In Serious Play, Michael Schrage shares a story about Mexican ladders from Peter Keen’s The Process Edge to explain why you need to model the right thing to get the right results:
A leading Mexican manufacturer decided to reengineer how it built aluminum ladders. According to its sales and accounting model, the company had been making an operating profit of $4.50 per ladder. The reengineering initiative nearly doubled profits to $8.20 per ladder. Unfortunately, those profit figures proved meaningless. The reengineering had completely ignored the most critical cost issues because the company’s business model — and its accounting mechanisms — were flawed.When the company switched to activity-based accounting to evaluate overhead, its managers were horrified to discover that the company’s legal expenses were higher for ladders than for any other product they manufactured. People who fell off ladders tended to sue the manufacturer. Those costs were crippling.
When the total litigation and settlement costs were tallied, the company discovered that it was losing almost $10 on every ladder that it made. And even after the reengineering initiative had slashed manufacturing costs by one third, it was losing more than $6 on every ladder.
With some legal finesse, the company found a way to offer its customers free accident insurance at a cost of just $2 per ladder.
