One of my favorite business books is The Goal written by Dr. Eliyahu “Eli” Goldratt. In the book, Dr. Goldratt makes a point I, and many others, have found to be powerful in terms of its ability to rally company employees around an idea and focus organizational efforts. He proposed the goal of a company is to make money, a simple notion. Of course, as usually happens, many business intellectuals tried to argue that making money was an objective or something other than the goal. The goal might be to make products for the greater good, or to make technologically sound products, or to offer services to address a key need in a target population.
These may be ideas the company’s founder sought to achieve when she started the company. The company’s leadership may have decided to target these ideas in their strategic plan. However, none of this can be accomplished without making money. Money is lifeblood. It provides energy. Without it, companies fail to thrive and, in fact, survive. The goal in managing and running the company should be to make money doing what the company was created to do.
It’s pretty clear, given the importance of money, we need the right tools to guide us and help us understand how to make it, to assess if we have made it, and to determine how much we have made. This, in turn, will help us understand the extent to which we are, or are not, achieving The Goal.
As suggested in the last chapter, companies use accounting for money-related information. They look to understand and manage costs with the objective of being more profitable; to make more money. The question, however, is whether accounting, specifically cost accounting, has the ability to provide us with the information that tells us whether we are making money and how to make more. The simple answer and the basis of much of this book is, “no.” In fact, focusing on calculated costs along with cost accounting and profit information are almost the worst tools you could use by themselves. Any tool that tells you by improving a particular metric you can become more profitable when, in fact, it causes you to lose money, should be considered useless. This would be like driving and having your GPS tells you to speed up when you’re at a red light. This can happen when focusing solely on accounting information. Again, this is not accounting’s fault. It is being asked to do something it was not designed to do.
This creates dangerous and unpredictable situations and management decisions. Here are just two examples. The first was a client looking to improve it gross margins through productivity enhancements. Simplifying the situation to make the point, assume a laborer is the only cost and she makes $30 per hour. On average, she makes 15 widgets per hour. By increasing her efficiency, she can now produce 20 versus 15 widgets in an hour. The cost per widget goes down, leading to the perception that the company is making more money on each widget assuming the sales price remains the same.
The reality is quite different. The sales price did remain the same and what she was paid on an hourly basis didn’t change. However, the “cost per unit” (costNC) was lower, leading to a higher gross margin and, therefore, a higher taxable income. Revenue was the same, money paid in salary was the same, and taxes increased, so the company made less money. Now, consider this as another potentially dangerous situation. What if the company believes they can reduce price as a result of the lower cost? The amount going out in labor is the same as it was initially, and the amount of money coming in is less.
The second example is a client that had desirable gross margins that may have been putting them out of business. Let’s say they bought material processed a particular way for an accounting cost of $1 per unit; they would buy 10,000 units for $10,000. If their products sold for $10, they had a gross margin of $9, again, simplifying to get the point across. Our suggestion was that they buy materials using another technology, which was assumed to be more expensive, to save money. Their counter, of course, was that they would lose money with the proposed technology. I asked how much it would cost to buy 5,000 units. They responded, “$8,000.” I replied, “Yes, you’re losing money, alright!” “How? If we bought the more expensive product, our gross margins would go from $9 ($10 – $1) to $8.40 ($10 – $1.60)!” Then, I asked, “How much demand is there for the product, on average?” Around 5,000 per SKU. “So, you generate $50,000 in revenue?” “Yes.” “Would you rather spend $10,000 to make $50,000 or $8,000 to make $50,000?”
Remember, the accounting profit calculation is not money. While their interpretation of the situation given the math they used was right, the math they used was wrong.
In these cases, the desired answer for the companies, from their perspective, involved looking at cost accounting information. Ultimately, however, they found it wasn’t the right answer when it came to making money. In fact, I’d argue cost accounting information, alone, does not provide anywhere near enough relevant information about cash costs to allow for maximum cash flow. There are a few reasons for this.
Let’s think about accounting costs. Accounting costs are calculated values. Someone has to figure out what the product, service, or activity costs, so they are costNC. To figure out a cost, there are several ways to do so based on what is being emphasized, what data are used, how the data are used, and ease of maintenance or use. That’s one opinion why you have so many different approaches to calculating costs. Each technique focuses on a different way to calculate a cost. Standard costing emphasizes standards, average costing is about ease and equal distributions of allocated costs, not accuracy, and activity based is tied to drivers with the objective being more accurate allocations.
In the end, however, the sole purpose of these methods is to calculate costs. They are all notionally the same. Each one attempts to solve the same problem: “What does this product, service, activity, or outcome cost?” Each method therefore, has its own approach or philosophy regarding how to calculate this cost. Each, then, will calculate different answers. Here’s a question to consider. If these calculated costs were money, how, logically, can the amount of money you spent, a tangible and measured value, change based on the technique you’ve chosen to use to calculate it? If I buy something for $1 and sell it for $2, I made $1 regardless of anyone’s opinion, cost allocations, or any other factors.
This is similar to the observer effect in physics. The suggestion in physics is that when we observe certain phenomena, the observation process changes what we are observing. If we use light to observe the location of an electron, the light will move the electron to a different position. This would be like GPS satellites moving your car every time they try to understand your position. Similarly, our costing techniques change the calculated cost, suggesting you will not converge, mathematically, on one cost. Instead, you will diverge to many costs.
Another factor to consider is scope; what should be included and left out of the cost calculation? With product costs, for instance, how is overhead handled? What should and should not be included? Who should be included? If you’re a hospital calculating the cost of a patient stay, do you include the folks who move patients around from room to room? Billing? If you’re in manufacturing, should defects be included? You’ll get a different answer if you spread costs across 100 good units versus 100 good and 10 bad units. What about warehousing and shipping? Are they in or out of product costs? In my previous experience helping companies with the design, development, and implementation of cost management systems, these and similar questions are often harder to answer and agree to than the allocation method. Because they’re up for debate, the choices made are subjective. Because they’re subjective and they influence the value of the calculated cost, the calculated cost, itself, is subjective. As with any analysis, your answer is limited by the least precise part of your model. If you’re guessing whether to include warehouse costs in your product costs, for instance, what difference does $0.001 matter at an operation? Get rid of warehouse costs and you might change the product cost by $1.00. As with costing methodologies, decisions you make based on subjective ideas should not and cannot change how much money you spent.
The last factor to consider is how certain accounting principles violate a basic rule regarding the timing of cash flow. Consider this. Say it’s March 1. You want to know how much money you made in the month of February, and how much you had at the end of the month. How would you figure it out? You start by considering how much money you had at the beginning of February. Let’s say, on February 1, you had $100. Then, you would consider the money that came in through the month, say $50, the money you spent, assume $30. You end up making $20. Straightforward, right? This is summarized in Equation 2.1. You ended February with $120. The key factors for consideration were the time period (one month), what you started with ($100), what you received ($50) and what you spent, and therefore no longer have ($30).
Let’s go back to the scenario in Chapter 1 and matching. What we didn’t consider, and what matching allows is money you spent December or expect in March. However, this is exactly what happens with matching. Revisiting, calculated accounting costs are tied to opinions about what factors should be considered in and out of scope when calculating costs. They’re based on opinions about the technique that should be used to allocate costs. They may be considered from timeframes outside the one being considered. In that context, how can accounting costs represent money? They can’t.
Now let’s consider profit. The basic equation for profit is:
This relationship is simple enough, until you factor in the issues I mentioned previously with cost types and matching. Some are not money and matching considers costs we spent previously and may receive after the analysis period. The profit equation then becomes something like this:
Profit = Σ RevenuesRECOGNIZED – Σ CostsMATCHED – Σ CostsC-RECOGNIZED IN PERIOD – Σ CostNC-RECOGNIZED IN PERIOD
Where
RevenueRECOGNIZED is the revenue recognized in the period by accounting CostsMATCHED are the costs associated with the sales recognized in the period
CostsC-RECOGNIZED IN PERIOD are the cash costs such as cash sales, general, and administrative (SG&A) costs recognized in the period
CostNC-RECOGNIZED IN PERIOD are non-cash costs such as depreciation and amortization that are recognized in the period
This is clearly nonsensical, crossing timelines and even value types.
The other factor to consider is basic arithmetic. Let’s say you did receive cash in February. I proposed last chapter accounting costs were not actually money. If this is the case, how do you subtract costs, which aren’t money, from money? We can’t subtract pickup trucks from trees, and have the answer be trees. We learned in second grade we can’t subtract dissimilar things such as apples from oranges, houses from jars of pickles, or pickup trucks from trees, right? Yet that’s what is happening when we try to subtract an opinion from money. Second, recall, each costing approach/scope scenario gives you a different cost, which will lead to different profit. Therefore, your profit is significantly influenced by your choices of how to calculate costs and the data you include in the calculation. Consider this. In our February cash example, it was clear how much money we made. From an accounting perspective, we can actually change what we think we made in profit based on the scope we choose and the techniques we use to calculate costs. Again, how can a choice we make determine how much money we made? We can make $10 using one approach or $20 using another? How can this make sense if we are focused on cash and the cash transactions are unaffected by accounting technique? Money is a measure and it is absolute. Profit, however, is a metric that can be influenced.
If the goal is to make money, and if accounting doesn’t serve this purpose, what should we do instead? I’d like to propose that there be a strategic cost transformation from accounting analyses to a more holistic framework called business domain management, or BDM. BDM looks at the business comprehensively and is designed to model cash and capacity, support the use of accounting for reporting purposes, and enable alignment between accounting/finance and operations. This transformation of costs to a larger and more comprehensive framework will focus on the factors that affect cash, provide a comprehensive look at business operations and cash, and form a foundation from which accounting information is determined. From this, more effective cash-based decisions can be made. This is the subject for the next chapter.