5.5 minute read...
When I first met Eli Goldratt back in the late 1980’s, his article and speaking tour, Cost Accounting: Public Enemy #1 of Productivity, was all the rage.
His main point was that cost accounting principles, when carried through to be the basis of local performance measures, lead to decisions that are more harmful than helpful for the business.
Last week, we looked at when departments and business units of the same company pretend to sell products and services to each other through the common practice of transfer pricing.
Today, I direct our attention to the way we distort costs, and the damage this distortion brings.
The Buck Stops With... Costs
Let’s face it. Most of us are held more accountable to costs than we are to revenues.
In the profit equation (profits = revenues minus costs), revenues depend on customers – people external to our organization – and costs depend on us. They are the thing under the control of the business itself. And therefore, they are the thing that most of us are measured by.
And I get it. None of us should be wasting our own or our organization’s money.
It’s the way that organizations divvy up costs that ultimately lead us to make decisions that hurt more than help.
A Thought Experiment
Your company makes and sells a single product for an average of $10 each.
Last year, you sold 1 million units and your company generated a profit of $1,000,000 on $10,000,000 in sales.
How might we go about increasing profits?
The most popular answer is, of course, to reduce costs. And the two most prominent approaches to cost reduction are:
- Getting suppliers to reduce their prices. How much do you think you can squeeze?
- Laying off a bunch of people. How lean can you really go before you’ve cut into muscle and bone? (See your weekly AHA from February 23rd for a discussion on this subject.)
A less popular but likely a quite viable answer is to sell more without a corresponding increase in labor or other costs.
How We Complicate Things
This is where we tend to complicate things. We calculate and use product costs and product margins as the pathway for making decisions that are intended to yield a positive impact on the company’s profits.
The belief is that quantity X profit margin (product selling price less product cost) is the equivalent of company profit (revenues minus costs).
(sales - costs = profits)
(product price - product cost) x quantity sold = profits
Note: The above logic also works for multiple products at multiple price/cost points; the math is just a bit more involved.
Dissecting Product Cost
No matter your business, someone has calculated the cost of each unit of whatever it is you sell. Cars, shirts, tomatoes, even consultant hours.
Some unit costs are clearcut. For example, the price we pay to external suppliers for materials and components that go into the product we are producing. Referring to our thought experiment example, the $3 million in raw material costs was the sum of the $3 per unit the company paid to its suppliers for the raw materials it used to produce the 1 million units sold.
Other unit costs are not so clearcut, so decisions are made on how to allocate them. Labor costs are typically allocated by multiplying the time it takes to produce the product by the wage rate paid.
Remaining costs (e.g. overhead) are allocated by multiplying the labor cost by a percentage defined by the ratio of overhead to labor for the prior year or years. In our simple example, for every $1 of labor costs, $2 of other costs would be allocated to the product.
The Big Distortion
The way most costs are allocated does not reflect the way the money is actually spent.
Outside of the money spent on things like raw materials and components, the vast majority of money spent is not spent on a unit by unit basis. People get paid by the hour or week or month. Leases, utilities, and insurance are also paid by the period. Advertising costs are paid per ad campaign.
None of these costs go up or down based on increasing or decreasing the number of singular units of product we sell. So oftentimes, what we perceive as increases or decreases in unit costs are a mirage, and distract us from making decisions that would move the needle in the way we need it moved:
- Increasing sales without corresponding increase in labor and other costs,
- Decreasing costs without negatively impacting sales.
Three Ways Distortions Hurt
When dealing with product cost and product margin, here are three ways that cost accounting can hurt more than help.
- Increasing production without corresponding increase in sales. The calculated unit cost will be lower, but the actual money spent will be more. We simply “store” the costs in inventory until we are able to move it. Sometimes, the extra inventory will be sold at full price, sometimes it is sold at discounted prices, and sometimes it's even written off if it sits too long. Operations gets rewarded, but has the company benefited?
- Avoiding markets for more sales if the product margins are “too low”. Sales is often held accountable for sustaining threshold levels of product margins. If we can segment a market and sell additional units at a lower price without proportionate increases in labor and other costs, the difference between the lower price and the totally variable costs like materials go straight to the bottom line. The Company benefits; sales gets punished.
- Attention diverted to explaining variances. The amount of time and attention that managers put into explaining the reasons for variations in calculated product costs and product margins is beyond the pale. It is a non-value added activity that brings more finger-pointing and mistrust than it does positive impact on the bottom line.
To sum it up, the focus on reducing product cost blurs our view from the realities of how our businesses earn and spend money.
A hint: focus on flow and creating more value for more customers instead.
When you decide to do this, TOC’s 5 focusing steps and 4 concepts of flow are enormously helpful.
Whenever you're ready, here are a couple of ways I can help you:
- Assumption Hacking Essentials. Dr. Eliyahu Goldratt said in his forward to The Goal, “The challenging of basic assumptions is essential to breakthroughs.” In this digital course, I'll take you through a three step process for exposing, challenging, and resolving those basic assumptions. Join the waitlist and get notified when the course drops on May 15th.
- Jenrada Programs. Customized workshops and longer engagements to help you create an organization of aligned problem solvers delivering extraordinary results. Complete this form, send me an email, or schedule a discovery call.