This is the second of a 2-part posting on the dangers of using traditional cost accounting to run your business that Bruce Nelson wrote in the appendix of our book Epiphanized. You will recall, that my last posting ended with the following…..
"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 want 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 happen? Was this the real outcome business owners really wanted from high efficiency?
In my next series of postings we'll look deeper into the problems faced by the sock maker.