In my previous post I tried to demonstrate how cost accounting based measures are leading you astray. There is a better alternative, sound, consistent and aligned with business objectives.
I often wonder, why is it that we continue using things we know are not good enough, or even bad? I believe there are two key contributors to that:
- As wrong as they may be, we believe doing these things is crucial for a valid need we have
- Comfort and conformity – we always did that in this way, and everyone else is doing that.
Cost accounting is bad fr business decisions, at best decisions based on cost accounting measures can be expected not to make the situation worse. It is highly unlikely these decisions will lead to improvements. But we believe these measures are crucial for decisions as we believe they help us keep costs under control. We are also used to them, we understand their mathematical logic (simply adding and subtracting) and everyone else is using them. So, we do too.
However, results are almost never as expected, so we tend to blame external factors: competition, economy, suppliers, etc. It’s easy too, as we can correlate. If economy takes a downturn, no wonder our efforts did not succeed. It is not truly a cause and effect logic, it is correlation. Again, correlation is something we understand, we are used to it, everyone else is using it. So, we use it too.
However, choosing to continue doing something we always did, because we always did and because others are using it, does not necessarily makes it the right choice.
As cost is of high importance, one can try to focus on cost reduction. This requires cost accounting measures and follows the assumption that cost obeys the additive rule. The fact of the matter is, cost does not obey the additive rule and cost reduction activities, based on this assumption, normally lead to virtual savings coupled with real cost being increased. This is because cost is associated with efficiency, efficiency is associated with the measure “quantity per unit of time”. More quantity per unit of time with the same resources, is cost savings. The reality is we spend more money to make more units, and we negatively effect response time. Higher quantities are leading to longer response times.
On the other side, Tacihi Ohno wrote in his book – “The Toyota Production System” – “All we do is look at the time from customer’s orders to collecting the money for that order, and try to shrink it“. This is the only focus. Try to imagine what happens to cost, when lead time is continuously reduced? It is reduced as well. The fact is that Toyota’s cost per unit is by far superior to any other car producer, without trying to cut cost.
So, what is required. To start with, we need to adopt a different perspective on the financials of the company. Let’s start with top line. Although sales (revenues) are a key financial measures, by itself it is misleading. As for every Dollar a company makes, it had to pay something directly to the external world – mostly it is for buying raw materials and paying royalties to sales people. This part of the revenue is not really belonging to the company. The financial view needs to start from looking at the net income – revenues minus the truly variable cost. And, no, the fact you can divide any number from the cost sheet by the number of units sold, does not make this cost truly variable. All costs are variable, but some change by the unit sold (raw materials and royalties) and others change with leaps in quantities (if you lay off an employee, or recruit one you do not reduce or increase capacity by one unit). Therefore, your net revenues are your gross revenues minus your truly variable costs.
Your net profit is your net revenues minus all other expenses, which are for all practical purposes, fixed (as long as your sales do not cross a top or bottom boundary).
Lastly your investment is defined as all the money you invested in putting in place the infrastructure you need to convert raw materials into sales. It includes buildings, equipment, inventory and people education. Now you can define your ROI as net profit divided by investment.
With these basic measures, we can now put in place an alternative decision support measurements. Any decision should be evaluated, not by it’s local impact (cost accounting) but rather by it’s global impact:
- How much additional Net revenues we will be able to make as a result?
- How much additional fixed cost is required? (and yes, cost does not necessarily needs to go down, actually you cannot make money without spending money. The question you should ask is, is cost growing in a slower rate than the growth of the additional net revenues. As long as this is the case, the growth in cost, is a positive effect).
- How much additional investment is required? Again, investment is a necessary condition for making money. The question here is would ROI grow together with the growth in investment.
These basic measures are simple, yet powerful replacement to the cost accounting ones. They are consistent, and aligned with business goals. And, they set the basis for a set of measures that can support all business decisions – more on that in my next post.