Originally published in Upsize Magazine April 2010

Oscar Wilde once said, “A cynic is a man who knows the price of everything but the value of nothing.” Unfortunately, the same could be true about traditional accounting systems.

Over time some of these systems have become more complicated in well-intentioned attempts to improve the accuracy and clarity of information. At best, these efforts result in complexity; at worst, the results lead managers to make the wrong decisions.

Variable cost conundrum

“I just want to know why I’m not making as much money as I used to,” said the founder and owner of a $12 million manufacturing company who had been blinded by how cost allocations can obscure reality. The company had been very successful, enjoying steady growth over many years, but the owner actually had a large under-absorbed overhead variance.

As the company grew, a general manager had been hired who instituted a standard cost system. This complex system allocated – with great precision – just about every type of cost and activity across the factory for calculating overhead rates. Labor hours were collected in detail and multiplied by these overhead rates to arrive at costs for work orders and, ultimately, products. However, this traditional accounting approach was completely useless for real decision-making.

The sales revenue for the company’s six product lines changed throughout the year and each used a different mix of production activities. Although several product lines appeared to be profitable, when the sales of those lines increased overall profitability for the firm declined.

This and other issues led people to mistrust the financial system. Several product lines needed additional financial support and management wanted to allocate the limited resources where it made the most sense. The owner needed a different accounting approach.

By treating many truly fixed costs as variable, it appeared as though these costs would change as production levels changed. In reality, these costs remained fixed. The company ultimately adopted an approach that looked at the contribution margin for each product line.

Contribution margin is calculated by subtracting the true direct variable costs for each product line from the related sales. Direct variable costs change correspondingly with changes in product volume. Material and sales commissions are direct and, therefore, variable; labor is not, unless a company has a lot of contract or temporary labor it can terminate and bring back to work quickly.

Comparing the contribution margin across product lines provides a clearer picture of the relative importance of each product line. This approach allowed the owner to quickly decide where to invest and which lines needed additional attention.

Taking it outside
In a similar situation, a vertically integrated media services firm had carefully allocated all costs to each of its internal departments. Some of the product managers had decided they could find those services more cheaply on the outside and had taken business away from the internal departments. Since many of the costs associated with those internal departments were really fixed, the firm simply ended up increasing overall costs with no additional revenue.

Another example illustrates how improvement projects appear to degrade financial performance. The general manager of a $20-million injection molding company was pleased with the progress his people had made. Quality was on the rise, lead times were decreasing and on-time delivery performance was improving. The shop was better organized and inventory was shrinking. Many of the non-financial measures were beginning to have a positive effect on behavior.

Unfortunately, financial performance was declining. Because the firm was selling off inventory, production levels had declined but operating costs had remained largely the same. As a result, both the current costs and the costs sitting in inventory were hitting the profit-and-loss statement at the same time.

However, the board didn’t understand the situation and brought in a new general manager who immediately started building up inventory. Profitability increased almost immediately, but so did lead times. Delivery performance and quality began to suffer. Once inventory levels stabilized, profitability declined rapidly.

It is important to understand the true effect of the improvement activities on the financial statements. Splitting out the sources of costs would have highlighted the issue. Furthermore, a focus on cash flow also would have revealed the true picture.

Wasting time
If all areas of the organization are showing improvement, the entire business must be doing really well, right? This concept is well entrenched in larger companies, especially those with well-developed systems of periodic reports.

The fallacy of this approach is best illustrated in a book by Eliyahu M. Goldratt, called “The Goal,” in which each factory department had efficiency measures. Every month, corporate expected improvement in these measures. Unfortunately, the best way to show improvement was to produce constantly with little or no down time.

Supervisors quickly figured out which products would yield the best efficiency report results and focused on those. The end result was growing product inventories that couldn’t ship because the parts needed would have hurt another department’s efficiencies.

The problem was most acute in those areas where the biggest, most expensive machines existed. Because overhead rates were highest there, a great deal of emphasis was placed on making sure those machines were always running, whether the parts were needed at all. Delivery performance, and therefore sales revenue, suffered constantly.

The alternative approach is to identify the bottlenecks, or constraints, and improve those areas first. High efficiencies in areas with lots of production capacity will only result in more unneeded inventory. Financial reports that emphasize local efficiencies should be scrapped. Costs of products can be adjusted to reflect the amount of time required from the constraint resources. Interestingly enough, the costs of products that don’t use the constraint at all appear to have much lower costs. Contribution compared to the constraint is also a useful measure.

In all three examples, the financial information was greatly simplified. Easier to calculate and understand, these changes to management accounting systems will ultimately improve performance. The data required is generally available and in much less detail than is collected. Once these new approaches have taken hold, it is frequently useful to reexamine the need for the complex systems of the past.