Dr. Reginald Tomas Lee begins this book by stating, “We’ve been fooled. Bamboozled.” I have a solemn confession: I was certainly bamboozled. I became a Certified Public Accountant, believing it would allow me to do anything I wanted in the world of commerce since everyone kept telling me it was the language of business. I was taught the importance of proper cost accounting in operating a successful enterprise, from determining a proper price to accurately calculating profit per unit. It was a cohesive body of knowledge, a tangible reality I could grasp, and a prism in which the world of enterprise I so admired could be refracted so as to make sense to a naïve practitioner who believed he knew more than he did.
One of the problems with education is the constant pursuit of practical knowledge at the expense of pursuing answers to profound questions. No doubt we all need practical knowledge to function in everyday life, earn a living, to just get by in the world. But I now realize people are not guided by what they know, but rather what they believe—their worldview, through which we all refract reality. But what if what you believe isn’t true?
This idea was made clear after reading C.S. Lewis’s essay, “Transposition,” in which he poses the following question: If you live in a two-dimensional landscape painting, how would you respond to someone telling you that the 2D image was just the faintest reflection of a real 3D world? Having grown comfortable in your 2D world—where the angles and edges and math all jibed—you might respond, “Three dimensions? I have no need for that hypothesis.”
Strategic Cost Transformation moves you into a 3D world with the concept of Business Domain Management, comprises the Accounting Domain (AD) and the Operations and Cash (OC) Domain. Most businesses focus their attention on the AD, ignoring the more important OC Domain. Understanding the difference between these domains is crucial, and the first step is the unequivocal distinction between a measurement and a metric.
The simple truth is, depending on the cost accounting method used you can calculate radically different cost allocations. Here are just several of the many approved cost accounting methods:
• Standard costing
• Total absorption costing
• Average costing
• Lean costing
• Variable costing
• Marginal costing
• Activity-Based costing
The preceding methods will result in a wide range of cost per unit. This should prove that allocated costs have nothing to do with cash.
This is why Reginald argues that cost accounting forces mathematical relationships that don’t make sense, and it confuses metrics with measurements. If you walk outside with two thermometers, you will probably get a relatively accurate temperature reading from each. That’s a measurement. Notice a measurement is not based on a choice.
With cost accounting, however, depending on the method you use, you’ll get a wide range of cost per unit—those are metrics. This explains the old joke about the accountant who is hired because when asked what 2+2 is, replies, “What would you like it to be?” It is how Enron and Bernie Madoff can report windfall profits, while being cash poor.
Furthermore, Segal’s Law applies to cost accounting: “A man with one watch knows what time it is; a man with two watches is never quite sure.” Despite these limitations, cost accounting data is treated as gospel. Yet, it is better to be approximately right than precisely wrong. Cost accounting is precisely wrong, and even new methods—such as Activity-Based costing—are just new ways to be wrong.
Reginald’s distinction between noncash costs and cash costs is brilliant, not to mention essential for understanding how manipulating costs will not alter cash. The goal is to generate cash profit, not accounting profit. Most costs in organizations today are for capacity: Human capital, facilities, and technology. These costs don’t change based on how they are utilized, and yet cost accountants force mathematical relationships that make it appear as if they did, such as cost per hour. The fact is, services and products don’t have costs, organizations do.
Besides, as Reginald makes clear, “You don’t need calculated costs for managerial purposes. The data in the OC Domain are precise and unambiguous [measurements]. The AD information is ambiguous and messy [metrics]. OC Domain provides everything AD does without the drama.”
He also points out that “AD creates information that is dangerous to the untrained eye.” As a former cost accountant, I can attest that it is just as dangerous to the trained eye, providing a false sense of accuracy and control.
Some examples: Cost accounting can create cash costs by increasing your taxes by misreporting profit; its worldview creates silos—insidiously known as “profit centers”—the equivalent of a wife giving her husband money; it leads to suboptimal pricing, especially if you use cost-plus pricing, since cost per unit changes with volume (and volume depends on price), and cost accounting method used; it leads to misleading Return on Investment analyses, since most investments will not change cash costs; it can lead an organization into having too much capacity as it nonsensically chases economies of scale and lower cost per unit. See General Motors bankruptcy for the perils of this mindset. Reginald instead proposes you model your costs to meet actual demand, not a target cost per unit.
Cost accountants have all sorts of metrics in their toolboxes they claim are the magic bullet for calculating profitability per job, or per product/ service. Yet these metrics of margin analysis won’t predict the need for additional capacity, or help you model cash flow, nor do they tell you from a pricing perspective if you’ve left money on the table. Further, these metrics do not help you improve the future performance of your organization. Cost accountants are collectively plunging a ruler into the oven to determine its temperature—it is the wrong tool.
One of Peter’s Principles is bureaucracy defends the status quo long past the time when the quo has lost its status. Cost accounting does not deserve to be the apotheosis of pricing, nor organization management. It focuses leaders’ limited attention on absolutely the wrong things.
By focusing more on the OC Domain, you will be better able to maximize profitability overall, more aligned with a portfolio approach than a profit per unit approach. But beware: this is not an easy change to make organizationally. The cost accountants and finance types will push back, mightily. Even though they understand cost accounting can be gamed, they will say, “True, but it’s better than nothing.”
Really? It’s as if three friends are lost in New York City, and one happily reports, “Don’t worry, I have a map.” “But it’s a map of Los Angeles,” says the second friend, while the third says, “Yes, but it’s better than nothing.”
In Strategic Cost Transformation, Reginald provides us with the correct map: cash flow and capacity modeling. Engineers invented and led us into cost accounting, even though no one paid heed to their warnings that it was a very inexact method. It is only fitting that an engineer now has not only lit a candle in the darkness but is leading us out of a 2D world and back into reality.
Reginald has provided the final nail in the coffin of cost accounting. If you’re an educated accountant, you have some unlearning to do. But you’ll also get exposed to an entirely new dimension of operating your enterprise and be more valuable to it as a result.
—Ronald J. Baker, Radio Talk-Show Host, The Soul of Enterprise:
Business in the Knowledge Economy (www.thesoulofenterprise.com), Founder of VeraSage Institute, and best-selling author of Implementing Value Pricing: A Radical Business Model for Professional Firms; Pricing on Purpose: Creating and Capturing Value; Measure What Matters to Customers; and Mind Over Matter.