Howard noticed that creeping feeling in his gut. He had just gotten the P&L, two weeks 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 high, cost of goods out of line, profits low.
Howard muttered under his breath, “Am I going to have to spend the next four days pouring over reports, checking for errors, only to find there was an inventory error, like last month?”
“How am I supposed to know what happened?” he went on. “Why do I have to wait until weeks have passed to find out, when it is probably too late to even know what really happened? What if it’s a fluke? I have two people on vacation and special orders out the wazoo. How can I oversee with my head buried in a spreadsheet. Why can’t they give me reports that make it easier to get my job done, instead of harder?”
Anyone directly responsible for supervising production knows, intuitively, there is something not right in the way companies keep the books. To be useful, a reporting system should model reality. Ask the wrong questions, and you come up with wrong answers.
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. In fact, it is strangling your business. I am going to tell you new ways to model your business to get it flowing again.
Think of a business, in this case a manufacturer of cheese, as having five arms:
• input, the raw materials that go to make each pound of cheese
• processing, the costs to process the raw material
• n 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 how the whole system has performed. But systems by definition behave in ways completely unexplainable by its parts, driven by the relationships between the parts. It calculates the cost of goods by loading it down with raw material “plus: “plus packaging, plus a bit of labor, a bit of electricity, a bit of this or that.”
The relationship to output of all but raw material is weak at best. How can I say that? Look at the facts. For those buried in the office or in meetings, get off your duff and go to where the action is, the work floor, and see for yourself.
Labor relates as much to capacity as output: the design of the plant and the need to keep workers. Whether a plant makes 1000 or 10,000 pounds of cheese 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.
Different people work at different rates, and different products require different amounts of handling. It is too complex to model accurately, and trying to do so may give the officers a sense of control, but it robs production of real control: essential timely, relevant information for understanding.
In practice, labor is more fixed than people are willing to admit, and fluctuations have as much to do with internal inefficiencies as volume. To see more clearly how money moves through your company, it is better not to include it in the cost of goods.
The same applies to all the other factors that muddle up cost accounting. I have seen plants adding in an average factor for the amount of money it costs for refrigeration to age their cheese. This is absurd, and dangerous. This prominent national producer bragged to me that they figured out back in 1975 that it cost 41 cents per pound per month to age their cheese. It was 1995. What hogwash, then and now.
Whether you make a million pounds or a hundred, you still have to pay the electric bill. Even if you can shut some down, the problem is one of capacity, unused capacity, not inefficiency of production. Plant design is as much a part of the system as any other part, and lends to the system a minimum level needed for labor independent of production.
You have to pay for your refrigeration and a lot of your other costs independent of how much you produce on any given day. In many plants it is practically a fixed cost.
And yet precious hours by your most dedicated and effective people are wasted on trying to “control” these costs.
The link between electrical costs and production is not as strong as the link to capacity of flow. That is where the profits are hidden.
What matters in making money is flow. To better reflect reality, accounting needs to change. It needs to be made to clarify the flow through the plant of the money invested in raw material, the one thing that should vary directly according to sales.
It needs to reflect the relatively fixed cost of processing and support, and it needs to reflect money frozen in inventory and how each of these is related to the other. We are measuring the wrong things the wrong way, and because of that making wrong decisions.
Will you know the exact moment this month when you have sold enough product to pay your monthly bills? Only until your bills are paid do you begin to make money, right? Until you pass breakeven, you make no money. It is blindingly simple.
Cost accounting paints a perverse picture, the wrong picture: dangerously so! There is no net profit on anything until the bills are paid. After that, there are no costs other than raw material, because the bills have already been paid. If you really try and understand this, it will revolutionize the way you do business.
For every dollar of sales after bills are paid, you need only subtract the cost of goods, mostly raw material, to find your true profit. Think about this. Even the calculation we use to figure profit is misleading, leading to poor decisions.
Another problem with cost accounting is that it treats inventory as an asset. Inventory is a liability, not an asset.
Plant design is as much a part of the system as any other part, and lends to the system a minimum level needed for labor independent of production.
Any amount of inventory more than what you need to keep production flowing and meet demand, freezes money. Money you can’t use is money you don’t have; money that is losing value; money that could be making you money instead of letting profits drip away.
Cost accounting leads companies and banks to think it a good idea to arrange financing based on inventory. What security is there in frozen money slowly evaporting value every minute it sits beyond the point where it is ripened and ready to sell.
How many dollars are tied up uselessly in products that don’t sell so well? How many hours of work that went into processing them? How many “specials” done to try and move product people don’t want? How much of your processing cost is spent making money to lose money by sitting in inventory? With cost accounting there is no simple way to tell.
Ever work for a company that uses inventory to pad the books? It is scarily common. Hiding losses is not a way to survive, but a way to lose your business. Cost accounting hides losses by making the flow of money more difficult to see. You will need courage to find another way, but change you must.
The following diagram is a more accurate way to look at your business:
Raw Material Input > Processing > Sales Output
Raw material comes in, is processed and goes out as sales. Everything else is support. This dynamic model also helps you understand how you truly make money.
For instance, where in the model do you put excess inventory? 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.
What is needed is an accounting system that models this. That generates reports that let you know in real time when your monthly bills are paid, so you can focus on maximizing througput, to maximize profits. One solution is called Throughput Accounting. You can Google it. There are others. You can even create your own.
Howard, who now has a new boss who has abandoned cost accounting for a more accurate one, knows that last Thursday, the company began to make money. With only a few days left to make profit, he agrees to let the sales manager, Jean, take a buck off a pound. The normal “factor” they used to use for labor, administration, fixed costs of processing and support.
Since all the company needs to
pay until the end of the month is the cost of goods, mostly raw material, they are about to make many more dollars profit without raising their costs. Pure profit, 16 truckloads worth. In the past, they would have turned the idea down, thinking they couldn’t make a profit. Cost accounting was strangling their business.
Separate into Parts and Analyze
Parts cannot explain behavior of
Value Inventory as Asset
Inventory is a Liability not an Asset
Banks lend money on value of
Increases odds of failure
Cost of Conversion in Private Label Costs
Inflates costs, loses opportunity to profit
All machines must be used Efficiently
Better to lie idle than create extra inventory
All direct costs must go into Cost of Goods
Only raw materials and true variables
Dan Strongin is managing partner and owner of Edible Solutions,
a consulting company focused on helping companies making great food
make a profit. He will be writing a monthly column in Cheese Reporter.
Strongin can be reached via phone at (510) 224-0493, or via e-mail at email@example.com. You can visit and blog with Dan at www.managenaturally.com.
Strongin Articles written for Cheese Reporter
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