This morning, I read a report that longstanding Japanese company, Toshiba, may have to close its doors. Why? Not making money.
Businesses must make money to exist. The common proxy for assessing how much money a company has made is profit. Question. "Is profit an effective proxy?" Answer? No.
In my last post, I talked about why the math of profit makes no sense. Why? You can't add (subtract) apples from oranges, but this is what some profit calculations do. This time, I will share three other simple reasons why profit doesn't reflect cash.
1. Revenue recognition. In accounting, you can sell something and recognize the revenue without having received money. Assume you sell something on 12/31 of 2017 and are paid on 1/1/2018. You can recognize the sale and capture it in your 2017 profit even though you won't get paid until 2018.
2. Cost matching. Say you spent money making widgets in 2017 but you don't sell them until 2018. The value is calculated as a part of your profit in 2018 when sold, not 2017 when you spent the money.
3. Profit isn't unique. Calculating the costs that go into profit starts with a real situation. You buy and pay for capacity (space, labor, materials, etc), you consume it, and you create output. This is clear and unambiguous. You bought 8 hours of labor. You consume, 6 hours making 25 units of output. Unambiguous.
Now comes accounting. If you want a cost for the output, you'll have to calculate it. Why? Because there is no direct relationship between where money is spent, buying capacity, and what you do with it, creating output.
Consider this. Assume long distance calls are 10¢ per minute. A ten minute long distance call will cost $1. How much is a ten minute local call if you pay $25 per month for unlimited access? Don't know right? Why? Because what you bought access, is independent of how you use it, calls. The number of calls, the location, and the length of the call, while perhaps useful, doesn't affect the $25 you paid. The values are independent.
Figure 1: Unambiguous data are plugged into accounting assignment/allocation algorithms to calculate costs.
Since the values are independent, you have to make up a relationship to tie them together (Figure 1). This is what cost accounting is all about; making up relationships. You don't need cost accounting for long distance calls where there is a relationship between length and cost. But you do for local calls where there isn't.
Each cost accounting methodology has a different way to assign or allocate costs. Each approach creates a different answer - a different cost (Figure 2).
Figure 2: Cost accounting must create a relationship between independent things; what you bought, how it was used, and what was created. Because they're independent, the relationship is ambiguous. This is why there are so many costing methodologies. Each one seeks to create a "less ambiguous" way to calculate costs.
If revenues are the same but costs are different, profits will be different.
If you spent money one way, how can the choice of an approach affect how much money you've made? It can't.
Strike 3. You're out.
Ultimately, profit has little if anything to do with how much money you've made.
In the next post, I'll begin talking about why costing and cost accounting is not smart management.
Until then, peace to you. Make sure you follow me on Facebook and Twitter to keep up with the latest news!
For more information about the topics covered here, get a copy of Lies, Damned Lies, & Cost Accounting.