Is Cost Accounting Holding You Back? (Part I)

From a post from the now defunct posterous, where my blog began, adapted From My Column in The Cheese ReporterVolume 135, No. 8 - Friday, August 20, 2010

Part One: Costs

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 do that?

Howard, a production manager at a midwestern food factory, had that creeping feeling in his gut again. He had just recieved the P&L one week after the end of the month, as usual. The general manager had already called and left a message. It didn’t look good: labor costs were up, cost of goods higher than his target, and profits were low. He had pulled out all the tricks he knew, cut back on purchases, asking people if they wanted to go home early, not replacing people who were sick, but to little effect.

Howard muttered under his breath,  “Even with the new reporting system, which was supposed to give me real time information, by the time I find out about a problem, it is too late: the only time I can really solve a problem is when I see it happening with my own eyes, in the moment, at the source. But they want me to spend my time on spreadsheets and justifications instead. How can I oversee the plant with my head buried in a computer screen? Why can’t they just give me reports that give me the information I need to make it to get my job done, instead of making my job harder?”

Bean Counters vs. Ops Guys n Gals

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, as is done by many small and medium businesses, focusing on costs  chokes business. How can I say that?

Think of a business that makes and sells things as a system having five arms:

  • Input, the raw materials that go to make each pound of cheese processing
  • The costs to process the raw material
  • Inventory
  • Output, your sales
  • And support

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.

The Lowest Common Denominator

When you can reduce a whole into parts, more often than not, you settle for the lowest common denominator. Systems by definition behave in ways unexplainable by their parts. Their behavior is driven more by the relationships between, not the characteristics of the parts themselves. When accounting systems calculate the cost of goods, for instance, by loading it down with packaging, plus a bit of labor, a bit of electricity, a bit of this or that,” This may make their job easier, but it hides what operations needs to know, like the cook who is heavy on seasoning, thereby masking the flavor of the dish itself.

Loading Backfires

When in supermarkets, because the financial reports came too late to be of use, I taught my managers to create a simple purchase to sales calculation, raw materials only, by hand and on paper. By stabilizing their inventory, they were able to get a sense of how things were going in the moment. They  made more money with this simple report, or at least stayed on goal more often than not, than by using any report generated by the front office. In face, more often than not, we already knew if the reports were right and very often had to find the errors they made for them.

Modeling or Stretching Reality?

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. 

And what about us?

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. Labor´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 pretending to do so robs resources that could be used to make better products for the customer. Rather than look at the system they created, management blames "human error," and dreams of fully automated super-factories, where, at last, the work that is done will match the reports of cost accounting.​ A factory without humans!

ABC, Perpetual Inventory and other ​Fairy Tales

Attempting to do the books in real time, companies are not been able to "nail it" without considerable resources being spent on tweaking and maintaining. Most depend on perpetual inventory, where for each item produced an allotment of COG may go into a WIP account, and is transferred from there to a finished goods account, etc., bouncing around like a marble in a pinball machine. This is logical, but not accurate, even with bar codes. It cannot be, due to Natural Law, as everything varies.

 You are more likely to see what is needed by spending time on the workfloor, observing directly, than trying to model it in a spreadsheet. Complex computer modeling may give company officers an illusion of control, but it robs production of real control: essential timely, relevant information for understanding. To visualize more clearly how money moves through your company, it is better not to include labor in the cost of goods.

The same applies to all the other factors that muddle up the cost in cost accounting. A prominent national cheese producer bragged to me they had figured out that it cost 41 cents per pound per month to age their cheese, to cover the labor and refrigeration, way back in 1975. 35 years of inflation later, and it was still hogwash.

Whether they were aging a million pounds or a hundred, they still had to pay the electric bill. The problem was one of capacity, not cost of goods. In most plants operating at a reasonable volume of sales/production, electricity varies more with seasonal rates, and natural variation than production. And yet cost accounting and its many layered reports waste precious hours by your most dedicated and effective people trying to “control” these costs: all because by reducing complexity to the lowest common denominator you lose the big picture of flow.

When I ask my clients how much they profit, invariably they will reply, X cents per unit, or Y% per unit, in spite of the simple fact there is no net profit on anything until the bills are paid. Once the bills are paid, there are no costs other than raw material, because the bills have already been paid. The right answer to the question of how much they profit should be, it depends on the relationship over time between income and bills paid!  

Hidden Profits, Hidden Losses

Hidden profits lie in the link between breakeven, production, (particularly in minimizing over-production), and capacity of flow. To better reflect reality, accounting needs to clarify the flow through the plant of money invested from dollar spent, or borrowed, to sale. Accounting should help those who operate the company see how to minimize the number of processes and the amount of time spent between the input of the dollar spent and the return of that dollar through sales. Understand this, and it will revolutionize the way you do business. You will leave no stone, or bean, unturned, to make sure you and your fellow workers know the exact moment each month when you have sold enough product to pay the monthly bills, because, for every dollar of sales after the bills are paid, you need only subtract cost of goods, and the rest is pure profit. Think about this. Even the calculation we use to calculate profit in cost accounting is misleading, leading to poor decisions. To become more effective, accounting needs to reflect back to operations, in a simple immediately readable format.

  • Cost of processing and support, especially when in the month they are paid
  • Direct variable cost of goods,
  • The money frozen in WIP and finished inventory, necessary and not!
  • And how each of these is related to the other.

Understanding the How is More Powerful than Setting Goals

Cost accounting leads to goal setting, one way or another. Goal setting is antithetical to optimizing an overall system, as it denies the complexities that influence any outcome, can demand unrealistic results, and act as a damper to full profit. (Set a goal and the one thing you can be sure of, you won't rise too far above it.)

There is a different way, one built on faith in the people that work for you, constant learning, and direct observation where the work of adding value is actually done, whether that be virtual, concrete, or in ever-changing locations. Accounting must evolve to clarify rather than hide the relationships that make your business run.

Next Column in the Series "Inventory, Part II" 

Original Responses:
Aug 28 2010, 6:38 PM michellehollida (Twitter) responded: Enjoyed the article -- very intriguing! It makes intuitive sense to me, especially as you talk about money flow.I wonder how it fits with the living systems model for organizations that I write and talk about. I suggest that "the organization" is more than its infrastructure and processes. It is also the people working within and the customers being served -- it's the whole system. I use a tree metaphor, with the employees represented by the roots and the customer interactions represented by the leaves and branches. In a tree, there is the cambium -- a thin layer of living tissue just under the bark of a tree. This is where life flows in both directions through the tree. The rest of the trunk is dead -- but it helps raise the branches up to the sun (customer interactions). Similarly, the organizational infrastructure and processes are valuable only inasmuch as they enable the flow of life and energy. And that includes money -- what one activist calls "green energy".Does this fit with your idea of flow accounting? Does such a living systems rather than machine metaphor make throughput accounting any more obviously relevant?

Aug 29 2010, 10:13 AM Dibyendu De responded: Excellent. Eagerly look forward to the next part.

Aug 29 2010, 3:00 PM Two comments from LinkedIn:" I've had direct and in-direct experience with many companies that were more than "hitting the numbers" and are no longer with us. I vividly remember attending meetings where they said we were operating at over 110% efficiency, but still losing money. ...And, it sure destroyed  morale. Made us all realize that no matter how effectively we produced, we could not control our destiny... It's all so darn simple to me. The Golden Rule works at least 99% of the time in how we treat others. It always worked with me and so I do the same for others. And all people eventually if not right away, positively respond to "real"..." Steve Hennel, Management Professional, Detroit"

Aug 29 2010, 3:02 PM LinkedIn comments continued: "The old saying "If you can't measure it, you can't manage it" is too strong and has led many organizations down the wrong path. Tracking the right metrics critical to driving business plan desired results (and understanding what influences them) is the practical approach. Cost accounting and EOQ metrics (economic order quantity) and closely tied to "push" (not pull) demand methodology and lead to measuring wrong things in a manufacturing and distribution environment." Guy Vachon, NC2 Global
 accounting, management, managing

About the Author

Dan Strongin works with medium to small companies, helping them master the art and science of managing.

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