By now you will hopefully come to the conclusion that costNC is of little value and does little more than create confusion. You do not really need it unless someone from the outside requests it. For example, if a customer asks you for your costs as a part of your relationship with them, you will have to calculate and provide them. In these cases, I’ve proposed that instead of using the idea of a cost, we use the idea of worth.
Let’s say you bought 10 pounds of flour for $10. We know that the cost transaction was buying the flour. Using a pound will not cost you $1. It will not cost you anything. It is consuming capacity you have already purchased. In that context, all you really need is to determine a reasonable value for consuming that flour. This is where worth comes in.
When we use a pound of flour, we may say we have used a pound’s worth of flour. Worth represents an amount or value of how much flour was used. The amount consumed is in capacity units, or CU. CU represents how you buy capacity. For instance, you buy labor, generally, in time. You buy space in square units such as square feet. You bought 10 pounds and consumed one of the 10 pounds. You have nine pounds left. If you need a dollar value for the capacity consumed, I generally recommend dividing the price you bought the capacity for by the amount of CUs you bought. For example, in this case you have purchased 10 pounds (pounds is the CU) of flour for $10. Each pound is worth $1. Notice this is not a cost. Using one pound does not cost you anything. It is an attempt to put a value on each of the 10 pounds of flour that you bought. It takes away the value of one pound versus another by considering them all equal. You can do this with any capacity you buy and use any relevant CU. If you pay someone $400 to work an eight-hour day, each hour is worth $50. A meeting that lasts two hours uses two hours’ worth of capacity or $100 worth of capacity.
I chose the term worth for two reasons. First, by using the term cost, people will believe it is, and behaves like cash. It does not. Worth eliminates that confusion. A meeting uses $1,000 worth of capacity tells you something about the consumption of what you paid for. Saying a meeting costs $1,000 conjures up images of money leaving your company, which it does not. Additionally, it can reflect relative value. If four senior members of the company are in a one hour meeting, we might expect it might be worth more from a time perspective than a meeting with four co-op students.
The second reason is that worth aligns with capacity really well. First, speaking specifically about capacity, you will know how much capacity you have and how much you’ve used because you are still working in CUs. For example, you fill your gas tank up, go on a trip to a friend’s house, and you come back home. You have a half tank of gas left. You know the trip took a half tank’s worth of gas. You know, then, that you have a half tank left. If you know your tank size, 20 gallons for instance, you can say you’ve used about 10 gallons worth of gas. Figuring out what you have and what you have used becomes much more clear when considering the CUs that you buy.
The second thing this allows you to do is tie what you paid to how you consumed it. If you bought gas at $4 per gallon, you can say each gallon is worth $4, and your trip consumed $40 worth of gas. It did not cost you $40, that is the value of what you consumed.
I recommend to people that they use worth to keep track of costNC information. If you absolutely have to have dollar value for capacity consumed, instead of reporting a cost, consider reporting worth and call it a cost if you must.
You may ask, “Without costs, how can I determine whether my products are profitable or not?” The simple answer is, you will not know if you have costs! There is not one true profit. First, remember, there are any number of costs that can be calculated for your product, and each one involves creating arbitrary relationships. Since there is not one cost, there is not one profit. If there is not one profit, how do you know which one is right? And again, we are not dealing with cash-based costs so what is profit telling you? So how valuable is the number? If you really needed a number, compare the capacity consumed to the revenue generated. This is a representation of efficiency and can be used to compare the efficient delivery of products and services.
Second, there is a bigger issue considering the profit of products, customers, and the notion of make versus buy analyses. Those devoted to accounting will assume these types of analyses are fine. You can consider the revenue two products bring in, subtract out the costs associated with them, and determine which is more profitable. You could look at customers, how much revenue they generate versus the cost to serve them, and determine customer profitability. Finally, there is the idea of whether we should make something or outsource it to another company or even another country.
With each of these analyses, you are ultimately subtracting costs from revenues. Assume for the moment we are considering cash revenues only. Some of the costs being subtracted from cash revenues are costC numbers, which are cash. However, many, if not most, of the costs and customer and product line profitability calculations are not cash. For instance, activity-based costing analyses consider how much time and effort one customer consumes versus another and calculates a cost for this. This cost is costNC. Folks will take this noncash number and subtract it from a cash number to calculate what is, to them, an important cash-based financial value. Subtracting a noncash number from a cash number is like subtracting rocks from trees. This does not make sense.
What is worse is that this number has assumed meaning. I’ve seen many cases where if costNC is greater than revenues, the product or service would be deemed unprofitable and actions would be taken. Does it make sense to subtract five rocks from three trees and assume, because the value appears to be negative it is bad? No, but the decision makers decide they will no longer offer the unprofitable product or service, or support what appears to be an unprofitable customer. There is a simpler way using the tools you have learned in this book:
1. Explicit cost dynamics
2. Worth
3. Efficiency
Explicit Cost Dynamics
Explicit cost dynamics will create understanding of where cash is coming from and going, and when. The focus will be on capacity and transaction costs and the rate of generating cash.
Worth becomes the basis for understanding more of the details behind capacity use and assigning a value to consumed capacity.
Efficiency
Finally, armed with this information, you can consider efficiency or productivity values to compare performance across products, services, or customers. The basis for the efficiency becomes how much revenue is generated compared to capacity used. Here’s a simple example of how I use these tools for clients.
Let’s say your kids want to create a sandwich shop for your neighbors. You tell them they must make money off of the setup. You buy a loaf of bread, with 20 slices for $5, two packs of cheese, 10 slices each, for a total of $8, and 25 slices of turkey for $10.
You spent $23. Assume you charge them $5 to use the front yard. To breakeven on a macro scale, the kids will have to sell at least $28 in sandwiches. From what you bought, they should be able to make 10 sandwiches that have two slices of bread. Table 20.1 shows what the average price of a sandwich would need to be to break even.
Table 20.1 The purpose of this analysis is to help you understand how much revenue you need to generate and how that ties to output capacity. It also helps you understand the importance of demand and quality. If you have quality issues and limit your output given the capacity you have, you have to make up that revenue with fewer sales opportunities. Second, and similarly, demand is critical. If there is little demand, as with quality, you have to make up your revenue with fewer sandwiches. It isn’t about the unit margin, it is about the cash you have to earn.
Any issues in terms of using their materials inefficiently or having quality errors that would cause the number of potential sandwiches they could make given their starting capacity to go down would mean the average revenues from each sandwich would have to increase.
The first question is: What will the kids offer to sell. They decide to sell various types of sandwiches, as shown in Table 20.2.
Table 20.2 The offering considers the use of the capacity involved to make it. This becomes the basis for worth calculations.
Next, we look at the worth of the ingredients so we can calculate the value of the ingredients that goes into each sandwich (Table 20.3).
Table 20.3 The suggestion with work is that when you buy capacity, all capacity units (CUs) are worth the same from a consumption perspective. It doesn’t mean some CUs will not generate more revenue. For instance, if you were to sublease office space you have, each square foot would be the same from a worth perspective, but space by windows or with a view may demand more revenue.
With this information, the kids can now begin to assign worth to each sandwich type. Of course, labor is left out here purely for the sake of simplicity, but it, and the other input capacity types, would be included where relevant in more comprehensive analyses. We can now look at the worth of the capacity consumed by each sandwich, found in Table 20.4.
Table 20.4 The values here represent the value of all the ingredients used to create the sandwich. It is unbiased and simple to calculate.
The kids can now begin thinking about how much money they need to generate and what price they believe the market will support. They set the lowest price at $3.00, assuming, based on Table 20.5, if they only sell the minimum sandwich, they can break even if the demand is there. They set the other prices considering their perception of the relative value that the sandwich has in the market.
Table 20.5 These are the initially proposed prices. Proper pricing practices align price with the perception of value on the market. Note that although the Turkey is the lowest priced offering, if they sold 10 plain turkey sandwiches, they would still pay their cash obligations, but would not earn much of a salary!
When you now compare the price to worth, there are two things that become immediately apparent. First, if you try to take the difference between price and worth, you will realize the number doesn’t make sense mathematically. You cannot subtract numbers with dissimilar units. Recall subtracting rocks from trees. Second, the difference between the price of a turkey sandwich and the worth of the ingredients consumed is $2.10 (Table 20.6). If you multiply this $2.10 by the total possible sandwiches, 10, you get $21.00, suggesting there would be a $21.00 gross profit.1 This does not happen. If you look at the money spent, you would gain $30 and you spent $23 on materials for a gross profitC of $7.00.
Table 20.6 This is the key information about each offering; the price and the worth. The tendency is to compare these two and calculate a profit. Do not do this. The worth does not take into account all that you bought and therefore spent cash on. Additionally, the numbers are dissimilar. One is a cash based value and the other is a calculated non-cash number. It only focuses on what you used. Therefore, there may be residual capacity you paid for that is not considered.
With price information and worth information, we can now look at efficiency. Efficiency in this context will help the kids consider how much revenue they are generating given the worth of their capacity consumed. This is a critical metric. Mathematically, you cannot calculate a cash-based profit for each sandwich because there is no costC associated with creating a sandwich. However, you can take a look at which products consume the most resources and compare that to how much revenue you generate. Consider the Turkey w/Cheese and the Double Turkey (Table 20.7). Both consume the same value of capacity from a worth perspective, but the Double Turkey generates a full $1 more in revenue, suggesting it is a more efficient product. The same occurs with the Double Turkey w/Cheese versus the Turkey with Double Cheese. When you consider the efficiency of all products, the Double Turkey is the most efficient. Notice, if you tried to create a “profit” by subtracting worth from price, you will find the most efficient sandwich is not the most “profitable” one. Both the Double Turkey w/Cheese and the Double Turkey w/Double Cheese have a greater “unit profit.”
Table 20.7 With worth being the input and price being the output, you can calculate efficiency using the efficiency equation. Interpreting the date would be, “for every dollar of worth consumed, this sandwich generated this amount of revenue.”
You can also pick target efficiency levels and determine pricing. In Table 20.8, you can see the updated prices given the desire for all products to reach an arbitrarily chosen 3.46 efficiency level.
Table 20.8 By targeting a certain efficiency value, you can determine the price. You can then compare the price to whether it can be sustained in the market.
When using this approach, you have a significantly more information. You know how much revenue you need to generate, how much cash you have flowing out. You know how much capacity you have and which products, or customers, consume that capacity, and you can compare it to revenues generated. You can even compare products, product lines, or customers. I call this approach worth and capacity analysis, or WACA, and it has been a very valuable tool to help me understand the situations clients are in, and make recommendations that directly improve cash flow.
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1Gross profit = revenues from sandwiches – cost of producing sandwiches, assumed to be the material costs in this case.