Accounting and accounting data have taken center stage with managerial decision-making for many decades. As a result, understanding and managing costs, and reporting desirable profit numbers has become the focus of many leaders and executives. The key question, though, is: Should it? Do you need accounting and accounting data to run your company? The answer is: No. Let me explain.
Let’s consider accounting dynamics from two perspectives. One is from hindsight and the other is foresight.
When looking at accounting data in hindsight, you will see a scenario like one seen in Exhibit 16.1.
Exhibit 16.1 In hindsight, accounting describes what happened in the past. Spending on capacity and transactions has already taken place, and the work has been done. There is one, and only one, true description of the activities and cash transactions that took place between T0 and TF. Accounting then uses its assumptions and math to describe the true activities in its own way
In this scenario, looking at it from the perspective of capacity and transaction dynamics, a couple of things should become clear. First, the reporting represents what happened through the analysis period. The one set of circumstances representing what was spent, what activities were performed, and the work output created happens between T0 and TF. All accounting can do post TF, is describe what happened.
As a result, when looking to a costing approach to improve your financials or reported data, the only thing that accounting can do in this case is represent the one set of circumstances in a way that is most desirable to you and your objectives. Its representation is limited by the circumstances that created it. For example, if you’re looking for the lowest taxable income, you can describe what happened in a way that lowers your taxable income. If you want the highest profit, you can represent what happened another way that shows higher profits. However, what happened between T0 and TF will constrain the extent to which your situation can be described. Accounting can’t, or at least shouldn’t, suggest something happened that did not. What you do between T0 and TF determines, to a great extent, what your numbers are going to be. Hence, your accounting technique can only influence how the numbers are represented, but what you do, to a greater extent, determines what the accounting numbers can reflect. If you want lower costNC, reduce what you’re buying that is allocable, then you’ll improve both cash and the calculated profit.
This is an important point, so I will state it differently. If you want to improve your accounting numbers, accounting techniques will go only so far. If you want your performance to be improved to the highest desirable level, you have to focus on capacity and transactions, by getting in front of what is being analyzed—capacity and transactions—not focusing on the allocated data.
People and companies often do things to attempt to affect costs in foresight. They will make decisions that they feel will affect future costs positively and avoid decisions that may have negative cost implications. The reality is that the accounting data they use can negatively affect and, in fact, distort the picture of future cash flow.
One situation I often see involves overproduction or overbuying. These situations usually begin with focusing on the gross margin level or the unit cost level. The idea is that if you can reduce production costs or buy in bulk, the average cost for each unit goes down. This will encourage companies to overbuy or overproduce in the name of efficiency, lowering costs, and ultimately improving overall profit by improving gross margins. Two common examples of this follow. First, consider the company that overbuys. In the name of efficiency, they attempt to take advantage of a lower-pricing opportunity by buying more inventory than they need. What if a company needs only 40 items, but would be given a desirable unit price if they ordered 70, so they decide to buy more than they need? The situation is captured pictorially in Exhibit 16.2.
Exhibit 16.2 Assume there is demand only for 40 units. The desired price for the units is $9.40 per unit. The unit price is 30 cents per unit, more expensive at 40 units ($9.70) than it is at 70 units. This information might lead some to overbuy in the name of “saving money”
There’s always the promise that the excess will be used. However, does anyone go back to validate this assumption?
In this case, paying a higher price leads to being more capacity productive even if, on the surface, it appears to be less cash efficient. In this case, buying the extra 30 leads to a costC increase of about $270 (Exhibit 16.3). Along with this increased outflow is the risk of the 30 not being used. How many items do you have laying around your house, office, or warehouse that were bought due to a discounted selling price, only to have it go unused?
Exhibit 16.3 When you focus on cash versus unit cost, you are led to the best cash flow decision. In this case, buying 30 more units when there was no demand for excess may not make much sense
The second example involves overproduction. This, too, is a far too common example. The idea is simple. The assumption is that the more you do, the lower the average unit cost. Let’s assume an order comes in for 500 coffee cups. You look at your cost curve and decide at 500 coffee cups, with a markup for profit added, the price would be too high. The anticipated selling price for each cup may, for instance, exceed the calculated cost for each cup (Exhibit 16.4).
Exhibit 16.4 Companies often look at certain output levels and determine their cost at that output level using this tool. The problem is, going back to Exhibit 15.8, what is this number telling you?
You decide, therefore, to double your production to 1000 to get a lower unit cost and, therefore, fall into the desired price range once profit is added. In essence, you doubled your output to lower your costNC so that you could make more money (Exhibit 16.5). Let’s examine this decision further.
Exhibit 16.5 By focusing on the unit cost curve and average costing, companies often spend more money and waste their capacity to produce more and create a lower unit cost
If you already had the capacity to produce 1,000 coffee cups, the marginal changes in costC are nominal—basically, utilities involved in producing the 500 additional cups and possibly other incidentals. However, what if you didn’t have the capacity? What if you had to buy the materials, buy more equipment, hire temporary labor to produce the additional 500 cups? Real cash, costC, is spent in the name of reducing a noncash number, costNC, and the spending actually will likely go unnoticed by accounting until someone paints a complete picture of the transaction.
Remember when I asked you if you would produce 20 of something if there were demand only for five? This is that scenario. Logically, you would make one decision, but somehow, in the midst of doing business and with alternate data presented, or pressure from management, we do illogical things.
Another example is Six Sigma and lean-type programs. As teams invade offices looking for efficiencies that lead to cost reductions, the focus is on reducing process cost, costNC. The financial justification often focuses and relies on allocated costs. Since costNC is mostly capacity, the improvement opportunities often involve capacity efficiency—getting more with what you have, by creating more output or reducing the effort required to reach current levels of demand (Exhibit 16.6). This leads to the perception of big financial savings that will not likely be realized.
Exhibit 16.6 Many improvement approaches seek to calculate dollar savings. These dollar savings are often costNC, and because costNC can often be large numbers due to the pervasiveness of wasted use of capacity, managers and leaders often get excited over the money they and their teams can save. They rarely see these numbers, because they are not real
The solutions often suggest lower costs, but the cost that is lower is costNC. CostC has not changed. This was once represented in a debate I had with someone who is acknowledged to be well-versed in costing. He explained how implementing some sort of a handheld technology saved, let’s say, $15 per transaction. He believed this to be true. It may have saved $15 in costNC, but it saved no direct dollars, costC. What it saved was time, and in this case, time was not money. It was just time.
Cost accounting paints a partial picture of operations and cash flow, and can distort the reality of how what you do affects what you make. Accounting approaches were created to report what happened, not to manage your business. Remember, cash is king. If, by using cost accounting approaches, you can destroy cash or promise cash improvements where they aren’t, how is it a productive tool? To answer the question at the beginning of the chapter, the answer is: No. Other than for reporting purposes, you do not need accounting.