Show Me the Money: Cost Accounting

Volume 135, No. 24  - Friday, December 11, 2010

In my last column, as part of a series on how cost accounting has failed and continues to fail business, choking it by encouraging wrong thinking, I discussed how inventory is evil, though at times, a necessary one. (See my previous column or at www.managenaturally.com.)

This time, I’m going to discuss the wacky way that cost accounting handles capital investments. I believe the right place for capital investments is in inventory, rather than in “assets,” and like all inventory, should be treated as liabilities. I owe a debt to Throughput Accounting for introducing this idea to me. Once I saw it, after years in the trenches, held in bondage by misleading reporting, I snapped to attention. Eureka! The emperor has no clothes!

When my son was 18 he was dying to buy a fancy looking sports car. His intuition, was that it would make him instantly popular. Like all adolescents, who are masters at marketing, he kept trying to convince me that buying a more expensive car was a good investment, because it “held its value over time.”

I countered, as true today as it was then, the minute you drive a car off a lot, it has lost a big chunk of its value.
Things that lose value are liabilities: you have to watch them closely so limit the loss in value, keep them maintained, stop thieves big and small, but worse, they freeze your money. It is not available to you to use to buy raw material and convert it into sales, the way real money is made in the real world.

This evil liability may be a necessary evil. You need to freeze money, investment to provide the space and tools to be able to add value to raw materials and thereby make money, but as long as your money is frozen they are liabilities, burdens you have to carry. Seeing them that way, will help you make better business decisions.

Last I checked money spent is money spent. Whether you spend it on raw materials, operational expenses, product inventory, or capital purchases, you still spend money. The definition of profit to me is when you make more money than you spend. I am a simple person.

Cost accounting gives us the impression that there is a difference between operational profit and ROI. Think about it! This is really weird! How can I have made a profit if I haven't paid myself back for all the money I put in?

Cost accounting tries to get around this problem by creating a little white lie called ASSETS. The theory is that at the end of the day, when you sell your business, you get all that money back; it’s all waiting patiently for you in your assets.

In practice, this doesn’t hold water. First, companies rarely can sell their assets at the full value at which they record them in the balance sheet. And worse, this little white lie encourages companies to play nasty with the books in order to get more funding, or dress up the books for banks and investors.

None of these activities by the way add value to a single product that then gets sold and generates real income for the company. Because when an owner sells the company, that’s good for the owner, it’s not always so good for the company.

It’s really very simple, if you put up 100 bucks to start a business and you’ve only made 50 back in profit you are still 50 bucks in the hole, by my count, but then, I am not a cost accountant. Perhaps there is some kind of secret logic besides common horse sense, but I haven’t found it

Perhaps the most damaging manipulation of reality due to the misleading and inaccurate picture businesses get due to cost accounting, is the focus it takes away from making a profit by producing goods and services. The nasty business of inflating so-called “assets,” to create the illusion of short-term profit, is just one small, all too common, example.

Purchasing capital goods under the assumption that they hold their value is just plain wrong; overvaluing the already purchased to cover less than perfect operating results is fraud, but many companies and their departments do it, as if it has always been done that way, keeping bosses, regional managers, investors and banks off their backs, because they too are only looking through the lens of cost accounting. Ask the wrong questions and you get the wrong anwers.

Since some deluded fool coined the phrase, shareholder value, companies have been playing nasty with the facts. To create and run companies only to be packaged and sold so the original investors can “cash out,” a dunderheaded strategy championed for years in executive MBA programs; treating a company itself is a just product with only a three to five year lifecycle that must be dumped quickly by inflating its value, is what has caused bubble after bubble.

The production of real goods is the foundation of true national wealth. As a nation, we headed down the road of no manufacturing, being a “service” economy decades ago. We are truly serving, and who we are serving are the only ones left manufacturing anything.We owe China over $900 billion, close to $3,000 per man, woman and child in the US, and on which we are paying interest. But, the underlying assumptions are so wrong, they are in trouble as well: based on cost accountings warped calculation of value, their wealth depends mainly on the US consumer, buying beyond our means.

And when we can no longer secure credit, as is happening today, how will we pay for that debt, by printing money? (oops, I was just joking, and then, the governement did!) The government has chosen that option, but how can a business whose capital assets are not worth what they have down on paper, and whose inventory is not sellable at the price they valued it at when listing it as an asset, or worse, is a service and has no real value until consumed, going to find the money to survive?

Covering over problems goes against the essence of good management. Surfacing problems so they become obvious, and can be dealt with, is far better than pushing them out of sight behind accounting tricks, or passing them over under the false assurance that you are protected by overvalued “assets.”

Cost Accounting lends itself to this kind of shenanigans because it does not properly reflect what really goes on: hindering a company by making it more difficult to understand how it operates.

Budgeting, in cost accounting, is a farce, leading to decisions based more on the affect on the fanciful balance sheet, than on operational effectiveness. If it looks like a duck, and walks like a duck it must be an aardvark! Don’t Tread on Me all over again! Give me an accounting revolution, a system that tells me what is really going on and leads me to ask the right questions!

But, hold your horses! For the last 20 years the shortcomings of cost accounting has been a hot button issue in the most prestigious international accounting organizations around the world. In fact, as early as 1985 Eli Goldratt, the creator of Throughput Accouting, spoke at the annual conference of the Institute of Management Accountants on the topic, “Cost Accounting-Public Enemy Number One of Productivity.”

I am not making this stuff up, and I am not a salesman selling Through put accounting. People do their books all kinds of different ways, and for me, making money is an outcome, not the goal, or at least, not the only goal.

But isn’t it kind of distressing to think that the most important source of feedback we have about our businesses, was around for only around about 50 years before the people responsible for its creation and maintenance began to doubt its value? Garbage in garbage out! Cost accounting is choking your business.

In Sum:
Cost accounting, the primary feedback mechanism for business, invented back when labor was paid for by the piece, provides an inaccurate picture of what really is taking place in companies today, and covers over the true dynamic of how money is made. It is targeted more at creating a false picture of “value,” turning the focus of a company upside down, stealing resources away from what makes money into what supports making money.
In the real world, not the world of green bar paper, breakthrough profit is made by “the repeater effect,” by how many times a dollar invested in raw material can be turned into sales before it has to be replenished. Cost accounting provides no effective way to see this.

Two of the most damaging aspects of cost accounting are the way in which it can encourage the creation of both in-process inventory and final goods inventory, and the way it treats capital expenditures. Inventory is a necessary evil that needs to be managed with skill, including your capital goods investments. Anything more than what you need for sales, to keep the flow of value adding output meeting the demands of the market, freezes money and dampens the repeater effect, losing you money.

Capital investments listed as assets invites fuzzy thinking, sometimes fraud. The factors generated by cost accounting may give a sense of control to those computing them, but they are far too inaccurate to operate from, and mask real problems in making money, that a better system, an operational accounting system, would bring to the surface and get solved.

Cost accounting is choking your business by putting the value on support, and not flow, and needs to go, to be replaced by accounting that clarifies rather than confuses the true nature of a company as a money generating system, illustrated in the following diagram with the emphasis on the upper flow:

(In my next column I will return to a marketing focus, and begin a series on marketing pioneers in the cheese business: upstreamers who made their own way when times were lean, and the world knew American Cheese as plastic wrapped orange slices.)

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 dan@danstrongin.com. You can visit and blog with Dan at www.managenaturally.com.

 

Other Strongin Articles written for Cheese Reporter

dot Cost Accounting Chokes, Part 2: Inventory
dot Cost Accounting Is Choking Your Business, Part 1
dot It Ain’t Over ‘til It’s Over
dot Raw Reason
dot A Story For The Holiday Season, Part II
dot A Story For The Holiday Season
dot Truth In Labeling
dot This Too Shall Pass or "What were we thinking?"
dot Marketing Language That Resonates
dot When Will We Ever Learn?
dot Cheese Competitions In The Context Of Marketing

dot Economy
dot Even The Best Laid Plans Go Astray
dot Root Causes: Communication
dot Partners
dot Diamond Cutting:
dot
It's What You Don't Know That Can Hurt You
dot Integrity and Ethics
dot Pricing:  The Perceived Value
Designing the Effective Sell Sheet
Common Sense
It All Begins in The Mouth
Of Cars...

The Gathering Storm
As Our Industry Evolves, So Should Our Terminology:

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