Hack:
Cost Accounting Chokes Business

By Dan Strongin

March 19, 2011 at 5:45am

Accounting

Cost Accounting

Reports

Moonshots

Reinvent the means of control

Make direction setting bottom-up and outside-in

Develop holistic performance measures

Summary

Cost Accounting chokes business by focusing on parts rather than the relationship between parts. As the primary feedback mechanism for business and organizations it leads to bad decisions. It is a recent development historically and needs to be abandoned for more systemic solutions, things that measure the key relationships and not just the parts.

Problem

It seems to me one secret of success involves the right people knowing the right things at the right time, so they can make informed decisions. And yet, do our current accounting and reporting methods meet that standard? Anyone directly responsible for supervising production knows, intuitively, there is something not right in the way most companies keep the books. Cost Accounting, which has been used to inform our business decisions since the late 1800’s, isn’t telling us what we need to know, nor how money is really made. Whether cost based, done in real time, or computed periodically like many small and medium businesses, focusing on costs chokes business. Of all the natural laws that govern physical reality, which includes the work place, the most important for making money is Fluid Motion.

Cost accounting supposes that if you reduce the sum of all your functions down to their constituent parts, you can somehow understand the performance of the whole system. When you can reduce the the whole into parts, more often than not, you settle for the lowest common denominator. Systems by definition behave in ways completely unexplainable by their parts. Their behavior is driven more by the relationships between, not the characteristics of the parts themselves.

Counting a portion of labor as a variable cost, for instance, is stretching the reality of what really happens. Labor relates as much to capacity as output, and capacity is mostly a function of plant design. Plant design brings to the system a minimum level needed for labor, independent of production. Whether a plant makes 1000 or 10,000 of a product on any given day, it has to have workers. Those workers have to be paid at least a minimum salary, or provided a minimum number of hours, or they will be forced to quit. It's fluctuations can have as much to do with internal inefficiencies and natural variation as volume of production.

Different people work at different speeds, and different products require different amounts of handling. Real life is too complex to model with pinpoint accuracy, and the work required robs resources that could be used to add quality for the customer. Rather than look four square at the system created, management blames "human error," and dreams of fully automated super-factories, where, at last, the work that is done will match cost accounting? (Even that won't help them, as what matters is the flow within and between functions, not the efficiency of the parts, measured or unmeasured.)

Solution

If what matter is the flow of what comes in the back, what is added to it, and what goes out, we should measure those things. We should move from Management, Cost or Financial Accounting, to Simplified Operational Accounting: real time thermometers of how the relationships within the system are functioning, right now!

First, we need to move all support functions into expense and not cost of goods, (inputs) then all in process and finished goods inventory, where this applies: inventory is support, what is important is the flow of value throught the money making machine. I cover this in more detail in the materials linked to below.

Then we need to measure flow, what some call throughput, and others dollar contribution. Subtract cost of inputs from sales, and anything else that truly varies with sales, what is left over is what you pay your bills with an make profit from. Everything else is support as it supports making money, it does not contribute to the flow. Measuring the flow through, or throughput, will help you optimize the effectiveness of your whole system, it gives useful feedback.

see a short youtube

Though this is not enough alone to remain in business, as this applies only to your closed system of production. You also need to be looking to the horizon. Looking in the rear view mirror is important, but fixating on it, the way cost accounting does, means you are only looking at those behind you until they pass you and you miss the potholes in front of you.

The second important operational report besides a thermometer for optimizing flow, is to know if your processes are under control. If not, they are chaotic and unpredictable. How can you manage the unpredictable? You can't!

How do you know if things are in control, use control charts!

Inventory is Evil, but Sometimes Necessary!

Another problem with cost accounting is that it treats inventory as an asset. Inventory is a liability, not an asset. While skype®ing with Louis Schultz the other day, he said: “Inventory is evil.” I couldn’t agree more, inventory is evil! But, can it sometimes be a necessary evil?

Any amount of inventory more than what you need to keep production flowing to meet demand, freezes money. Money frozen is money you can’t use, is money you don’t have; money that is losing value; money that could be making you more money.

See a short youtube

Cost accounting leads companies and banks to think it a good idea to arrange financing based on inventory, for instance. What security is there in frozen money, evaporating value every minute.

With cost accounting there is no simple way to add up the losses because it treats the losses as if they don’t exist; it’s an asset, remember? How many dollars are tied up in inventory in products that don’t sell? How many hours of work that went into processing them? How many “specials” will need to be done to try and move product people don’t want? How many products will break, lose flavor or rust, or disappear over time? How many potential customers lost because they associate your company with the less than optimal product they bought on deep “inventory reduction” discount. How many customers come back asking for the same discounts on the rest of your products, erodig your margins? How much of your time cost is spent working to make products that lose money by sitting in inventory? How many resources wasted maintaning and counting it.

Hiding losses is not a way to survive, but a way to lose your business. The more efficient and timely conversion of raw materials to sales, the less time your money is tied up, the more turns your dollars can make and the more profit. I call this the repeater effect.

What is needed is an accounting system that provides useable information for those who create, build and deliver the product or service you sell, the only thing that generates revenue, not one for the people that sit in the accounting and executive offices.

Practical Impact

And no two industries nor two businesses are exactly the same. A unified approach to accounting doesn't exist. What does exist is the result of trying for so many years to hammer the square pegs into the round holes. What is needed is some simple basics, like a real time breakeven report, so the people actually doing value adding in the company know at what point in the month they cross the line from paying bills to making money. The second fundamental report is a thoughput, or gross dollar profit contribution report, on a daily basis, to be able to measure the relative effectiveness of converting whatever input into liquid assets, the flow. The third is a relative measure of the state of control of processes: can they be depended on to behave predictably, and the last are relative measures providing feedback on the efficiency of inventory management, and wise use of resources such as costs of support, which will depend on the type of business.

The practical impact will be

1. A clear idea of how effectively the company is adding value to inputs to create profit.

2. A system that measure the reality of how business makes money, rather than an unconnected series of parts.

3. A clear idea of when the bills are paid, when the business of making profit can begin.

4. Self-motivated employees who can affect and learn from their actions as opposed to applying their creativity to gaming a system they do not understand and is out of their control.

5. Conversion from an organization that seeks efficiency in wrong things, to being effective in doing the right things.

First Steps

First steps are to realize there is a problem, and to move from faith in spreadsheets to faith in direct observation where the action is, the only place real value can be added, the only functions that make the money, rather than support the making of money. The aim is to find measures of Flow through the entire system.

A quick look at Throughput Accounting and Lean Accounting principles will help, and the end of the balance sheet as a measure on which to base anything but the value you can sell your organization for, as it is far more destructive to actually running it than helpful.

Reading the volumes of information made available by the International Association of Management Accountants, who have long since known the failures of cost accounting, and a clever hand at journal entries, to convert your new, useful simplified operational accounting tools to financial accounting reports, so the banks and investors feel comfortable with what you are doing.

Credits

http://managenaturally.posterous.com, http://www.demingcollaboration.com, Eli Goldratt for his work on Throughput Accounting, which I don't hold to completely as I hold to no pre-packaged system, but it is far better to use as a starting point than cost accounting.

Videos

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October 17, 2018 at 6:49pm

Yazmin Barajas

In accounting you need to focus on all aspects so that the business can measure how the financial will flow not just focus on parts, you need to also focus on their relativity with each other. Accounting is a sensitive matter and needs to done accordingly. Moreover, some accounting solutions out there has processes and they dont just focus on parts but they focus as a whole.