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 success involves the right people knowing the right things at the right time so they can make informed decisions. Do our current accounting and reporting methods supply 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. 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. The general manager had already called and left a message.

Howard muttered under his breath,  “Even with the new reporting system, in so-called real time, by the time I find out about a problem, it is too late. I can only solve many problems when I see it happening with my own eyes, in the moment, at the source. But my bosses want me to spend my time working on spreadsheets and writing justifications instead. How can I oversee the plant with my head buried in a computer screen? Why can’t they just give me straightforward reports that give me the information I need 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 has been used to inform our business decisions since the late 1800’s, whether cost based, done in real time, or computed monthly, don´t reveal what the people doing the work need to know, nor clarify how and where the money is really made. 

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. A singular focus on cost control chokes business.

The Lowest Common Denominator

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

Get As Close As You Can to What is Real

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 the reports generated by the front office. Those arrived too late, too little and more often than not, peppered with errors. My managers  knew if the reports were right or not, and very often found the errors in them that needed to be corrected. How much energy, money, heart and time is wasted monthly on chasing problems that may not exist, but simply be mathematical errors or misunderstood data on spreadsheets?

Modeling or Stretching Reality?

Counting a portion of labor as a cost of goods, 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 your customers. Rather than look to the system, which 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!

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.

ABC, Perpetual Inventory and other Fairy Tales

Attempting to do the books in real time, companies have not been able to "nail it" without considerable resources being spent on tweaking and maintaining. The dream of 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 is logical, but in the overwhelming number of cases I have seen not accurate, even with bar codes, without continual adjustments, due to Natural Law, as everything varies.

 Complex computer modeling may give company officers an illusion of control, but it robs production of real control: essential timely, relevant information for understanding. 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, and capacity of flow. (Particularly in minimizing over-production.) To better reflect reality, reports need 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 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, generate fear or complacency, and thereby act as a damper to full profit potentcial. (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 with 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 Costs, 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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