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Cost accounting: Attempting to solve the impossible?

April 18, 2017

 

 

Welcome back.

 

I'm pro-cash.  Cash is money.  It's raw, unprocessed, clean, and unambiguous.  Cost accounting data are processed and have little, if anything, to do with money.  I often say cash is like tomatoes, garlic, basil and onions.  Cost accounting is like store bought spaghetti sauce.  It may have tomatoes, but that's where the similarity ends.  Spaghetti sauce is often processed and has other stuff added in.  In general, it's just not as healthy or valuable as the real thing.

 

Part of the problem is, cost accounting is trying to do something that is mathematically wrong.  To calculate costs, cost accounting assumes a mathematical relationship between two independent things.  This ain't cool.  Consider this example.

 

Say I write for you; $100 per article.  Our cash relationship looks like the chart in Figure 1.

 Figure 1: There is a clear relationship between the number of articles I've written and what you paid me.

 

You decide to hire me for $240 per day instead.  Now our financial relationship looks like the chart in Figure 2.

 Figure 2:  In this case, I am paid the same single-day salary regardless of my output in articles that day.

 

These charts highlight something very important.  In the first case, your cash cost changed with articles because you were buying articles.  There was a dependent relationship between articles and costs. In the second case, what you paid me did not change with the number of articles.  Why?  Because you bought time not articles.  The cost is $240 per day regardless of the number of articles because the two are independent.  The dependent relationship is between cost and time.  Buy another day and your cost increases to $480.

 

Now, assume one day I wrote four articles in four hours. What was the cost?  $400 cash in the first case at a price of $100 per article.  Tomatoes.  Second case?  $240 cash.  Tomatoes.  What about cost per article?  You may calculate an average cost of $60 per article.  You may also consider the time involved and use $30 per article.  You can create any number of scenarios to calculate a cost per article and each is just as wrong as the next if you think the calculated cost is money.  Spaghetti sauce.  Why?  

 

Because there is no mathematical relationship between money spent and articles written. 

 

The problem is, you need a relationship to calculate a cash cost per article.  So what do you do?  You make one up.

 

This is how cost accounting works.  It creates cost relationships between two or more things that are independent such as labor and materials, and output, such as manufactured products.  

 

In the first case, you didn't need accounting to figure anything out because there was a relationship.  In the second case if you wanted to figure out your cost in terms of days, there is a relationship.  Cost per article?  No go.

 

In most cases, the arbitrary relationships created by accounting involves capacity (I call capacity what you buy in anticipation of use; space, labor, materials, equipment, etc) and the output it created.  Think about the cost of an invoice.  An AP clerk's salary has nothing to do with invoices.  To get a cost, you assign a value to their time spent processing and voila!  You have a cost!  $120!  But that number isn't money.  You don't spend $120 when you process an invoice and you don't save $120 when you don't.

 

The same holds true for goods and services.  When you calculate the cost of a product, your cash labor costs are independent of what they created.  In most cases, it's the same with materials.  Hence, when you say an article (or your product) costs $30, you need to remember two things.  

  1. The $30 could have just as easily been $60, $45, or $92.65.  It's not absolute, exact, or unique.

  2. The $30 is not money.  You didn't pay me based on the number of articles I wrote.  It just so happens one day I wrote four.  It could have been five or none and I would have received $240.

 

The $100 and $30 may look the same and may be called the same thing, dollars, but what they represent is very different. One is money.  The other isn't.

 

The output of accounting is nothing more than an opinion of the value of the capacity consumed.  If you go with the $30, you say each article took $30 of my time to write.  If you go with the $60, the value is $60.  It's an opinion because you're choosing a method or perspective you think best captures the situation. 

 

If you look at accounting data as value rather than money, its relevance seemingly increases, but it still tells you nothing of value operationally.  Can you look at the $30 and know that you paid me for the day if you didn't know?  What I wrote?  How many I wrote?  How much time it took?  No.  Combine that with:

  1. Calculated costs change with costing approach, and

  2. By taking less time to write an article, I can reduce the cost per article with zero impact on cash.

Tell me, again, why are costs so important financially?  Doesn't this seem jacked up to you?  You can have scenarios where costs go down and no money is saved.  Worse yet, I regularly see situations where companies increase cash costs unnecessarily to make their accounting costs go down!  Seriously.

 

This should change the dialogue.  When someone asks what something "costs," if you had to figure it out using a cost accounting-like approach or algorithm, your answer is not money.  It does not cost $7.18 in real money to manufacture that widget.  It does not cost $120 in real money to process an invoice.  These are opinions of value not money. 

 

I look forward to your feedback.  Thank you for your comments, e-mails, and texts related to the other blog posts.  Make sure you follow me on Facebook and Twitter to get the latest updates!

 

Peace,

RTL

 

 

For more information about the topics covered here, get a copy of Lies, Damned Lies, & Cost Accounting.

 

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