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Not enough dimensions: Why cost accounting doesn't provide a real picture of business performance

May 1, 2017

The world exists in 3-D.  What would it look like in 2-D?

Welcome back!

 

I regularly point to the notion cost accounting is useless from a cash/making money perspective.  Over the weekend, this metaphor came up that offers one interesting example why.  Well, I think it's interesting  Let's see what you think.

 

Worlds Collide

Let's say we live in a 2-D world.  Our world is flat like a piece of paper or a countertop.  Along comes a ball that intersects our flat world.  What would it look like to us?  How would we describe it?

 

When a 3-D ball intersects a 2-D plane, the result is a circle (Figure 1).  The only thing we'd know about the ball in our world is that circle.  We are clueless otherwise.  Since we only have two dimensions, we can't process a third. Imagine the real universe with four spatial dimensions.  How could we process the 4th dimension when we live in a 3-D world?  Everything is defined by three dimensions, up/down, left/right, front/back.  A 4th dimension wouldn't make sense (I almost used the term orthogonal here, but I realized I'd sound even more like a nerd and I'm trying to suppress my nerdivity).

Figure 1:  When a ball intersects a plane, the result is a circle in the plane.

 

Ultimately, what may be critical information such as the diameter of the ball, its surface area, and volume are lost, and the circle changes size depending on where it intersects our world (Figure 2). 

 

 

Figure 2:  The interpretation of the ball in a 2-D world depends on how the ball intersects.  When you live in the plane, all you see is the circle which may tell you little, if anything, about the ball itself.

 

What's this have to do with cost accounting?

This situation is a lot like what happens when cost accounting describes real operations and cash data.  Consider this.  Let's say we calculate the cost of a widget to be $3.14 (You like that? 𝜋?  Circle?  Diameter?  Nerdivity coming out).  What do you know about the situation that created the widget?  How many were made?  Who made them?  What was their cost to us in cash (salaries)? Were they temporary or permanent?  What and how much materials were used.  How much of the material did we buy?  How much do we have?  Did we use the material and labor efficiently and productively?  If you want to manage operations effectively, you want to know this information.  However, when you look at $3.14, the information is not there.  You're told the cost is $3.14 and you either hit or missed your target.

 

Another cost issue is similar to the diameter of the circle.  If you think about it, the ball doesn't change its size.  However, depending on where and how we slice the ball with our 2-D world, our interpretation, what we see or are told, can change (Figure 2).  Hence, we can come up with lots of different descriptions of the one ball based on how it is projected into our world.

 

Like the ball, in business, there is one description of what happened.  The people you have, what you paid them, what they created, when they created it, etc is unique.  However, you can describe them lots of different ways depending on the costing approach you use (Figure 3).  The scope of the analysis and how data are allocated will change your answer, your cost.  That $3.14 can just as easily be $2.71, $2.54, or even $9.81 (recognize those numbers?).

 

Figure 3:  Cost accounting approaches can take the exact same data, process it differently, and create different costs.  In fact, the same approach can be used by the same person and they can get different costs.

 

If the objective is to make money, what's important is managing the ball not the circle.  All the key data such as cash transactions, how much capacity you have, how you use it, what it creates, and how efficiently, are all a part of the ball that cost accounting does not see.  Cost accounting does not have enough dimensions.  It loses the cash and operations dimension of your business when it projects data into its own world.

 

Costing matters for some regulatory purposes, but otherwise?  No.  How many companies hire tons of cost accountants who spend an inordinate amount of time calculating arbitrary numbers to the nth degree?  For what purpose?   Does that circle give you any more insight into the ball?  No.  It's just one slice and the key elements to manage your business are in a dimension that cost accounting cannot see.  On the flip side, many cost accountants stand there scratching their heads with that look on their face asking why companies don't value them.  Well, it's because your data is bogus, that's why.  Invoices don't cost $120 to process, so why are you trying to convince people they do?

 

Your business models need to include the cash and operations dimensions of the activities that occur within.  Without them, you are making decisions by looking at the circle rather than the whole ball.  This will, of course, limit the effectiveness of your decisions.

 

I hope this makes sense.  It was fun creating the model, but I'm an engineer.  What's fun to me may be torture for you!

 

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 these concepts, feel free to grab a copy of Lies, Damned Lies, and Cost Accounting.

 

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