In my last blog post, I talked about how cost accounting can't and doesn't create a complete picture of your operating and financial environment, especially when the focus is on making money.
Being blindsided is a common sports metaphor that also has business relevance. Companies are blindsided by new competitors, new technologies, or even unexpected publicity. I recently came across an interesting example of how a company can be blindsided by making very common decisions in the cost accounting dimension, but have a negative effect in the cash flow dimension.
Blind side: verb blindÂ·side \ËˆblÄ«n(d)-ËŒsÄ«d\
1. : to hit unexpectedly from or as if from the blind side blindside the quarterback
2. : to surprise unpleasantly
The objective was to improve gross margins by implementing lean. Their product cost was $6. The $6 is composed of both cash and non-cash dollars. Cost accounting typically makes no distinction between the two. It focuses primarily on variable costs, values that change with output, and fixed costs, those that don't (some activity based costing gurus will come up with lots of other distinctions such as semi fixed, or semi variable, or whatever, but those are just red herrings as you will see in a bit).
The problem is this. When you pay someone by the hour, their salary doesn't vary with output. It varies with how many hours you buy. Hence, when it comes to fixed and variable costs, from a cash perspective, accounting is dead wrong. Direct labor is considered a variable cost from an accounting perspective. All that step fixed crap ABC gurus talk about is nonsense. From a cash perspective, costs only change with what you buy, not how it's consumed or how you assign it to various accounts. If you pay someone $30 for an hour of work, you pay them $30 whether they do nothing, create something, or create an infinite number of somethings. The pay does not change with output, so it is not a variable cost from a cash perspective (Figure 1). Likewise, material costs do not change with use. When you buy 1000 lbs of material for $8000, this cash cost doesn't change when you consume the materials. It only changes when you buy more.
Calculated accounting costs just represent an opinion of the value placed on capacity consumed. Nothing more. If something takes 30 minutes, you may value it at $15. However, there is no $15 cash transaction for that 30 minutes. Likewise, if you use 250 lbs of material, you don't pay someone $2K for using what you already bought. The $2K represents the value of materials consumed. Since there are no cash transactions involved, the $15 in labor and the $2K in materials are non-cash costs.
Figure 1. When you buy capacity, you buy it anticipating using it. The price you pay is tied to how much you buy. The amount you pay doesn't change when you use it as cost accounting may tell you. It changes when, and only when, you buy more.
The $6 in product cost is mostly non-cash costs. If the previous points don't prove this, ask yourself this question. If a product costs $6, who do you give the $6 to when you make one? Do you save $6 for each one you don't make?
With this client, $5 of the $6 were non-cash costs such as direct labor and materials. $1 was a cash cost. Their selling price was $8, which meant they had an accounting gross margin of $2 per unit. Their cash gross margin was $7 assuming they sold each unit they made. Say they were taxed 30% on their profit. That means, on a gross margin of $2, they were taxed 60¢. From a cash perspective, they received $7, were taxed 60¢, so they made $6.40. Now, comes lean.
Non-cash cost reductions occur when you consume fewer resources to create output. In other words, you've become more efficient. By reducing processing from 30 minutes to 20 minutes, your accounting labor costs have gone from $15 to $10. Nothing changed from a cash perspective. In this case, through efficiency improvements, the labor and material costs were reduced from $5 to $4. Now, the unit margin has improved from $2 to $3. Great news, right? Not so fast. They have now increased their taxable income. $3 taxed at 30% is $0.90. They received $7 but pay 90¢ in taxes leading to a total cash profit of $6.10 (Figure 2). By improving efficiency, they lost money. BAM.
Figure 2: Accounting profit increases, but not without penalty. More profit can mean more tax. Interesting, by not seeing the cash aspects of the situation, the company completely misses the implications of reducing product cost without changing the cash dynamics..
This is an example of how focusing on costs can suboptimize cash flow performance. When the objective is making money, you have to have models that reflect the dynamics of making money and make decisions considering the most appropriate metrics. Accounting cannot do this. Over the next 3-4 blog posts, I'll offer tips that help establish cash based models so you are looking at the right data when seeking to improve your cash flow profit.
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I wrote this on Mother's Day, so, Happy Mother's Day everyone. What a special day for all and especially those who have sacrificed so much in the name of being mom.
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For more information about the topics covered here, get a copy of Lies, Damned Lies, & Cost Accounting.