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.