merely a narrow analytical approach suitable foraddressing a specific issue in a specific manner. Rather, IBP defines the natural structure of the“enterprise” domain such that any and all relevant forms of analysis can be performed.In more formal terms, we say that in IBP, variables have “infinite degrees of freedom.” Any variable canrepresent either a fixed input or a decision variable to be solved for. More importantly, anycombination of variables can be used to specify the input set and any combination of variables can beused to define the set of decision variables that are to be solved for. In IBP, there is no restrictionwhatsoever on the input variables or the decision variables. Rather, IBP defines HOW to determine asolution, virtually ANY solution, given a problem defined in terms of an enterprise diagram, an initialstate, and a set of input constraints.As will be discussed in a subsequent chapter, this is an economic analysis paradigm that providesanalytical power comparable to that of the many engineering disciplines that are rooted in NewtonianPhysics.It is also important to point out that there are many software applications that use a graphicalrepresentation as a means for specifying mathematical analyses. Enterprise diagrams are quitedifferent. Enterprise diagrams explicitly represent the structure of an enterprise in terms of the flow ofprocess and financial activity – effectively all the forces acting on the enterprise. While the enterprisediagram itself does not represent any particular mathematical analysis, every possible mathematicalrepresentation or analysis of the enterprise can be derived from a validated enterprise diagram.More formally, we say that, in IBP, the enterprise diagram defines the problem(s) to be solved in termsof intuitive domain constraints. This terminology will be revisited, expanded and clarified throughoutthe remainder of this book. For now, it is important to stress that when reference is made to,“Constraint Oriented Reasoning,” this is what is meant. In other words, Constraint Oriented Reasoning,or “COR,” is a process whereby problems are expressed in terms of the natural, intuitive domainconstraints, and problem solving involves a knowledge-based interpretation of the constraintrepresentation that is used to automatically determine the problem(s) to be solved and to thenautomatically build and execute an algorithm to solve the problem(s).Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 35
  36. 36. Second Law of IBPThe purpose of IBP is to bring a level of understanding to decision making that enables us to explainobserved phenomena and predict the consequences associated with any particular decision. The FirstLaw of IBP establishes the necessary frame of reference. The Second Law of IBP establishes the basis forevaluating a decision by specifying the impact that decision has on the enterprise.The Second Law of IBP corresponds closely to Newton’s Second Law which defines the impact of a forceapplied to a body in a given frame of reference. Newton’s Second Law is simple to state mathematicallyas, F=ma, or “force equals mass multiplied by acceleration.”The IBP analog is defined in terms of the Activity, A, associated with a decision.Second Law of IBP: 1. The financial consequence, F, of an activity, A, is the product of A, cost, C, and a financial transaction vector, T, or F=ACT. 2. The Input, I, of an activity, A, is the product of A and a distribution vector, D, or I=AD. 3. The Output, O, of an activity, A, is the product of A and yield vector, Y, or O=AY.Very often, even the slightest application of mathematical nomenclature makes a simple definitionappear complex. Regardless of how it might appear, the Second Law of IBP is intuitive and easy tounderstand.For example, let’s analyze the decision, “How many apples should we buy?” Assume the cost of eachapple is $.25 and we have decided to buy 10 apples. In this case, the Second Law of IBP tells us thefollowing with respect to a corresponding “Purchase Apples” process: 1. F = 10* $.25; the cost of the apples is $2.50. 2. I = 10 * 1; 10 apples are input to the apple purchasing process. 3. O = 10 * 1; 10 apples are also output from the apple purchasing process.Please note that the relationships defined in the Second Law of IBP are with respect to a specificdecision or action. The aggregation of all the individual actions defines the enterprise balancerelationships. Enterprise balance relationships are addressed by the Third Law of IBP.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 36
  37. 37. The financial analysis in this example is simplified for explanatory purposes by ignoring the effects of thefinancial transaction vector. For now, a few additional details regarding financial transaction vectors willbe discussed but most details will be addressed through examples in later chapters.In general, the structure of financial transaction vectors corresponds to double entry accounting. So, forthe apple example, the activity of purchasing 10 apples actually results in a $2.50 debit to a costaccount, Net Purchases, and a $2.50 credit to an asset account, such as Accounts Payable or Cash.If you are not an accountant, or perhaps even if you are, this might seem overly complicated. The goodnews is that for all of the analysis examples in this book, the processing of financial transaction vectorswill be handled automatically. For the sake of clarity, wherever it makes sense to do so, financialtransaction vector details will be simplified and explanations will be given in more intuitive terms.Now consider an incremental decision, “Should we use 10 apples to make apple cider?” Assume there isa variable processing cost of $2.00 to make apple cider. Now, with respect to a “Make Apple Cider”process, we have: 1. F = 1 * $2.00; the cost of making apple cider. 2. I = 10 * 1; 10 units of apples are input to process of making apple cider. 3. O = 1 * 1; 1 unit of apple cider is the output of the process.In both Newtonian Physics and IBP, it is easy to express the impact of a force or the consequences of anactivity. The difficulty lies in analyzing the impact of a force or an activity in the context of an enterprise.In the case of our apple related decisions, a full enterprise representation would involve combining thedecision regarding buying apples with the decision regarding making apple cider. While combining thetwo examples is a straight forward task, it does involve effort. For example, both decisions havecorresponding input and output variables. Minimally, these must be tagged in some manner to avoidconfusion. Keeping the tags properly sorted and understood is relatively easy with only two decisionsbeing considered. But real-world enterprises can (and do!) have millions of decisions that need to berepresented. Without modern software tools to automate the generation and processing of thesemathematical constraints, IBP analysis is virtually impossible.Driver-Based AnalysisA critical aspect of IBP, one that differentiates it from alternative analytical approaches, is that itexplicitly represents the causes of enterprise behavior. More specifically, IBP does not represent cost asan average value. Instead, IBP represents cost in terms of how the cost is actually incurred. This isreferred to as “driver-based analysis.” Newtonian Physics similarly requires driver-based analysis.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 37
  38. 38. In contrast, prevailing approaches to economic analysis are overwhelmingly based on the use of averagevalues, especially for costs and prices. The figure below is from a textbook definition of marginalanalysis. Recall from the previous chapter that the conventional definition of the marginal value ofactivity A, MVA, is; MVA = (incremental benefit of A) – (incremental cost of A)In the diagram above, it appears that the “Marginal Cost” function, labeled “MC,” can be closelyapproximated with a straight line. Therefore, current economic science uniformly argues thatdefinitions for “incremental benefit” and “incremental cost” can be accurately expressed in terms ofaverage values.This is a fatal mistake. Even if the prevailing definition of marginal value were suitable for predictivemodeling and causal explanation, which it is not as discussed in the previous chapter, the use of averagevalues for incremental cost and benefit would render it less than useless.This observation motivates the statement of the second General Principle.General Principle II – The only thing we know about average costing (and average revenue) is that it isincorrect.To emphasize this principle, consider the Steel Mill example used in the presentation of the Law ofUniversal Marginal Value where we added the production of one more ton of tempered Pickled Strips.There are no circumstances for which it is reasonable to expect the cost (or revenue) of the next ton tobe anywhere close to the average cost or revenue.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 38
  39. 39. - What if the next ton of production required the addition of an additional evening shift? A full shift of cost would have to be absorbed by a single ton of production! - What if the next ton required the addition of a weekend shift at overtime rates? - What if the next ton required the purchase of an entire shipment of coal that then had to be placed in inventory or discarded? - What if the next ton required the purchase of additional coal, but there was no coal available in the local market and it had to be imported at a cost 3x greater than that of the previously used coal? - What if the next ton of production increases carbon emissions beyond allowed limits and the enterprise incurs a $10,000,000 fine?It is widely known amongst experienced analysts that the use of average values in planning solutions is afatal mistake. Real-world cost functions do not look like the contrived graphs from textbooks. Real-world cost functions are much more likely to look like the figure below, which is based on real-worlddata and represents the incremental costs of admitting post-operative patients to an overnight stay in ahospital.In contrast to conventional economics, IBP’s driver-based approach means that, in the definition of theSecond Law of IBP, cost, distribution and yield, C, Y, and D, can be functions and not merely fixed,average values. For example, the figure below shows the cost elasticity function used previously. In thiscase, cost, C, is a function of the change in price, P, with respect to the change in quantity, Q.Mathematically, this is represented as:C = dP/dQConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 39
  40. 40. Thus, C can be thought of as the Cost Elasticity or the Cost Response Function. In the case where theactivity is a sales event, then C represents a “negative cost” and can be thought of as the “PriceElasticity” or the “Price Response Function.”The distribution and yield vectors, D and Y, should be thought of in similar terms.This is a critical aspect of IBP and it cannot be overemphasized. The driver-based nature of IBP analysisis a natural extension of the constraint-based manner in which problems are defined. In other words,using IBP, analysis is performed in terms of problems expressed as enterprise diagrams and constraintsassociated with variables such as, “100 tons of coal can be purchased at $2/ ton, an additional 60 tonscan be purchased for $2.25/ ton, an additional 75 tons can be purchased for $2.75/ ton, …” and so on.The First Law of IBP defines the frame of reference for analysis and the Second Law of IBP defines thedriver-based mechanisms for translating the enterprise diagram and the constraints into correspondingmathematical analyses. The Third Law of IBP defines how this is extended to integrated analysis.Before continuing further, it is necessary to clarify certain issues. In particular, in IBP analyses, it willoccasionally be advantageous or even necessary to use average values for variables representing cost ,revenue, process rate, etc. While this might seem a contradiction to General Principle II, thecontradiction is covered by the third General Principle.General Principle III – All universally quantified statements are wrong.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 40
  41. 41. For now, General Principle III will be left to stand on its own merits. If these are not readily apparent, donot be concerned. The will be explicitly addressed in subsequent chapters.Infinite Degree of FreedomTo conclude this section on the Second Law of IBP, we revisit the issue of “Infinite Degrees of Freedom.”Consider for a moment Newton’s Second Law which can be expressed mathematically as,F=ma, or “force equals mass multiplied by acceleration.”Given this definition, we can perform a variety of analyses. Obviously, if we know m, “mass,” and a,“acceleration,” we can calculate F. In addition, because of the mathematical transformation rules ofAlgebra, we also know that:m = F/ a, or “mass equals force divided by acceleration,” (Quick Algebra Review: This is derived bydividing both sides of the equation “F=ma” by “a” and flipping the terms on either side of the equal sign.The “flipping” is done to conform to commonly used conventions where the variable to be solved for ison the left of the equal sign. )We also know that:a=F/m, or “acceleration equals Force divided by mass.”This is an example of what is meant by “infinite degrees of freedom.” In other words, a methodology issaid to provide infinite degrees of freedom when it does not in any way constrain the problem to besolved to a subset of the overall representation. Newtonian Physics provides infinite degrees offreedom. In contrast, analysis methodologies such as Monte Carlo simulation, which is not an empiricalscience like IBP and Newtonian Physics, do not provide infinite degrees of freedom.Clearly, the Second Law of IBP establishes a similar framework for economic analysis in that it allows usto define any aspect of an enterprise model as the problem we are trying to solve. More specifically, theSecond Law of IBP is specified in three parts. As with Newton’s Second Law, each of the three parts ofthe Second Law of IBP can be mathematically transformed such that any of the variables can be definedin terms of the other variables.Furthermore, because the variable A appears in each of the three parts, the three parts are allinterrelated in such a way that Part 1, for example, can be transformed to solve for A and thensubstituted into Part 2 to solve for I. This would result in:Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 41
  42. 42. I = (F/CT)D. This is derived through multiple algebraic manipulations corresponding to the textualdescription above. More specifically, clauses 1 and 2 of the Second Law of IBP state F=ACT and I=AD.Clause 1 can be rewritten as F/CT=A by dividing both sides of the equation by CT. This result can beused as a replacement for the term A in the second clause to give I = (F/CT)D.For those readers who are excited about such things, it should be apparent how IBP establishes aprincipled foundation for engineering high-value business management solutions. This is a capabilitywith the potential to transform how businesses and economies are structured and managed.For those whose interests are not so inclined, please note that from this point forward, you will neveragain need to be able to perform or understand these algebraic manipulations in order to exploit thepower of IBP. All you need to understand is that with IBP, these algebraic transformations are possibleand you can leverage this power for decisive competitive advantage.Third Law of IBPNewton’s Third Law is commonly given as, “For every action, there is an equal and opposite reaction.”The IBP analog is,Third Law of IBP: 1. For every process activity, the material/ energy and financial flows associated with that process activity must balance. 2. For every enterprise diagram, the material/ energy and financial flows represented in the enterprise diagram must balance.In both Newtonian Physics and IBP, the purpose of the Third Law is to establish a basis for systemicanalysis.In terms of IBP, the Second Law defines a basis for analyzing all aspects of each element of an enterprisediagram. The Third Law defines how the balance constraints associated with the Second Law areextended throughout the enterprise diagram and the integrated system it represents. More specifically,the inputs, outputs, and financial consequences of any action are defined in terms of the inputs,outputs, and financial consequences of the interrelated actions and the Law of Universal Marginal Value.As an example, let’s look at three problems involving the Steel Mill example introduced previously. First,let’s ask the question, “For a given amount of available Hot Strip, what products should we make andsell to maximize profits?” For reference, the original enterprise diagram is shown below.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 42
  43. 43. For the initial problem we are trying to solve – determining the output that will optimize profit for agiven amount of input material – we can use the Second Law of IBP and apply it to the process activityrepresented by the object labeled, “Purch Hot Strip” to determine O, the output, and F, the financialconsequences associated with that action. We can then use the Third Law of IBP to mathematicallydetermine the input, I, to the process activity represented by the object labeled, “Hot Strip Inv.” Weknow the input, I, for “Hot Strip Inv” because we have determined the output, O, from “Purch Hot Strip”and because we know, based on the Third Law of IBP, that the output from “Purch Hot Strip” mustbalance the input to “Hot Strip Inv.”Conceptually, the balance constraints related to the Third Law of IBP propagate through the enterprisemodel as shown below. The large green arrows show the Input Constraints and the associated Solution.The smaller yellow arrows show how the mathematical constraints implied by the Third Law of IBP flowthrough the enterprise diagram. For each of the yellow arrows, the inputs to the next step(s) in theprocess flow are specified by the output of the previous step(s).Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 43
  44. 44. Now let’s consider a second problem, “For a fixed sales mix, what input materials should we purchase tomaximize profits?” In this example, as shown in the diagram below, the input constraint is placed on thethree Sales objects and the mathematical constraints implied by the Third Law of IBP flow backwardsthrough the enterprise diagram to the “Purch Hot Strip” object where the solution is determined.To be more specific, in this second example, the input for each of the sales objects is defined in terms oftheir constrained outputs. This requires a mathematical transformation and substitution based on theSecond Law of IBP that gives:I = (O/Y)D.Similarly, the balance requirements defined in the Third Law of IBP define the Output of the objectlabeled, “Finishing Lines” in terms of the input to the object labeled, “Finished Inv” and this, in turn,Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 44
  45. 45. defines the input to “Finishing Lines.” Thus, for each of the yellow arrows, the output of each step(s) isdefined by the input of the following step(s).Although they are not trivial, it should be clear that the mathematical transformations required forthese different analyses can be determined from The Second and Third Laws of IBP. It should also beclear that these are not transformations anyone would want to do manually! Fortunately, as we workthrough example exercises, computer software will handle these mundane details for us.Before continuing to a third example, please note that if for some reason we want to do these analysesmanually, let’s assume for the moment we are using a spreadsheet tool, we will have to completelyrebuild the spreadsheet representation for each variation. This will not only require an extensiveamount of mathematical transformation and substitution, it will also require an understanding of how toConfidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 45
  46. 46. sequence the computations so that required computations are available as needed. Thesemathematical manipulations are extremely difficult, even for relatively simple problems. While thereare a variety of complexities to consider, one of the more difficult is the issue of ambiguity.With this in mind, let’s now consider a third example, “Given a requirement to run our Tempering Mill atfull capacity, what input materials should we purchase and what products should we make and sell tooptimize profits?” The implications of this example are shown in the figure below.In this example, both the purchase and the sales activities are now solutions. Other balance constraints,and the associated mathematical transformations, defined by the Third Law of IBP flow through theenterprise diagram as indicated by the yellow arrows. The Input Constraint is applied to the Conversionobject labeled, “Tempering Mill.”Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 46
  47. 47. Above the green Input Constraint arrow is a red circle with two yellow lines, one directed upward andthe other downward. This is an example of an ambiguous balance constraint and a potential constraintconflict that could result in an infeasible IBP model in which there is no solution that simultaneouslyresolves all constraints. The ambiguity is the result of two flows of balance constraints. The first flowsfrom the Tempering Mill, through the object labeled, “Tempered CRS” to the Finishing Lines, and thenbackwards from the Finishing Lines to the objected labeled, “Cold Reversed Strips.” The second flowsfrom the Tempering Mill, through the object labeled, “Annealed CRS” to Batch Annealing and then to“Cold Reversed Strips.” (A more thorough review of the preceding examples will reveal similarambiguities that we chose to ignore until now.)In other words, do the constraints on the object labeled, “Cold Reversed Strips” propagate from theTempering Mill through the Finishing Line? Or do they propagate from the Tempering Mill throughBatch Annealing? Or do they flow from the Tempering Mill through Pickled Strips and then through theCold Reverse Mill?The answer is, “Yes.”Mathematically, all these balance constraint flows must be consistent and any solution must satisfy*ALL* the implied constraints on inputs, outputs and financial consequences. It is well-known thatthese types of ambiguous material balance constraints can be represented with the matrixrepresentation described earlier. That is not difficult. There are, however, two considerations that aremore problematic. First, it is necessary to formulate the required representation using appropriatedomain semantics. Second, it is necessary to resolve all ambiguity through the use of a mathematicaloptimization technique.For now, it is only necessary to understand these issues at a conceptual level. This book is about thefundamental principles of IBP, how to apply them to solve real-world problems, and how to leverage thisknowledge to your personal advantage. The specific details associated with these issues are dealt withmore appropriately in technical documents.With respect to establishing a proper conceptual understanding, the following are the critical points.You can feel comfortable ignoring technical specifics until you might actually need them, but you doneed to understand the following: 1. IBP is based on well-founded mathematical principles that stand up to close scrutiny in a manner analogous to Newtonian Physics. 2. IBP analyses require software built specifically for that purpose. They cannot be fully supported by spreadsheets, simulation tools, statistical analysis tools, OLAP tools, etc. 3. IBP absolutely requires true mathematical optimization techniques.Confidential Draft – Do Not Redistribute – Copyright 2010-2011 All Rights Reserved Page 47