My Years With General Motors

by Alfred P. Sloan Jr.

  The headquarters staff assisted the division managers in this task with a seasonal analysis of the year's sales estimate, and a computation for each division of an absolute minimum working stock to be maintained and the maximum seasonal excess over that minimum that was allowable at the end of each four-month forecast period. And every ten days, when the reports from the dealers came in, each division manager compared his actual results with the forecast for the month and reviewed his production and purchasing schedule. This was the heart of the matter. If sales were running behind the forecast, production was reduced. If sales were booming, he could, within the limits of his plant capacity, increase his output. Each month he adjusted his forecast for the next four months to conform to the current sales trend. Thus, instead of laying down a hard-and-fast production schedule four months ahead and sticking to it, whatever the actual trend of retail demand, we were able to change production schedules when sales indicated to the management that such a change was necessary. We were able to keep production in line with the indicated retail demand while still keeping the accumulation of finished products in the hands of both divisions and dealers no lower than the desired minimum.

  Thus the more important thing in the end was not the correctness of the index for the model year but the sensitivity to actual market changes through prompt reports and adjustment. The objectivity and systematic use of the information had a co-ordinating influence upon the headquarters staff and the divisions of the corporation. It reduced the possibility of irrational conflict such as that of 1924. It also operated as a basic control on expenses, employment, investment, and the like.

  The effects of the new forecasting and scheduling were apparent in operating results. Materials inventories were kept to a minimum. In 1921 total inventories of materials, goods in process, and finished goods turned over about two times. By 1922 the turnover had increased to four times, and by 1926 to nearly seven and one-half times. An even greater improvement was shown in the turnover of productive inventory (total inventory less finished product), which reached ten and one-half times annually by 1925.

  Progress was made, too, in stabilizing employment. But the problem of keeping production at a stable level is still unsolved today and very likely will remain so, owing in part to the incompletely solved problem of forecasting sales in the uncertain future. Other problems—the variations in the level of demand, both cyclical and seasonal, and the influence of the model change and the buying habits of the general public—have also had much to do with keeping production from remaining stable. As a matter of fact, we could achieve perfect forecasting and still find ourselves unable to stabilize production much more than we can today.

  The closer alignment of current production schedules with the movement of the final product into the hands of consumers also improved the turnover of dealers' inventories and hence their profit position. In 1925 the turnover of new-car inventories in the hands of General Motors dealers throughout the United States was twelve times, approximately 25 per cent greater than in any previous year.

  Our production-control system was essentially complete in 1925. Since then progress in this area has been a matter of refinements.

  The Key to Co-ordinated Control of Decentralized Operations

  Having thus established techniques of control in the particular areas of appropriations, cash, inventory, and production, the general question remained: How could we exercise permanent control over the whole corporation in a way consistent with the decentralized scheme of organization? We never ceased to attack this paradox; indeed we could not avoid a solution of it without yielding both the actual decentralized structure of our business and our philosophy of approach to it. I have dealt in earlier chapters with the organization aspect of the question as it was developed in theory and practice in General Motors in the early 1920s. But that alone was not enough. It was on the financial side that the last necessary key to decentralization with co-ordinated control was found. That key, in principle, was the concept that, if we had the means to review and judge the effectiveness of operations, we could safely leave the prosecution of those operations to the men in charge of them. The means as it turned out was a method of financial control which converted the broad principle of return on investment into one of the important working instruments for measuring the operations of the divisions. The basic elements of financial control in General Motors are cost, price, volume, and rate of return on investment.

  A word on rate of return as a strategic principle of business. I am not going to say that rate of return is a magic wand for every occasion in business. There are times when you have to spend money just to stay in business, regardless of the visible rate of return. Competition is the final price determinant and competitive prices may result in profits which force you to accept a rate of return less than you hoped for, or for that matter to accept temporary losses. And, in times of inflation, the rate-of-return concept comes up against the problem of assets undervalued in terms of replacement. Nevertheless, no other financial principle with which I am acquainted serves better than rate of return as an objective aid to business judgment.

  This principle had governed the thinking of the Finance Committee of General Motors since 1917, as it had governed the thinking of the du Pont people and certain other businessmen in the United States before that time. I do not know the origin of the principle itself. Even the least sophisticated investor measures his profits from stocks, bonds, or savings accounts in terms of what he puts into them. So, too, I imagine, every businessman evaluates profits in terms of his total investment. It is a rule of the game, so to speak. There are other measures for the running of a business; for example, profit on sales, and penetration of the market, but they do not supersede return on investment.

  However, the question is not simply one of maximizing the rate of return for a specific short period of time. Mr. Brown's thought on this was that the fundamental consideration was an average return over a long period of time. Under his concept General Motors' economic objective was to produce not necessarily the highest attainable rate of return on the capital employed, but the highest return consistent with attainable volume in the market. The long term rate of return was to be the highest expectation consistent with a sound growth of the business, or what we called "the economic return attainable." (Note 8-1.)

  When Donaldson Brown came to General Motors he brought with him a financial yardstick. It was a method of crystallizing facts bearing on the efficiency of management in the various phases of the business, such as inventory control, plans for capital investment in relation to expected demands on production, cost control, and the like. In other words, Mr. Brown developed the concept of return on investment in such a way that it could be used to measure the effectiveness of each division's operation as well as to evaluate broad investment decisions. His concept can be expressed in the form of an equation for computing return on investment, and it is still one of the measures used by the du Pont Company and General Motors to evaluate divisional performance. This book, however, is not the place for such technicalities as formal equations. I shall touch only on general concepts of financial control.

  Rate of return, of course, is affected by all the factors in the business; hence if one can see how these factors individually bear upon a rate of return, one has a penetrating look into the business. To obtain this insight, Mr. Brown defined return on investment as a function of the profit margin and the rate of turnover of invested capital. (Multiplying one by the other equals the per cent of return on investment.) If this seems obscure, pass over it and note only that you can get an increase in return on investment by increasing the rate of turnover of capital in relation to sales as well as by increasing profit margins. Each of these two elements—profit margin and rate of turnover of capital—Mr. Brown broke into its detailed components, a case, you might say, of aggregating and de-aggregating figures to bring about a recognition of the structure of profit and loss in operations. Essentially it was a matter of maki
ng things visible. The unique thing was that it made possible the creation, based on experience, of detailed standards or yardsticks for working-capital and fixed-capital requirements and for the various elements of costs. To get standards for commercial expense and manufacturing expense, Mr. Brown used past performance modified by plans for the future. The yardsticks thus established were compared with actual performance. The heart of the financial-control principle lies in such comparisons. Mr. Brown was able to set up tables showing, for example, how the sizes of the inventory and working capital were affecting the turnover of capital in the different divisions, or to what extent selling expenses were a drag on profits.

  To make this concept work, each division manager was required to submit monthly reports of his total operating results. The data from these reports were put on standard forms by the central financial office in such a way as to provide the standard basis for measuring divisional performance in terms of return on investment. Each division manager received this form, which spelled out the facts for his division. For a number of years this gave each division its rank in the corporation on a rate-of-return scale.

  The divisional return-on-investment reports were constantly studied by the top executives. If the indicated results were not satisfactory, I or some other general executive would confer with the division managers about the corrective action to be taken. When, as chief operating officer, I visited the divisions, I carried a little black book in which was typed in a systematic way both historical and forecast information about each division of the corporation, including, for the car divisions, their competitive position. The figures did not give automatic answers to problems. They simply exposed the facts with which to judge whether the divisions were operating in line with expectations as reflected in prior performance or in their budgets.

  The early return-on-investment form, which with some modifications is still used in General Motors, was the first step in educating our operating personnel in the meaning and importance of rate of return as a standard of performance. It provided executives with a quantitative basis for sound decision making, and thereby laid the foundation for what was to be one of General Motors' most important characteristics, namely, its effort to achieve open-minded communication and objective consideration of facts.

  In the beginning many limitations in our method were evident. The reports, for example, were not usable for evaluation and comparison until they were set up on a uniform and consistent basis. Uniformity is essential to financial control, since without it comparisons are difficult if not impossible. One of the immediate tasks, therefore, was to strengthen the accounting organization, both centrally and within the divisions, and to institute standard accounting practices throughout the organization. The classification of accounts throughout the corporation was standardized on January 1, 1921. A standard accounting manual, specifying a uniform set of procedures, became effective throughout the corporation on January 1, 1923. To co-ordinate financial organizations of the divisions and the central Financial Staff, we reaffirmed in 1921 the principle of dual responsibility for the divisional comptrollers, which had been introduced in 1919 to make those comptrollers responsible not only to their divisional general managers, but to the corporation comptroller as well.

  The development of a uniform accounting practice enabled us to analyze the internal condition of each division and to compare one division's operating performance with another's. But what is equally important, the uniform accounting practice created guidelines, with some exceptions, for overhead-cost accounting, both for actual costs of production and for developing yardsticks for evaluating operating efficiency.

  The Concept of Standard Volume

  While we had developed and applied the concept of return on investment and had made progress in standardizing our procedures, before 1925 we had no well-defined governing objective against which to measure our results. As a practical matter, because of the influence of changing volume, our results showed wide fluctuations from year to year, which made an evaluation particularly difficult. Therefore, beginning in 1925, we adopted a concept developed by Mr. Brown which related a definite, long-term return-on-investment objective to average or "standard-volume" expectations over a number of years. We took the view that the existence of such a desired long-term return-on-investment goal would provide a useful yardstick for evaluating operating efficiency and the effect of competitive pressures on pricing. With this approach we were not likely to lose sight of the long-run earnings objective and, in evaluating our prices, we would always be aware of the extent to which competition was preventing the attainment of the objective. The concept which Mr. Brown developed, of course, was only a theoretical one because operating results are determined by the interplay of actual prices, competitively determined, and the total costs incurred in the particular year regardless of volume. However, by applying a yardstick, unaffected by short-term volume fluctuations, we could isolate the extent to which we were deviating from our long-term profit goal and make a thorough evaluation of the underlying causes. The concept is a good illustration of our management philosophy of defining a soundly conceived theoretical reference to guide us in the practical management of our affairs.

  The standard-volume concept is a method for viewing the long range performance and potential of our business and its divisions, based on average volume over a number of years. In establishing this policy in the form of a procedure, I wrote in May 1925:

  ...What concerns our stockholders is a return year in and year out, the average of which represents a fair measure of the possibilities of the business in which we are engaged. It is believed the establishing of the principles outlined in this Procedure will lead to this result.

  It must be agreed that no definite rule for establishing prices can ever be rigidly adhered to. That is in no sense intended. It is believed, however, that a development of standard prices reflecting proper relation to cost, volume, and return on capital employed, will be most useful in guiding the Corporation toward determining what should be done in each individual case.

  There are these elements in the standard-volume approach: volume, costs, prices, and rate of return on capital. At a given volume, cost, and price—theoretical but founded on experience—you can compute a desired rate of return. If, in fact, the anticipated return does not result, it may be because competition dictated a different price, or somewhere the costs were out of line, suggesting a look at the costs. You may find fifty men sitting on a roof somewhere because of a mix-up in a plant. That's not typical, but it actually happened once. The calculation of return on investment itself tells you what to expect if the volume is higher or lower than the adopted standard unit volume.

  The chief theoretical contribution of Mr. Brown and Mr. Bradley in this area was in the way they made allowance for the effect on unit costs of variations in rates of production over the years. As long as material costs and wage rates are fairly stable, direct costs of production tend to remain constant per unit, regardless of volume. Every car produced contains a certain amount of steel. It also has an engine, wheels, tires, battery, and so on. A certain number of man-hours of labor is required for manufacturing and assembly. Our production engineers and cost estimators could determine the amount paid for each purchased part, the quantity of various kinds of raw material used, and the hours of labor required in manufacturing and assembly operations.

  Fixed overhead costs, of course, behave very differently. These fixed costs include supervision, maintenance expenses, and depreciation; tooling, styling, and engineering costs; administration expenses and insurance, and local taxes. With plant facilities established at any given capacity, the total amount of such fixed costs is relatively constant, regardless of the level of operations. Hence, fixed overhead costs per unit vary inversely with volume; they increase as volume falls, and decrease as volume rises. For complete accuracy this concept needs to be qualified by the semi-fixed costs which do not come down automatically with increased volume. But, in gene
ral, unit costs will go up in years of low volume and, conversely, they will go down in years of high volume.

  In order to avoid the influence of fluctuating volume on the unit costs to be used as yardsticks, unit costs were developed on a standard-volume basis. Standard volume may be defined as the estimated rate of operations at the normal or average annual utilization of capacity. This capacity must be large enough to meet the cyclical and seasonal peaks which are characteristic of the automobile industry. Standard volume takes into account the necessity of operating the business at various levels of volume and over a period of many years. In actual practice standard volume in General Motors proved to be close to the actual average utilization over a period of years, although the individual years varied.

  The standard-volume costing concept permitted us to appraise and analyze our costs from one year to the next on a basis unaffected by changes in volume at a given plant capacity. Changes in these unit costs reflected changes only in wage rates, material costs, and operating efficiencies and were not affected by year-to year changes in volume. Even more importantly, unit costs at standard volume gave us a bench mark against which to evaluate our cost-price relationship. They also provided a consistent set of unit cost data against which to compare actual unit costs and thus served as a gauge of the efficiency of our performance from one month to the next as well as from one year to the next.

  It is important to recognize that the standard-volume concept of costing also enabled us to establish detailed operating standards for manufacturing expenses. Our uniform accounting practice made it possible to make an allocation to each department in a plant, of the indirect manufacturing expenses, or what we call "burden." Burden commonly includes three types of costs: first, fixed-burden costs such as rentals, insurance, depreciation and amortization, which in general remain constant regardless of the level of operations; second, semi-fixed costs, such as supervisors' salaries, which are also fixed within a reasonable range of production; and finally, variable burden costs, which tend to vary directly with the level of production, such as labor related directly to manufacturing, cutting tools, packing and shipping supplies, lubricants, and maintenance. All of these expenses vary from department to department and allocating them properly in computing the cost of goods produced is a difficult part of any cost system in a manufacturing company. To do this, the indirect costs are related to direct productive labor; the latter can be determined on the basis of time studies and known wage rates. The fixed and semi-fixed portions of costs can be translated into per unit terms through the standard-volume approach. The variable unit costs (direct labor, materials, and burden) are based on past operating experience, current material costs, and wage rates. This classification of manufacturing costs thus segregates the areas where expenses can be controlled by the divisional management. By comparing actual results with the yardsticks established for these items, pressure was exerted to maintain the efficiency required to attain the cost objectives. The guiding principle was to make our standards difficult to achieve but possible to attain, which I believe is the most effective way of capitalizing on the initiative, resourcefulness, and capabilities of the operating personnel.