In the next few series of
postings, I’m going to discuss accounting procedures and some of the problems
that Cost Accounting brings to the table.
For those of you who have a copy of Epiphanized:
Integrating Theory of Constraints, Lean and Six Sigma, you will remember
the tale of the Sock Maker that Bruce Nelson wrote about so eloquently in
Appendix 2. For those of you who haven’t
yet gotten a copy of Epiphanized, I
want to share with you the tale of the Sock Maker as presented by Bruce Nelson. It just might give you a different
perspective on how some of the decisions made using cost accounting might
negatively impact your business.
The Sock Maker
In the early 1900s Cost
Accounting (CA) was in its early stages and beginning to be widely accepted and
used. For a business owner there were
many things to consider in the day-to-day operation of the business. One of the most important functions of the
business owner was tending to the daily needs of the business financial situation.
Things like keeping the books, calculating the cost for raw materials, calculating
labor cost and making sales were all important issues to be dealt with on a
daily basis.
It was understood by
business owners that in order to stay in business and make money the cost they
paid for the products or service rendered had to be less than the selling price
of their products or services. If it
wasn’t, then they would quickly go out of business. Then and now, the needs of
business haven’t changed much, but other things have changed.
The ideas and concepts about
what was important to measure and how to measure it were starting to form and
were being passed from one generation to the next. This was considered
important information that you needed to know in order to be successful.
Without this understanding, it was assumed that you would fail. Back then, the business structure and methods
were different than they are today. The
labor force was not nearly as reliable and most workers did not work 40 hours a
week. When they did work, they were not paid an hourly wage, but instead were
paid using the piece-rate pay system.
As an example, suppose you
owned a knitting business, and the product you made and sold was socks. The
employees in your business would knit socks as their job. With the piece-rate
pay system you paid the employees based on the number of socks they knitted in
a day or a week or whatever unit of measure you used. If an employee knitted ten pairs of sock in a
day, and you paid a piece rate of $1.00 for each pair knitted, then you owed
that employee $10.00. However, if the
employee didn’t show up for work and did not knit any socks, then you owed
nothing. In this type of work
environment labor was truly a variable cost and deserved to be allocated as a
cost to the product. It just made sense
in a piece-rate pay system. The more
socks the employees knitted, the more money they could make. Also, as the business owner your labor costs
were very precisely controlled. If
employees didn’t make any socks, then you didn’t have to pay.
In time, metrics for
calculating labor costs changed and the labor rates changed as well. Many
employees were now paid a daily rate instead of a piece rate. Labor costs had now shifted from a truly
variable cost per unit to a fixed cost per day. In other words, the employees got that same
amount of money per day no matter how many pairs of socks they knitted or
didn’t knit. As time went by, the
employee labor rates shifted again. This
time labor rates shifted from a daily rate to an hourly rate. With the new hourly rate came the more
standardized work week of forty hours, or eight hours a day, five days a week. With the hourly rate the labor costs now
become fixed.
With these changes it became
apparent to the sock-knitting business owner that in order to get the biggest
bang for the labor buck, the owner needed to produce as many pairs of socks as
he could in a day in order to offset the rising labor costs. The most obvious way to do that was to keep
all of your sock knitters busy all of the time making socks. In other words, efficiency was a key ingredient and needed to be increased. If the owner could make more pairs of socks in
the same amount of time, then his labor cost per pair of socks would go down. This was the solution the business owner was
looking for—reducing his costs. If
everyone was busy making more and more socks, and they could make a lot of
socks in a day, then his new labor cost per pair of socks could be reduced! This had to be the answer— look how cheap he
could make socks now! Or so he thought.
With these new found levels
of high efficiency came another problem. The owner quickly noticed that he had
to buy more and more raw materials just to keep his employees working at such
high efficiency levels. The raw
materials were expensive, but he had to have them. The owner knew that his past success was
directly linked to his ability to maintain such high efficiency and keep his
cost low. More and more raw materials
were brought in. More and more socks
were made. The socks were now being made
much faster than he could sell them. What
he needed now was more warehouse space to store all of those wonderfully cheap
socks! So at great expense, the owner
built another warehouse to store more and more cheap socks. The owner had lots and lots of inventory of
very cheap socks. According to his
numbers the socks now were costing next to nothing to make. He was saving lots of money! Wasn’t he?
Soon the creditors started
to show up and wanted their money. The
owner was getting behind on his bills to his raw material suppliers. He had warehouses full of very cheap socks,
but he wasn’t selling his socks at the same rate he was making them. He was just making more socks. He rationalized that he had to keep the costs
down and in order to do that he had to have the efficiency numbers high. The business owner soon realized that he had
to save even more money. He had to cut
his costs even more, so he had to lay people off and reduce his workforce to
save even more money. How did he ever
get into a situation like this? His
business was highly efficient. His cost
per pair of socks was very low. He saved
the maximum amount of money he could, and yet he was going out of business—How
come?
Reality had changed and
labor costing had changed (labor shifted from a variable cost to a fixed cost),
but the cost accounting rules did not change. The owner was still trying to treat his labor
cost as a variable cost. Even today many
businesses still try to treat their labor cost as a variable cost and allocate
the labor cost to individual products. When the labor costs are allocated to a
product, then companies try and take the next step—they work hard to improve
efficiency and drive down the labor costs per part, or unit. This erroneous thought process is ingrained in
their mind, and they believe that this action will somehow reduce labor costs. And if you can reduce labor costs, they think,
then you are making more profit. But
take just a moment and reflect back on the consequences of the sock maker’s
experience with cost savings and the high efficiency model. Are these end results anywhere close to what
the business owner really wanted to have hap-pen? Was this the real outcome business owners
really wanted from high efficiency?
In my next posting I’ll
expand upon the negative effects of the performance metric efficiency and begin another discussion on an alternative
accounting method known as Throughput
Accounting. I have posted other
discussion on TA, but I’ll try to present a bit of a twist.
Bob Sproull
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