Monday, September 23, 2013

Focus and Leverage Part 250

In the last two postings we’ve talked about our sock maker and how if he uses the wrong accounting system model to make his financial and staffing decisions, he could be heading in the wrong direction in terms of profitability.  Let’s now continue on with Bruce Nelson’s musings and consider some other accounting factors.

The Efficiency Model

The efficiency model, when measured and implemented at the wrong system location will have devastating effects on your perceived results.  The end results will actually be the opposite of what you expected to happen. I wonder why with all of the technology improvements accomplished through the years, why it is still acceptable to use cost accounting rules from the early 1900s?

Cost Accounting
The primary focus of Cost Accounting is per part or per unit cost reductions.  Because perceived cost reductions are viewed so favorably, is it any wonder why there is so much emphasis on efficiency?  And yet cost reductions don’t seem to be the answer.  There have been many highly efficient companies that have come close to going out of business or have gone out of business.  Have you ever heard of a company that has saved themselves into prosperity?  Think about it, any perceived savings that the sock maker thought he was getting were quickly eroded by buying more raw materials.  In fact, it ended up costing the sock maker much more money than he realized and not saving him anything!  He was doing all of the recommended practices and yet he was failing—How come?

Many companies will emphatically state that the primary goal of their company is to make money, and yet they spend the largest portion of their time trying to save money.  It would appear they’ve forgotten what their goal really is. The strategy you employ to make money is vastly different than the strategy you would employ to save money.  For most companies, the assumption is that saving money is equal to making money—that is, if you somehow save some money it’s the same as making money.  This is simply not true.  These two concepts are divergent in their thinking—each takes you in a different direction with different results.  If the real goal of your company is to save money, then the very best way to accomplish your goal is to go out of business.  This action will save you the maximum amount of money—goal accomplished!  However, if the goal of your company is to make money, then a different strategy must be employed—maximizing throughput through the system.

Throughput Accounting

Suppose we consider again the same example using the sock maker.  Suppose the sock maker wants to make three times as many socks as he is making now.  What does he have to do?  Using the piece-rate pay system he would have to hire three times as many employees to be sock makers and pay them a piece rate of $1.00 per pair.  So in order to make three times as many pairs of socks, the labor rate must go up—he has to hire three times as many people. In the piece-rate world getting three times as much through the system will cost him three times as much in labor.  But let us suppose our sock maker is paying an hourly wage rather than a piece rate, and he figures out a way to make three more pairs of socks, per worker, per day.  By being able to make three times as much, how much do his labor costs go up?  They do not go up at all!  His labor rate stays exactly the same.  He still pays the workers an hourly rate whether they make one pair of socks or ten pairs of socks.  He only has to pay the employees once, not a rate based on the number of socks made.  His only increase in cost comes from buying more raw materials to make the socks.  So why does modern day cost accounting still try to allocate a labor cost per unit of work and then claim that increased efficiency drives down the cost per part?  It does no such thing!  In today’s reality, labor costs are fixed not variable!

Perhaps it is possible that some of these cost accounting rules and methods might be wrong and mislead the user into thinking some results are better than they really are.  Is it possible that there might be another way to look logically at the practice of accounting that will truly get us closer to the goal? What if there was another way? A way that provides an alternative accounting method that allows us to remove, or abandon or ignore the CA rules that are causing so much trouble?  In my next posting, we’ll have a look at Throughput Accounting.

Bob Sproull

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