If you are about making money, don't look to accounting profit to tell you whether you are. It doesn't work. Why? Two reasons. First, the math is as questionable as a three dollar bill. Second, making money is about cash, and profit does an extremely poor job modeling cash. I'll focus on the first today and address the second with the next post.
We learned in first grade you can't add (or subtract) apples and oranges. But, this is exactly what accounting does. Six year old kids know you can't do it, yet business people try to do it and academics teach it. Hmmm 🤔
The profit equation we all know is:
Revenues - Costs = Profit
For profit to be money, both revenues and costs have to be money, right? Apples - Apples = Apples. Assume, for now, revenue is money. It is not always money, but let's go with it for now (teaser - with revenue recognition, you can count revenue as profit without having been paid any money).
I'd like to propose cost is not always money. Sometimes it is, but in many cases it isn't. 😲
Consider the Apple pencil (you like how I used Apple in the apples and oranges conversation? Slick, huh?).
Let's say Apple decides it costs them $20 to make a pencil. Do they pay someone $20 each time they make a pencil? No. Do they save $20 when they don't make one? No. There is no $20 cash transaction when a pencil is made. The $20 is one of many possible opinions of the value of resources involved in making the pencil. The $20 isn't money.
Consider a factory worker making $28 per hour. If a task takes them 15 minutes, we may say the task costs $7. In reality, it doesn't cost anything. We pay them $28 whether they do something or not. There is no $7 transaction that occurs when they perform the task. It's these types of calculations, which often include labor, materials, and other factors, that are used to come up with the $20 for the pencil.
Back to the apples and oranges thing. Can't subtract them, yet, that is exactly what accounting does.
Revenues (money) - Costs (opinion) = Profit (money)
Money - Opinion = Money
Esto no es bueno.
In this context, profit is not money. I'm not really sure what it is. You can't subtract opinions from money (apples & oranges). What is it? Who knows? If it isn't money, how can it be used to tell me how much money I've made? That's like using the trees in my back yard to tell me how many pets I have. They're completely different things!
Next time, I'll go into the second reason profit is a poor proxy for cash, and it's even worse than this one!
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For more information about the topics covered here, get a copy of Lies, Damned Lies, & Cost Accounting.