CHAPTER 3

Strategic Cost Transformation—An Overview

What Is Strategic Cost Transformation?

Strategic cost transformation (SCT), here, is about transforming the scope and focus of cost analysis from traditional accounting-based cost management systems to a corporate wide system that models and aligns cash, operations, and accounting. This system, Business Domain Management (BDM), includes and models each of two business domains; the Accounting Domain and the Operations and Cash Domain (OC Domain). Traditional accounting information such as calculated costs and profit reside in the Accounting Domain.

We typically look to the Accounting Domain to provide information that will help us make cost management decisions. However, as mentioned last chapter, our companies need cash to sustain themselves. Cash, and calculated costs and profit, are very different.¹ Cash is money, a measure, and money is exact. Calculated costs and profit are reporting metrics that can be influenced by opinion and arbitrary assumptions. To improve cash, you must understand it through effective cash modeling. Effective cash models capture the factors that affect cash dynamics. This happens in the OC Domain. A complete picture of your organization and its operational and financial performance cannot exist without modeling the OC Domain. BDM, combines the Accounting Domain and the OC Domain into one framework that provides a comprehensive view of all operations, cash, and accounting information (Exhibit 3.1).

Exhibit 3.1 If the Accounting Domain is one dimension, the OC Domain is the second. Having a 2-D view of your organization will create greater clarity regarding what is happening in the organization, why, and what you can do to improve than a 1-D view can offer. This is the foundation of Business Domain Management, which is the objective of SCT

Why Is a Transformation Necessary?

To stay in business, companies must make money. We look at gross and contribution margins, for instance, to understand whether a particular product, service, or opportunity has made money. We look at cost information to identify targets for cost reduction. However, since accounting information does not represent money, cash, it is limited in its ability to model cash. This suggests it’s limited in its ability to tell you whether you’ve made cash and why. It cannot offer precise information that guides you how to reduce cash costs. It cannot provide data regarding what specific managerial actions can lead to making more money. In fact, the modeling can be so inaccurate, there are situations where cost accounting may show a cost_NC reduction when, in fact, the situation would increase cost_C (see Inset: Artificial Cost Reductions).

If managing and reducing costs to make more money is the objective, cost accounting tools aren’t enough. The Accounting Domain and cost accounting offer a one dimensional (1-D) look at your business, but business exists in what is akin to a two-dimensional world (2-D). 1-D analyses are incapable of fully comprehending things that exist in a 2-D world. The information from the second dimension has to be reduced, simplified, or even eliminated. Consider, for example, the cost of a product. You calculate an electric pencil/stylus costs your company $19.38 to produce. What does that number tell you about the size of your organization, your cash requirements, how efficiently you’re operating, how much output you created, what output you created, or how it was made? Nothing. It only offers a very limited representation of the activities that happened previously. To understand what happened comprehensively, you need another dimension, one that includes the business activities and cash transactions that are ultimately used to calculate the $19.38.

The objective of SCT isn’t to change accounting by creating a new costing approach or allocation schema. There are already enough of those out there. Instead, the purpose is to expand the narrative by offering a different, accretive, dimension of data and information. It starts by using the OC Domain to create a second dimension to your accounting analyses. The OC Domain adds a more complete perspective of business performance. For instance, the OC Domain answers questions such as:

The answers to these questions, the operations and cash data and the resulting information, are often used by the Accounting Domain as inputs to answer questions created by accounting inquiries and reporting requirements. When considered comprehensively, these data will help both those inside and outside accounting see where the numbers come from and how they can be managed to improve cash performance.

The Foundation

SCT begins by modeling cash. Imagine putting a box around an entire company and modeling cash_IN, the rate of cash coming into the box, and cash_OUT, the rate of cash leaving (Exhibit 3.2). Focusing on cash_OUT is of particular interest for SCT because it is the source of all costs, both cash and non-cash. Cash_OUT comes from paying for something you’ve bought, such as capacity and services, or paying obligations such as taxes, fees, and royalties (TF&R).

For most companies, the largest cash expenditure is capacity. Capacity is what you buy in anticipation of demand or use. Typical types of capacity are space, labor, materials, and technology.² We consume this capacity for the purpose of doing work and creating output. While products and services provided to the market are types of output, they aren’t the only types. Processed invoices, filed financial statements, R&D activities, planning budgets, and hired employees, too, are forms of output.

The entirety of these activities and their corresponding cash transactions comprise the OC Domain. All business activities and cash transactions occur here (Exhibit 3.3). Data regarding whether your company has truly made money, the amount of capacity it purchased, how it was consumed, how efficiently and productively it was consumed, and what it created are all determined in the OC Domain.

Exhibit 3.2 A box around the company (the cash_IN cash_OUT or CICO Border) helps define what does and doesn’t affect cash. Whether you’ve made cash for a period is determined solely by considering what crossed the CICO border over a specified period. Also, if an improvement does not reduce cash_OUT, there are no cash savings. Note, cost accounting and the income statement has no such discipline regarding costs and cash

Exhibit 3.3 Operationally, we buy capacity, space, labor, equipment, materials, and as we pay for them, cash leaves the company. We then consume the capacity we bought to do work and create output. The output that is sold leads to revenue generation. This is the OC Domain

When someone asks about the cost of a product or to perform a service or activity, this information is not natively available in the OC Domain. Answering that question requires the subjective and arbitrary data manipulation mentioned previously, that transform the OC Domain data into a different form than native OC Domain data. These transformed values create the information that comprises the Accounting Domain. Consider the following example.

Let’s say you buy local phone service for $25, and with it, you get one month of access with no limits to the number or length of local calls you can make. If you want to make a long-distance call, however, it will cost 10¢ per minute. A 10-minute long distance call will cost $1. How much will a 10-minute local call cost?

There is an inherent challenge to answering the question. There is not enough information in what I gave you to create a reasonable and useful answer. The reason is, there is no relationship between what you bought, access, and how you use it, making calls. Ultimately, to calculate a cost, you will need to transform OC Domain data—$25 for access, 10-minute call—into a cost per minute or cost per call metric, which is Accounting Domain information. To do this, there will be subjective and arbitrary components used to create your answer.

Subjective

To calculate a cost, you will need to determine what data to include in the calculation; the scope. For instance, when calculating the cost of an activity, you will often need data and information such as labor rates or a proxy for labor rates and how long the activity took. For instance, if you pay someone $30 per hour and you want to determine her rate per minute, there are many ways to do so as was brought up in Chapter 1. You could divide the $30 by 60 minutes to create a 50¢ per minute cost rate. Similarly, to calculate a cost per call, you will need to calculate a rate per minute based on the access cost. However, what do you use for calls? Every minute of the month? If so, how many days do you consider for each month; 28, 29, 30, 31, 30.4 or 30.5?³ Do you only consider the amount of time you’re awake to make phone calls? How do you determine this with a reasonable degree of accuracy or precision? Do you only consider the times you most likely make phone calls? Only the time you spend on the phone? These are just a few of many possible questions that can, or should be addressed before calculating a cost per minute. It should be apparent that the process begins with a significant amount of subjectivity.

Arbitrary

If you look at the cost of access in Exhibit 3.4, you will see that the cash cost, $25, and how it is used, making calls or consuming minutes, are mathematically independent. The cost that should depend on the length of calls does not change as the length of calls increases. Compare this to the curve for long distance where there is a relationship. The cost increases as the length increases.

To create a cost for a 10-minute call, you need a relationship between the access cost and how you use the access. Since no mathematical relationship exists, you will need to make up a relationship. Since the relationship is made up and connects two mathematically independent concepts, it is arbitrary. You can create a relationship between the number of trees in your yard and the number of blue sedans in your neighborhood, but that doesn’t mean the relationship has any validity. If you plant a new tree, that won’t cause blue sedans to start showing up in your neighborhood just like buying a new sedan won’t cause a tree to pop up in your backyard.

Exhibit 3.4 When you make a local call, no money leaves the CICO Border. This means there are no cash costs involved. Organizational capacity behaves this way. Consuming space, labor, material, or equipment you have purchased does not change the rate of cash leaving your company, unless there is a cash use charge involved with the purchase. If the costs you calculate for using capacity don’t leave the CICO Border, they are not cash costs

Hence, the cost of access and the number of calls made, or the length of calls made are no more mathematically related than the number of people at a baseball game in New York and the temperature in Saigon. Any math relationship you create between two mathematically independent subjects is mathematically arbitrary.

The Anatomy of the Transformation

To calculate a cost, we consider and capture data from the OC Domain (scope) and create a way to assign or allocate what is essentially capacity cost and use data, to the output it creates. The process is captured in Exhibit 3.5. The assignment/allocation process involves creating a relationship where there is none. Notice, we did not have to go through a transformation for the long-distance costs because a relationship existed.

Exhibit 3.5 Creating Accounting Domain information is how cost accounting works. A subset of OC Domain data is taken and assigned or allocated to create an accounting image or cost. Notice, no new data come from this process. We are still using data available in the OC Domain. This process is a projection of what happens in the OC Domain into the Accounting Domain. By only having one dimension, the Accounting Domain, you’re left with the task of projecting something that is 2-D into something that is 1-D. Doing so will often cause the loss of data and information

Exhibit 3.6 By changing what OC Domain data you will use and how you will transform it, you will create different images or costs. This suggests calculated accounting costs are subject to the opinions of those who seek to determine it

However, by changing the scope or the relationship (the assignment or allocation), you can create different images or costs as you can see in Exhibit 3.6.

This partially shows why calculated costs are not absolute. They can be manipulated and are subject to opinion. What scope should we use? How shall we assign costs? These are both questions where the answers rely on opinion. Hence, the costs they calculate, are based on, and therefore are, opinions.

This leads to another important fact about this transformation; the costs it calculates are no longer money. If calculated costs were money, we would see a cash transaction every time we make a local phone call in this instance. If we calculate the cost of a 10-minute local cost to be 5¢, for example, you do not spend 5¢ for each 10-minute call and you don’t save 5¢ if you do not make the call. Recall, depending on the transformation approach, this cost could be 5¢, 4¢, 6.5¢ 1.3¢ or $5 (Exhibit 3.7). If the value were cash, this would not happen. As mentioned in Chapter 1, cash cannot change based on subjective criteria applied using arbitrary relationships. The $25 you paid for access was clear, distinct, and does not change based on opinion or what happens throughout the month.

This leads to a couple of important considerations. First, there are two types of costs, each introduced before; cash costs (cost_C) and non-cash costs (cost_NC). All calculated accounting costs are cost_NC. The output of all costing approaches, whether standard, activity-based, lean, or average, are all cost_NC. If you have to figure it out, it’s likely not money. Second, calculated costs are not as bullet proof as we are led to believe. Part of the problem comes from the question being asked; “What does it cost?” and expectations we have from the response. There is no cost for a local call that is equivalent, money-wise, to the cost of a long-distance call although we expect them to be the same. The other part of the problem comes from the techniques used to answer the question, because the answer relies on the subjective notions and mathematically arbitrary relationships we discussed.

Exhibit 3.7 Costing methodologies are all just transformation algorithms. Mathematically, they are basically the same. They all take OC Domain data and transform them into accounting images or costs. While one may claim to be more accurate than others, they all rely on arbitrary relationships to calculate this cost

Implications

Buying capacity, in your company, is the same as buying local phone access. You buy space, you pay the rent, and it doesn’t change with how you use it. You buy steel, you have it in inventory, and the cost, from a cash perspective, doesn’t change with how you use it. You buy an X-ray machine, and the payments don’t change with the X-rays you perform. The OC Domain is home to these data along with the cash transactions associated with running the business. However, historically, we’ve looked to the Accounting Domain to provide this information. Ultimately, the Accounting Domain fails to do so. This means we need a different way, different data and information to manage our companies if the goal is to make money.

Recommendation

The recommendation is to move from analyses and managerial decisions that reside primarily in the Accounting Domain to using the more comprehensive BDM framework. The BDM framework creates an effective alternative to analyses and management systems that focus solely on accounting information. This is an extremely important step that can ultimately enable full business transformation. Consider Toyota.

In his book, Profit Beyond Measure, Dr. Tom Johnson looks at the evolution of Toyota’s Toyota Production System (TPS), sometimes known as just-in-time and the precursor to lean.⁴ He compares it, and Toyota’s success, to production philosophies and managerial approaches of US Big Three of GM, Ford, and Chrysler. He begins the book by talking about how Henry Ford was able to create a significant cost advantage by making only one version of the Model T at the famed River Rouge plant. When the need for variety ultimately ensued, there was a split in approaches on how to address the challenges.

There are challenges to creating variety on an assembly line such as Fords. Converting from making identical Model Ts to offering options or even different models would create significant disruption to an assembly line. Equipment changeovers to accommodate variety could take hours if not weeks. This, of course, would have implications on metrics such as efficiency and costs. To address the physical challenges and the desire to maintain product profitability targets, the Big 3 used accounting numbers to attempt to drive or influence the work. Since downtime from changeovers could be extensive, the idea was to produce each model or product in larger batches to take advantage of economies of scale. This would reduce unit costs, of course.

Each of the Big Three saw poor financial results. Toyota, on the other hand, was more profitable than all three combined. How? Johnson argues Toyota focused on the work, the means of production, while the Big Three focused on the results. By focusing on the means, Toyota minimized the effects of model changeovers. For instance, if model changeovers took three minutes versus three days, many of the benefits of Henry Fords approach to mass production are maintained. Ultimately, by focusing on the efficient, effective, and productive use of capacity, Toyota achieved optimal financial results. However, by focusing on the results, the Big Three achieved suboptimal financial and operational results.

This experience aligns well with the suggestion here that we focus our managerial efforts on the OC Domain. The means Johnson discusses, where the work happens, is in the OC Domain. The results the Big Three sought and ultimately failed to achieve are in the Accounting Domain. When we open our analyses up to the entire organization we get a more comprehensive picture of business performance and how to improve it. By focusing on reducing changeover time, for instance, Toyota achieved the cost results they sought. By focusing on the cost targets, they sought, the Big Three arguably made enough of a mess that Toyota became the source of inspiration for people such as the CEO of Ford. Interestingly, when the CEO of Ford went to meet with Toyota to learn from them, the CEO of Toyota ironically thanked Henry Ford for teaching them what they needed to know.

Developing these thoughts, I’d like to propose the following steps related to transforming the operations and management of companies.

Use BDM to Model the Entire Company and as a Foundation for Managing the Means

The BDM model represents the entire organization (Exhibit 3.8) and all its operations, processes and cash transactions. This creates an unambiguous picture of all aspects of the organization including capacity levels, capacity consumption, efficiency, effectiveness, productivity, and output. It also creates insight into demand-type information such as what output was sold, how much was sold, and when money from sales is received.

Model and Highlight the Environment That Creates Costs

When modeling the organization’s OC Domain, you capture all the data that are used to calculate costs. For instance, you have the cost_C of capacity, how much was purchased, and how it was used to create output. These are data that are native to the OC Domain. The cost transformation process uses a subset of these data with a particular allocation schema to calculate costs and create accounting information. Notice, no new data are created in the Accounting Domain. The Accounting Domain only uses OC Domain data, which are transformed into accounting information.

Exhibit 3.8 This is the Business Domain Management (BDM) framework. It is a model that represents the entire company and brings together both domains so that the relationship between the two can be understood and managed. The OC Domain represents all capacity and cash related activities. The Accounting Domain focuses on providing accounting information that should be used primarily for reporting

This helps explain why managing the means is better than managing the results. By improving performance in the OC Domain, you will see improvements in the Accounting Domain. If, by being more efficient, effective, and productive, you can get by with using and therefore buying 10,000 lbs of material versus 11,000, 25 people versus 30, or can lease 7,000 square feet of material versus 10,000, you will see improvements in your accounting information. Accounting Domain improvements most often result from changes made in the OC Domain, where better numbers create more desirable inputs into the calculation of Accounting Domain information. If that’s the case, we really do not need Accounting Domain information for managerial purposes.

Table 3.1 If data are the raw numbers, information is the answer to queries using the raw data. All business data are captured on the OC Domain before a single cost is ever calculated. This suggests that from a data perspective, the Accounting Domain provides nothing new. There is, therefore, little, if any risk shifting out of the Accounting Domain to the OC Domain to capture data and manage the company

There may be apprehension when giving up accounting information for managerial purposes. There is usually concern from the perspective of losing information. How, for example, do you price without a product cost?⁵ However, there are a significant amount of data and information available in the OC Domain before costs are calculated in the Accounting Domain. Table 3.1 offers a snapshot of some of the data and information that are available before calculating a single cost. This suggests that when shifting data and information requirements to the OC Domain from the Accounting Domain, there will be no loss of data. This results in the OC Domain being the more desirable domain to create accurate corporate and cash models.

Data Not Affected by Accounting Conventions

One of the benefits of this approach is the notion that OC Domain data are not affected by accounting convention. The data exist prior to being subjected to the rules and conventions used for allocations, matching, accruals or any other ways to define, categorize, or account for activities and costs. Hence, by using these data, you have values that are in their native format, and unmanipulated by accounting techniques. Notice, one set of OC Domain data can create practically an infinite number of Accounting Domain representations. As such, it is often more effective to go to the source of the data for decision making rather than to one of many possible Accounting Domain images. I call using pre-processed data getting ahead of accounting.

Helps Describe and Resolve Conflicts Between Cash and Accounting Profit

One thing the BDM framework will highlight is the difference between cash and accounting profit. Cash profit reflects how much money was made in a period. It strictly considers cash inputs and outputs within the period. This is different from accounting profit, especially when it is accrual-based, which may use non-cash information, revenue recognition, and matching across periods; each of which may violate the rules of cash transactions.

Without a means to consider the impact to both cash and accounting profitability simultaneously, one may, for instance, improve accounting profit without realizing the negative cash implications of doing so. With proper insight, the implications of changes in both the OC Domain and the Accounting Domain can be considered and used as input to the final solution.

Enables Alignment Between Finance and Accounting

The BDM framework enables the creation of a comprehensive, organization-wide operations and cash model that supports the creation of accounting information. This model enables a common understanding, language, and set of measures and metrics that can be used by both accounting and operations. This creates enhanced opportunities to align the two groups and helps them manage the means so that they can create the desired financial results together. This, in turn, can lead to improvements in several areas including:

For example, instead of discussing negative variances, the two groups understand the operational source of the negative accounting variance (produced two fewer widgets last hour). The next step may be to consider whether the situation has relevance from a cash perspective (no extra money spent on labor or materials). They can talk about what, if any operational changes need to occur (no changes; output is within normal statistical variations), and whether the changes or lack of changes will have a negative effect on cash even if accounting profit will improve (no effect on cash or profit).

The next step is to delve into the theory behind Business Domain Management.

¹ Lee, R.T. March-April 2016. “Why Profit Doesn’t Translate into Cash.” Journal of Corporate Accounting & Finance 27, no. 3, pp. 63–66.

² See Yu-Lee, R.T. 2002. Essentials of Capacity Management. New York, NY: John Wiley and Sons.

³ 30.4 is the average number of days in a non-leap year. 30.5 is the average during a leap year.

⁴ Johnson, H.T., and A. Bröms. 2008. Profit Beyond Measure: Extraordinary Results Through Attention to Work and People, Chapter 1. London: Nicholas Brealey Publishing.

⁵ Leading practices in pricing suggest that prices should be a tied to the value of the product or service as perceived by the customer rather than to costs. See, for example, Baker, R.J. 2006. Pricing on Purpose: Creating and Capturing Value. New York, NY: John Wiley & Sons.