Revisiting the Objective—Cash and Decision-Making
There comes a point when you have to ask the question, “What is my objective?” when it comes to financial decision-making. Companies spend an inordinate amount of time creating, analyzing, and trying to affect accounting data. They make substantial investments in large departments with many people, and in IT systems that sometimes seem almost singularly focused on creating and keeping track of accounting data. Consultants have made many billions, if not trillions, of dollars helping companies to cost better, calculate better cost data, and reduce their costs.
When you look at each of the cost accounting approaches that exist, what the people who designed them and use them fail to see is that it is the paradigm that is wrong, not the technique they use. Let me explain.
At the risk of alienating an industry for the sake of example, let’s pick a simple concept. Let’s say that you like to spend time spinning in circles to help you feel better, and you choose to do so, arbitrarily, in an anticlockwise manner. Your physician comes to you and says, “That doesn’t work. It isn’t going to help you feel better.” So you decide to start spinning clockwise because you believe, and know in your heart, spinning does make a difference Things aren’t better. You’re still spinning. So you decide to do forward rolls. Again nice idea, but you’re still spinning. You’re just doing it around a different axis. The issue is, you’re still trying to find a different or better way to spin, but the answer is: Spinning doesn’t address the issue—no spinning does. Just because you create better or different way to spin doesn’t mean you have solved your problem or have a better solution.
The same issue occurs with cost accounting. I was once a part of a discussion among cost accountants that was focused on trying to increase the relevance of their profession and of cost accounting in general. My suggestion to them? Stop costing. It doesn’t matter how you choose to cost things. What is wrong is the notion of costing itself. There are three reasons costing is a bad practice, and it doesn’t matter what technique you use:
1. To get a cost, you have to create and force math and relationships that do not exist.
2. By doing this, you lose touch with your operations.
3. You create meaningless numbers that people consider as gospel.
Remember the example of old telephone charges described in Chapter 6? The idea of land lines and long-distance calling charges? The question still remains: How do you determine the cost of a local call? You have to create an artificial relationship because a mathematical one does not exist. You can take the total number of calls and divide them into $25. You can consider the length of the call. You can even consider the number of ducks that fly over your building during the call. You can actually do anything because in the end, the relationship is arbitrary. It does not exist naturally or mathematically. The number of calls you make, the length of your calls, and the number of ducks have nothing to do with the $25 you pay per month.
The different costing approaches focus on helping you do the equivalent of determining how to assign the monthly fee to a local call. Each tries to come up with a better way to assign the costs, but in the end, they are still spinning. The issue isn’t how you allocate cost or assign costs. It’s that you’re assigning them that makes it wrong.
When you choose to create a relationship that does not exist, you lose information. Let’s say you take the number of calls and divide them into the $25 fee you pay for service. If you make 25 calls, each call is calculated to cost you $1. How long was each call? Will the cost per call tell you? No. You don’t know. Let’s say next month the cost per call goes down to $0.96. What is that telling you? Does this mean you saved $0.04? How did you save it, and where is the four cents showing up each time you make a call? If it doesn’t mean this, what does it mean?
In the latter example, you may have made one more phone call in the second month. You made 26 calls versus 25 calls. But when I tell you $1 per call versus $0.96 per call, although you may be able to back into the answer in this simple example, many situations are much more complicated. If you are making mobile phones, will you be able to tell, simply and clearly, where that four cents came from without detailed explanation? No. Additionally, in the case of the phone calls, which description made it easier to comprehend what actually happened? I made one more call or I saved $0.04? What does it mean when you reduce costNC from $1 to $0.96? Regardless of what your answer is, we know it doesn’t mean you save cash by making 26 calls because the cost for access is still $25.
With costing, you choose to go down an allocation path when you choose the technique you will use. Once you go down this path, the result is a single representation of an artificial reality. Assume you allocate costs using activity-based costing, and you end up with a number—a costNC. Now, let’s assume you don’t know how you got the cost, but you have it. Someone tells you it costs $12 to make an insulated mug. What do you know about what it took to create that mug either operationally or financially? Let’s assume you try to reverse this process in its entirety without understanding how you got there. You will not have a complete picture of how you got to where you are cost wise. For example, if you use standard costing to calculate a cost savings, but the cost was calculated using activity-based allocations, your savings projections will likely be wrong because the assumptions used to get the $12 are very different from the assumptions you’re using for improvements.
In the end, your cost per call is a meaningless number from a cash flow perspective. It is costNC. In addition, it can, in many situations, create the disconnect between accounting/finance and operations. What happens? Someone uses an approach, calculates a number, and now it’s gospel. How many times have you heard someone talk about the cost to create an invoice or cut a check? No matter what attempts people make to explain why the number isn’t valid, others have already latched on to it. Once they see this value, it now becomes the basis of conversation, regardless of how the number came to be.
Once on LinkedIn, a commenter decided to calculate a cost per meeting and wrote an article about it. Once mentioned, people accepted the number and discussed the implications, but no one challenged the number. How did this number come to be, and what does it mean? The author took salaries, created an hourly rate, and used that to determine the cost for the meeting. Let’s say this cost was $1,000. Is your organization paying someone $1,000 to have a meeting? No. It is costNC. However, instead of asking whether this number had any relevance, everyone followed the first lemming off the cliff assuming this was an important and valid number, and committed themselves to it.1 It wasn’t valid. It meant nothing from a cash flow perspective, only from a costNC perspective, and since many don’t know the difference, they think paying $1000 for folks to have a meeting would be the same as paying someone $1,000 to come in and sit in a meeting room.
When people quote a cost per number, others latch onto it. It costs us $100 an invoice. Each customer service call is $6.75. These are costNC values, but people often use them as if they were as good as gold. The reality is that most of the time, you don’t spend any differently when you do work, suggesting costC doesn’t change. Recall, you pay to have the local phone service, so there is no costC change when making local phone calls. The numbers are not real, but people hold on to them. They believe they are in the real world, but in reality, they are in the accounting equivalent of The Matrix and its subsequent artificial reality.
The implications of these suggestions are huge. How much time and effort does your organization put into calculating these costs that are not related to cash? Likely lots, because they are hard to create and manage. They are all based on the approach you used to create them. Your systems have to be designed to reflect this approach. Your people have to identify variances and why they believe these non-cash costs may be increasing or decreasing. How much money does your organization spend trying to do what is mathematically the equivalent of trying to calculate, manage, and reduce the cost of a local call? My guess is, a lot. These numbers they are managing are assumed to be the equivalent of cash. They aren’t. Companies spend millions of dollars on people and information technology to manage costs that have nothing to do with money. What decisions are being affected by this information? You decided to make a huge investment in technology or lean because you will save $10 million. What if $9.5 million were costNC and only $0.5 were true cash savings, costC? Would it change the decisions you make? It should. How you calculate the ROI? If you spend $2 million, your cash flow ROI will not be 4:1. Instead, it will be −0.75:1. Isn’t this difference pretty significant?
What is your objective? Is it to create numbers that you know are wrong for the sake of having a number? Or is the objective to understand your organization and to make better decisions as a result so you can improve cash flow? To understand how some things you do will not affect cash at all, and to be able to identify them and plan for them?
The bottom line is this. You may be thinking the same thing as many others have asked me; I understand what you are saying, but at least I have something when I have a cost!” My response is, why is having a useless number better? Think about these three characteristics of costs.
1. There is no single cost
2. Costs are created through arbitrary relationships
3. Costs are not tied to cash flow
The cost you have is determined by the approach you use. The calculated costs using different methods do not converge to a single value as you would expect or hope it would if there were just one cost. Ten thermometers might create confidence that the temperature is a single number say 55°F. This should tell you that each measurement device, considering the inherent error, will still come up with a value that represents the reality of the environment. The same does not happen when calculating costs—determining a value for costNC. Each approach takes the same information and creates a unique value, which should cause you to question any value you get at all (Exhibit 10.1)
Exhibit 10.1 Even though you bought something and consumed it one way, it is possible to create multiple representations of what that consumption costs
As stated throughout the early parts of this chapter, the dynamics of calculating costNC require arbitrary relationships to be created. When you pay someone a salary and you want to calculate the cost of a report she creates, there is no relationship between her salary and what she does or creates, including the report you’re trying to cost. As mentioned before, the only way to make a connection is to make one up. Because this relationship is arbitrary, its inherent value should be called into question.
As stated numerous times previously, calculated costs, costNC, have no relationship with cash flow. You can lower costNC and have no effect on cash. For example, if costs per call were calculated by dividing the number of calls into the $25, making more calls has no effect on cash, yet costNC is lower. Likewise, you can reduce cost and have no effect on profitability. If you lower the cost of a meeting to $500 by cutting a $1,000 meeting in half time-wise, not only does it not affect cash flow, it would not affect profit either, since sales, general, and administrative (SGA) numbers on your income statement will not change just because you’re efficient. SGA costs are mostly tied to what you buy, not how you use it.
In the end, what are you trying to accomplish? Ultimately, I would propose that the objective of all this is to put yourself in a position to understand how you spend your money, what you buy, and how to get desired output levels in an efficient and productive manner. You want to make decisions that will help you improve cash flow and avoid promising improvements from investments that ultimately fall flat. If you can do this, you should be in a good position, and the fact is, you can do this without calculating cost and without using accounting data.
The hypothesis that shapes the rest of this book is that you can get information you’re looking for without a single costNC being calculated. The idea is to look at how your company is structured, what it buys, and how efficiently it creates output. This will provide you with simple understandable data that not only helps you see your organization more clearly, but you’ll also have much more correct and relevant data than you would have using the output from cost accounting. What is this approach? Understanding and managing capacity. Let’s begin by creating a foundation.
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1I’ve heard the lemmings suicide story was false and was a story perpetuated by Disney. I’m ok with that because A. We are aware of the story and it works in this context, and B. How is this different from perpetuating a false story of a mouse being able to talk and carry on conversations?