We’ve been fooled. Bamboozled. What has fooled you, me, and practically every business person on the planet? Accounting information. It is pervasive and practically everyone uses it. Kids with neighborhood lemonade stands calculate how much money they believe each cup of lemonade will make. Executives at major global companies look at accounting information as they try to “make more money” by increasing profits. Hospital executives try to reduce the length and, therefore, the cost of a patient’s stay in the hospital to improve profitability. Those who offer capital and debt services look at accounting information to determine whether, and to what extent, the companies they are looking at funding are making money.
See a common thread? People look at accounting information such as costs and profitability to determine whether a company is making money, and for guidance and information about how to make more. We are led to believe this accounting information represents money and making money, but it doesn’t provide us with the information we truly need to make money, and I’m not convinced it even tries. For example, if accounting were about money, why are there noncash items on the income statement where profit is calculated? Why can the value of an asset on the balance sheet be determined by subjective data and arbitrary relationships? Why, when using the indirect method to create a cash flow statement, can you use net income data from the income statement when the net income calculations include data from accruals and the cost of goods sold (COGS)? Why is this a problem, you ask?
In my last book, Lies, Damned Lies, and Cost Accounting, I argued extensively, and will again here, that COGS, the key cost component for gross margins, isn’t money. It has the same unit of measure as money; dollars for instance, but COGS is an opinion of worth or value. It is not money. Therefore, the gross margin calculation, itself, is questionable from a cash perspective. How can you take revenue, which, let’s say for now is money, and subtract something that isn’t money from it? But revenue doesn’t get a free pass either. You can recognize revenue for a sale before you have received money from the sale. In other words, you can calculate a profit from revenue you haven’t received. If that’s true, the revenue used in profit calculations isn’t always money either. This leaves us with a calculation that is supposed to be about money, but instead often compares money not received to an opinion of value from money spent in a previous period. Somehow, this is supposed to tell us whether we’ve made money in the current period.
The idea of tying COGS to revenue from a sale is an accrual technique called matching. Here is how absurd matching is. Let’s add a bit of detail to the earlier example. Say I sell you a coffee cup for $5 in February. I made it last year in December and my COGS was calculated to be $2.50. Matching basically says, “take that $2.50 and tie it to revenue from the product when it is sold.” In other words, I incur the $2.50 cost from a profit perspective in February when I sell you the cup and recognize the revenue. I sell you something in February, but I incurred the cash cost of buying labor and materials months before. To make it even more fun, I let you pay me in March. I can calculate the profit in February by taking revenue I won’t receive until March and subtract a noncash value based on production activities—money spent from two months ago—and calculate a value I think is money. How much sense does that make if the objective is to understand whether you are making money in the current period?
The reliance on accounting information has caused really smart people to do not-so-smart things. For example, consider make-versus-buy decisions where a company has to decide whether they are going to make a product or buy an equivalent from another company. An accountant calculates an internal cost of $3.18 for an item her company makes. An outside provider will sell an equivalent to her company for $3.05. She believes she is saving 13¢ per unit by going with the outsourced option. However, there are two problems. First, the $3.18 is a cost calculated using a particular scope and allocation methodology. If she changed scope or costing methodology from standard costing to activity-based costing, for instance, she will more than likely come up with a different cost. The calculated cost could just as easily be $3.25 or $2.91. In fact, the numbers can differ sometimes by as much as 200 percent.1
Second, whatever number she calculates is not cash anyway. A calculated cost is an opinion of the value of resources or capacity consumed in making a product or performing a task. Say you perform a task at work that takes ten minutes. Someone calculated that task to cost $25. When you perform that task, no money changes hands; there is no cash transaction. How did the $25 come about? Someone likely put a rate on time, such as $2.50 per minute, hence, a 10-minute task would cost $25. As we will find later, that number will change based on the assumptions that go into the $2.50 per minute calculation. When doing the make-versus-buy savings analysis, our accountant compared an opinion of value that isn’t money and whose magnitude can change by tweaking a few assumptions or parameters (make) to spending money (buy). Then, she pats herself on the back when it appears as though she’s saved 13¢ even though that number could just as easily be 20¢ or −14¢, and, again, it isn’t money anyway. Imagine how many jobs have been lost as a result of analyses such as these that are mathematically unsound.
I don’t blame accounting. Accounting is like a butter knife. Butter knives were designed to cut butter. Once we try to use the butter knife to cut things it wasn’t designed to cut, or use it to do things it wasn’t designed to do, it fails. Butter knives are not good at cutting leather, or cutting down trees, and they’re horrible hammers. Knocking the butter knife because it can’t cut down trees or drive nails is senseless. Because it’s good at cutting one thing doesn’t mean it is ok to extrapolate that into all things cutting, or to use it in any other type of situation you can conceive.
Accounting was arguably designed to report. Because accounting creates a portion of a company’s financial information (cutting butter) doesn’t mean it should be used for all others matters that appear to be money related (cutting down trees). It is the overly ambitions academics, consultants, and business folks who look at cost accounting and say, “Hey, we can calculate a cost for this pencil (cutting butter). What if we use the same basic approach to calculate the cost of an activity such as processing an invoice (cutting leather)? How cool is that?” Or, “We calculate profits for reporting purposes (butter), why don’t we calculate profits for customers, or departments, or patients (cutting down trees)? How cool is that?” It isn’t.
Since accounting techniques were designed for reporting, certain concessions were necessary for it to perform properly. Let’s consider the early textiles companies. Around 1812, the textiles industry began to integrate vertically. This created a challenge. Before, companies would buy output from artisans. There was a clear transaction—money for a rug, for instance. Companies started hiring artisans and paying them a wage. Let’s say this wage was $2 per day. This creates a challenge when reporting profit. It was easy before. They bought a rug for $1, so that was the cost. Now, they’re buying the artisan’s time. Whether they made no rugs or an infinite amount in one day, the cash cost for labor was still $2. The question is, if you have to report the gross margins, revenue − COGS, how do you determine the cost of a rug? This is a question accounting is still trying to answer 200 plus years later. It’s an extremely challenging mathematical question, and every new cost accounting technique tries to come up with a better way answer it.
The issue lies in what accounting is asking math to do. There is no mathematical relationship between the $2 you pay an artisan worker for a day of her time and the rugs she makes during that time. But if you’re required to report the cost of the rug, you will need a relationship to calculate it. The problem is, a relationship doesn’t exist. Since it doesn’t exist, you have to make one up, and since it is made up, it is arbitrary. This calculation is a questionable move mathematically when used for reporting, so in the context of creating managerial information, it can be downright dangerous.
The result has been a misunderstanding of what accounting information tells us, when to use it, and how it’s different from making money. Consider these four, very common cost-related sacred cows:
1. Costs are money
2. Reducing costs saves money
3. More profit equals more money
4. Costs and profit are measured
Each one of these is false, but we’ve been bamboozled into thinking they’re true. Let’s consider each in turn.
Costs Are Money
Say you make $60,000 per year and you perform a two-hour activity. Someone asks, “What did that activity cost?” How would you figure it out? One way may be to try to turn your salary into an hourly wage, such as $31 for each hour you work, but how? Do you assume a 2000-hour work year? 2040? 1960? What number do you use? It’s a guess, at best, in foresight. You won’t know how many hours you worked until the year is over, and even then, do you consider only productive work time? Are breaks included? There is a lot of subjectivity just in calculating an hourly rate.
Let’s say you use 2,000 hours for simplicity to calculate an hourly wage of $30. The task takes two hours, so you decide the activity costs $60. There are two problems with this. First, the $30 per hour is not an hourly wage. It’s a proxy. You aren’t paid by the hour. If an hourly worker works another hour, the company pays her another $30. If you work another hour and you’re salaried, you’re late for dinner and you are going home with no extra money. As a result, the $30 and, therefore, the $60 cost for the activity are not cash. It’s one of many possible representations of the value of your time. Second, to reinforce this notion, if the $60 were cash, who is your company paying when you perform the activity? Does your company lose $60 when you perform the task or save $60 if you don’t? No. There is no cash transaction when you perform the activity, so the $60 is not money.
I call these calculated costs costNON-CASH or costNC, so people know they aren’t cash values. The only cash value in this scenario is what you’re paid in salary, which is $5,000 per month before taxes. The cash cost for you to work for the company, paid as your salary, is designated costC for costCASH. Although they’re both costs and they have the same unit name, dollars, they are very different. One is money and the other is not, suggesting only some costs are money.
Reducing Costs = Saving Money
Let’s say your company spends tens of millions of dollars buying an ERP system for a huge transformation and hires a very large global consulting firm with tons of consultants to implement it. One of the thousands of value opportunities they’ve included in their business case to help them justify you paying all that money, is the $60, two-hour task that you perform. They propose their new software will cut the amount of time it takes you to perform the task in half, from two hours to one. This would suggest a reduction in cost from $60 to $30. Let’s say this task is performed by you and others in your organization 1000 times per day. The consultants will claim to save your company $30,000 per day. Over the course of a 52-week year, this equates to $7.8M. Wow. Impressive, right? No.
First, remember the subjectivity that went into figuring out $60 in the first place. Next, recall the $60 was not cash. Finally, you all aren’t being paid any less money as a result of spending less time doing the task. All the solution did was reduce the amount of your time that is consumed performing the task. This, of course, leads to a lower calculated cost, or costNC, but you are still paid the same and you still have other work to do. The key difference is, now you will have more time to do it. Overall, no money has been saved. Imagine the poor soul who agreed to $23M in savings over three years and bought the software and expensive consulting, believing they will see savings for the firm. Large costNC savings may occur, but no money is being saved.
More Profit = More Money
Assume every time you perform the $60 task, you’re able to charge a customer $100 for the service. After the improvement, there is no increase in demand for the task, so you will not be performing the task more than before. Your technology solution has now reduced your cost, costNC, from $60 to $30. Does that mean you’ve now made $70 as a company versus $40 before? If so, where is the additional money coming from? They still pay you $60,000 regardless of how much time it takes. The company still receives $100 in revenue each time you perform the task. From a cash perspective, costC is constant, hence, you have not made any more money. From an accounting perspective you have improved margins. Cash says no more money has been made and accounting says profit has increased. That’s a problem.
Now, you may try to argue the efficiency improvement may improve the cash position because the company can sell more or reduce capacity by reducing the number of people employed. In other words, the efficiency enhancements caused other improvements to occur. This is like blaming airplane crashes on gravity. Gravity does not cause a plane to crash. It is an enabler. If there is a significant enough failure, the plane will fall. Similarly, efficiency improvements don’t automatically create savings, they enable them. If there is a significant enough improvement, you can make changes. If you have more time, you can perform the task more frequently potentially creating more output. The financial improvement from increased output, when the output is salable, comes from greater revenues, not reduced costs. There is a caveat, though. There’s an assumption there is demand for the output. What if there isn’t?
The only cost cutting opportunity, in this case, is reducing capacity; buying fewer or cheaper people. There must be a managerial decision and act to change the staff level. The IT solution improvement won’t fire people and people won’t fire themselves. Although the people are more efficient, something must occur to realize cash savings.
This notion is often overlooked by managers willing to “do good.” I was once brought into a situation where a major global technology firm needed to reduce costs significantly. The leadership needed eight figure reductions in costs, but they weren’t willing to part with people. They believed by making their people more efficient, $20+ million dollars would just disappear. Unfortunately, money doesn’t work that way, even though scores of consultants make such promises. As long as the people were still on their payroll, the cash costs would still remain, hampering their ability to realize the desired savings.
I often see consultants telling prospects they measure costs and profit. I hear and read academics talking about the notion of measuring costs. Robin Cooper and Robert Kaplan, Harvard Business School professors even wrote an article for the Harvard Business Review titled Measure Costs Right: Make the Right Decisions. If anyone tells you they measure costs and profits, and they use accounting techniques to do so, you should look at them funny. Measures suggest certainty. You can measure by counting and you can measure using a measuring device or standard such as a tape measure or a thermometer. In each case, within the precision of the tool or approach, you’ll converge on the same answer. It’s 55 degrees F plus or minus 2 degrees. Twenty-three people walked in the front door. Cash is a measured value. You know you spent $5,000 or received $2,718.35. These amounts are known, or at least should be. If they aren’t, that’s a topic for another book.
Accounting costs and profit are just the opposite. We didn’t measure the $60 for each two-hour task, we figured it out; we calculated it. We made assumptions to create a rate of $30 per hour, which could have just as easily been $20 or $40 depending on the assumptions we made, scope we used, and costing technique we chose. How realistic would it be if you walked outside to check the temperature and found it’s either 55 degrees, 72 degrees, or 12 degrees? Or if either 12, 17, or 33 people walked through the door? How much sense does this make when you’re looking for a precise, measured value such as what something costs? None.
Accounting costs, therefore, aren’t measured. They’re calculated. Profit, too, is calculated. You don’t measure either, you figure them out, and a different set of assumptions will lead to a different cost or profit. If you have multiple costs and profit values, which one is right? Taking liberties with Segal’s Law, a woman with a watch knows what time it is. A woman with two watches is never quite sure. This is practically the opposite of measuring something where your opinions and ideas don’t matter and will not, therefore, change the outcome. Neither the temperature nor the actual number of people who walk through a door are affected by your opinion of what they should be. However, with calculated costs you can use practically any assumptions and techniques you want. Want to reduce taxes? Make profit smaller by considering more factors that will increase your costs. Want to improve market value or improve credit worthiness? Accounting can accommodate. This is not accounting’s fault. It is how we have chosen to exploit the tool.
What’s sad is, this information seems almost like a drug of choice to business leaders. There is an addiction to it and a fear of discontinuing its use, even when they know the information is either suspect or downright wrong. Many who have read, The Goal by Eli Goldratt, for instance, loved what he had to say. They buy into Dr. Goldratt’s ideas, talk about how great the book is, and then turn around and ignore what he said and focus, instead, on the cost accounting numbers he lambasts. Others, too, have questioned the relevance of cost accounting information. Taiichi Ohno, the leader within Toyota who was responsible for the Toyota Production System, the precursor to lean, was adamant about not using cost accounting. In fact, Ohno reportedly suggested, it wasn’t enough to drive cost accountants out of his factory. He had to drive cost accounting out of the heads of his people. He knew the potential negative effects of cost accounting information, yet many companies I’ve worked with who claim to have implemented lean still use cost accounting information. Dr. H. Thomas Johnson, coauthor of Relevance Lost with Dr. Robert Kaplan of activity-based costing fame realized, after Relevance Lost was published, that they were wrong and spent years trying to address the issue, writing books such as Relevance Regained and Profit Beyond Measure. The information is out there, but we refuse to use it.
There are options that can allow for a shift away from misused and misunderstood accounting information toward an environment that is more effective at modeling whether you made money and provides better context for managerial decisions. It all begins with The Goal.
1 Cooper, R., and R.S. Kaplan. September–October 1988. Measure Costs Right: Make the Right Decisions, 100. Harvard Business Review.