CHAPTER 15

Understanding the Cost Dynamics of Capacity

When doing research, consulting, and just talking to people about capacity and costing, one thing that becomes clear is, there is a general lack of understanding of the interactions between allocated capacity costs and cash flow by the accounting community and those who use accounting tools. Much of this belief stems from the notion that to many of them, costs are costs, and they are all the same; there is no difference between cost_C and cost_NC. Also, they believe both are generally cash numbers. Of course, we know this is not true. However, their need to create cost_NC by costing work, products, and activities so they understand the so-called financial implications of products, services, and activities begins to validate this idea in their heads. The rest stems from a general lack of understanding of capacity types and dynamics. The idea of inputs and outputs, of what is static and what is dynamic, is not language they know, understand, or use. To understand companies the way they believe they do, however, they must understand capacity because of its influence on the cash dynamics of a company.

When we buy input, we are buying a static amount at a fixed price. This is the largest cost_C component of most companies. We buy a day or a year of someone’s time. We buy a certain amount of square feet, number of machines, pounds of material, or amount of terabytes. When you plot the cost to buy capacity, it looks like the graph in Exhibit 15.1. Notice two things. First, the cost_C is tied to how much we buy. Second, the only way the value, cost_C, changes is if we change the amount or capacity we buy or the price at which we buy it (Exhibit 15.2).

Exhibit 15.1 Capacity is no different from any other financial transaction. Capacity cost is tied to how much you buy and the price you pay. The only time capacity costs go up, therefore, is when you buy more capacity or the price that you buy has increased. This is why capacity costs and how you use capacity are mathematically independent

Exhibit 15.2 When buying input, there are only two ways to reduce costs: either buy less or buy the same thing cheaper. For instance, if you want to reduce space costs, you either have to reduce the total area you are buying, or find a location that offers the same amount of area at a lower price

Upon buying input capacity, we can use it to do work (Exhibit 15.3). Notice when we began consuming input capacity, there is no change to what we paid for it. The cost_C and the output are mathematically independent, because no matter how we change the independent variable (output), the dependent variable (cost_C) does not change, as seen in Chapter 12 and repeated here for convenience in Exhibit 15.4.

Exhibit 15.3 You buy input capacity to have it available for consumption. Consuming input ideally creates output. However, the act of consumption, of creating output, does not change what you paid for your capacity

Exhibit 15.4 There is no mathematical relationship between the capacity you buy and what you do with it. Capacity costs change only when you buy more or higher-priced capacity. Because there is no relationship between output and capacity, and because cost accounting wants a relationship between the two, it must create artificial relationships

Contrast this with buying labor based on output rather than time. If I pay you one dollar for each piece of output you create, you will see a direct relationship between output and cost_C. It’s like long-distance phone calls. That creates a scenario where the cash is tied directly to what is created, output, and the resulting chart looks like the one seen in Exhibit 15.5.

Exhibit 15.5 This chart is very similar to Exhibit 15.1 conceptually. This chart suggests the more output you buy, the more you have to pay for it. Exhibit 15.1 says: the more capacity you buy, the more you have to pay for it. This suggests that cost_C changes only with what you buy

What if you want to calculate the cost of output created by your input capacity? You will find yourself needing to use a cost allocation technique, and if you do, you will find yourself in a precarious position. There is no mathematical relationship between the output and what you bought, but you need one to calculate costs. If you do not have one and you need one, you have to resort to arbitrary assignments to get your answer. You have no choice. Let me explain.

Let’s say you want to calculate the cost of a customer service call. The anatomy of the situation can be seen in Exhibit 15.6. To get a cost for output (the call), you will need to allocate the input costs, the customer service rep’s salary to the call. Either there could be logic behind it such as with purposeful allocations—using techniques such as activity-based costing—or you can do it by spreading costs using a less purposeful approach. Let’s consider both.

Exhibit 15.6 Cost accounting attempts to put a financial value on consumed capacity. Since the values are independent and an arbitrary and artificial relationship must be created to calculate this value, we end up with a multitude of approaches trying to come up with the best way to determine this “cost.” If a relationship already existed, one wouldn’t need to create one

Purposeful Allocation Techniques

Purposeful allocation involves attempting to use some sort of logic to assign capacity costs to output. Approaches such as activity based costing and standard costing set parameters that attempt to use logic or reason as a basis the allocation or assigning of costs. For example, if someone makes $30 per hour, one inclination may be to suggest that each minute costs $0.50. So 10-minute task would cost $5.

Although it may seem logical, this number is still not cost_C; hence, it has no cash implications. If you make another call, you will not see a charge for, and your cash change by five dollars. However, the costing numbers tell a different story. Let’s say your cost_NC for a 10-minute task is $5. This would suggest that if you could reduce this value by consuming less input or doing more tasks you can reduce costs, specifically, cost_NC, but believed to be cost_C (Exhibit 15.7).

Exhibit 15.7 Cost_NC can vary due to changes in capacity consumption rates. In A, we see a reduction in consumption equal to the amount in black. This would suggest that cost_NC has gone down. In B, the consumption has increased by the amount in medium grey suggesting a cost increase. Clearly, there are no changes to the capacity costs; hence, cost_C has not been affected by the improvements

I’d like to take a moment to offer an example of believing cost_NC is the same as cost_C is a conversation I had with a health-care executive who suggested that a day in the hospital costs $7,000. The thought this person had was that if they could reduce the cumulative length of stays annually by 1,000 days, they could save $7 million. He believed that the $7,000 was cash.

This number was calculated primarily by allocating capacity costs to a patient day during a hospital visit. There is the cost of her room, carved out of what is paid for the building. There is the time the nurses and other staff spent with the patient. There are tests to be run, drugs to be administered, and so on. The cash costs do not change based on whether a patient is there or not. The allocated costs are values placed on the consumption of resources when taking care of a patient for a day. This calculated value is the essence of cost_NC.

If you are the decision maker and you don’t realize the $7 million is not real, you are duped into believing that there is a huge financial opportunity on the table. Instead of basking in the glory of making a $1 million investment to gain $7 million in improvements, you’re left on the hook to explain to your boss or your board why you invested $1 million and barely broke even.

Changing how you consume capacity may affect cost_NC, as seen in Exhibit 15.7. You consume less, so it makes sense that something should go down. However, changing the rate of consumption of what you have already paid for does not change cash, it just improves your efficiency.

Less Purposeful

When costs are allocated without regard to whether there is a different rate of capacity consumption or some attempt to add purpose to the allocation, the cost assignment is less purposeful. One example is the average cost per unit. With the average cost per unit, you basically take your capacity cost and divide it by output. Pictorially, it is seen in Exhibit 15.8.

Exhibit 15.8 When you take a capacity cost and divide it by output, you end up with the average cost hyperbola. The question must be asked, though: What does this curve tell you? We have established that cost per unit represents cost_NC and, therefore, does not affect cash. Logically, considering Exhibit 15.1, the idea that the more you create, the more capacity you’d consume and, therefore, possibly buy, cost_C should be a monotonically increasing function with respect to consumption. Simply, this means that as consumption rates increase, the cost of the capacity will either remain the same or increase. Consuming capacity will not put you in a position where the cost, cost_C, goes down with increased use. If cost_C does not go down but this curve does over the same domain, how useful is this curve? It describes the opposite of reality

If someone made 30 calls in an hour where they made $30, each call had a calculated average cost of $1. If you made more calls, the average cost per call would be less than $1. If you made fewer than 30 calls, the average cost would be greater than $1.

There are many issues with this approach, of course. An assumption may be all calls have similar attributes. Although this may be okay in some cases such as when considering call length with a fairly small time standard deviation, what happens if there is a large standard deviation? One client used this broad approach to cost their products. The most simple product had the same cost_NC as products that were many times more difficult and complex from a production perspective, with substantially more labor and material consumption. Again, both had the same cost_NC.

This created an issue for that client. The question was what to charge their clients when the costs don’t reflect effort, complexity, and capacity consumption? One answer is, of course, your effort doesn’t matter when it comes to pricing. Have you ever purchased a car, a meal, or clothes at a given price solely because of the perceived effort of creating it? Rarely, if ever. Generally, you have no idea how much effort was put into the bottle of wine, the suit jacket, or the phone you just bought. Another answer is that cost, itself, is irrelevant when it comes to pricing.

We generally do not buy based on effort or cost; we buy based on the perception of value. However, by being smart, extra effort may be captured and articulated in ways that increase the perception of value. Hand-built cars and custom-tailored suits may be perceived as being more valuable; therefore, they often demand a higher price. Also, specialty items may consume more input, so this may limit your revenue potential unless you earn a higher price. In this client’s case, the fact that they would take the time to create specialized products and packaging should increase the perception of value if marketed properly. In addition to not affecting cash flow, there is another reason modeling cost_NC is of limited value: the same set of circumstances can create different costs. Let me explain as this issue also came up in Chapter 10.

There are many ways to calculate the cost of a customer service call. Each approach leads to its own answers, and if two answers converge, it is likely a coincidence. Exhibit 15.9 shows how the same scenario can create multiple answers; multiple costs. These different costs are due to the various ways of assigning input costs.

Exhibit 15.9 In physics, there is an idea that you cannot know the exact location of an electron. The reason is the technique you would use to determine where the electron is would move the electron. It would be like your GPS moving you every time it tried to figure out where you are. Costing is similar. The answer you get when trying to calculate the cost changes with the technique you use and how you use it. Given this to be the case, how confident can you be with any calculated cost number?

If one scenario leads to multiple costs, you have to ask, which cost is right? Is any one of them right? What does right mean in this context? I regularly deal with executives of companies who tell me they understand their costs very well. But do they? Since costing requires the arbitrary assignment of capacity, you, I, or anyone else could come along and create a different cost value in as much detail, from the same set of circumstances and data. So, although they may have precise information about their particular costing calculus, anyone else can come along and create a completely different and equally valid calculus that could challenge theirs.

Conclusion

The cost dynamics of capacity are simple. You buy capacity and you pay for it. That’s it. All the attempts of individuals, accounting groups, and organizations to come up with a better way to cost are just attempts to create a different way to allocate costs—to create relationships where they do not exist. They are spinning. That is arguably why these approaches exist at all. Each approach, however, is abstractly the same. They all try to tie two independent things together, and in the end, this fails logically and mathematically. It is for these reasons I argue changes in efficiency, effectiveness, and productivity have no direct cash flow affect. Efficiency, for instance, often involves reducing the rate of capacity consumption and in that context it will not affect how you spend money. Being inefficient, ineffective, and unproductive may create a situation where you may need to buy more capacity than necessary or sooner than necessary to meet demand, but changing any or all of the metrics will not affect cost_C. This notion is critically important to understand and is covered in Chapter 12. If improvement opportunities and their business cases are heavily weighted in total value or magnitude by cost_NC, your cash flow improvements will not be realized as expected.¹

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¹Reginald Tomas Lee, “How we Overstate ROI on Improvement Projects,” Cost Management, November/December 2015.