A good friend and mentor told me many years ago that “If you ask lousy questions, don’t be surprised to get lousy answers”. I found over the years two facts: The first one is that this sentence is amazingly true and the second, is that with small adjustments this sentence can be rewritten to accurately describe other facts of life. One such truth is “If you use lousy measures don’t be surprised to get lousy results“.
In measurements, we can define Key Performance indicators (KPI’s), and I do not mean KPI’s in the meaning of these projects companies are performing resulting with mountains of measurements to be measured everywhere. I would like to define KPI’s as those (very few) indicators that will be the only ones everyone will consider when the situation get’s rough.
For many companies, these KPI’s are a derivative of cost accounting. Here we can define yet another truth ‘If you use lousy tools, don’t be surprised to get lousy results“. To start with, cost accounting tools were invented to enable external entities to get a picture of a company’s performance in the past. They were not designed to support decisions, or measure performance in the present, and clearly not to help evaluate how will the performance be in the future. Sadly, they are commonly used for the latter two objectives. It is as effective us using a screwdriver to dig a tunnel in a rocky mountain. I am certain, most people will not consider the option of diffing a tunnel using a screwdriver, the main reason for that is that it is visibly obvious the tool is not fit for the job. Sadly, in management decision support systems, there is o such visibility. It is a bit similar to sitting in a car, while it is in motion and taking a picture of the car driving in front of you. If you look at the picture the car seems to be standing still, raise your head and it is no longer there.
Cost accounting introduced some of the most harmful concepts for measuring performance and supporting decisions. They are harmful as they seem to be making sense, while they at best guide decisions that will lead to random effects on business results, and commonly they guide decisions that lead to negative effects on business results.
The error of cost accounting decision support measures start with the fact that when “freezing” a company’s performance for a given date, at that specific frozen moment cost obeys the additive rule. This allows many ways of “splitting” costs, and then summing them up again, leading to measures like: Product cost, Work center cost, Customer service cost and so on. It seems to be making sense, nevertheless it doesn’t!
For example, most companies will do their utmost to sell all of their products, and/or services profitably. Meaning that based on the indicator product profit the selling price of the product is grater than it’s cost. Why? Well, because if all products/ services have a good enough margin it guarantees the company is profitable. Does it? So, how is that aligned with the fact that so many companies are selling the vast majority of their products and service, profitably and still are losing money? The other reason is the belief that nay sell with negative margin, reduces the company’s profit. Does it really? When a company has excess capacity (and so many companies have excess capacity) any sale in a price above the raw materials cost, will increase profits.
The main reasons that make cost accounting measures erroneous for measuring performance and for decision support purposes are:
- Cost, does not really obey the additive rule. Local decisions do not effect the global performance at their face value (saving a cent in one location, may actually increase cost by a Dollar in another).
- Fixed cost cannot be transformed to variable, simply because mathematics allow the division. Allocating fixed cost to variable entities (such as products) only works for reviewing the past. Any change in actual numbers in the present or future, makes the analysis valueless.
In the next post, I will review some of the commonly used cost accounting based measures, how they lead the company astray and will present a consistent and business aligned alternative.
After so many years of being mislead by cost accounting measures, it is high time to leave them to their original purposes and replace them with measures that will guide you to the results you desire.