Ron Baker is on a mission to change the way accountants do their work. He’s killing our sacred cows — first it was the time sheet and the billable hour. And now he wants us to get rid of cost accounting.
Baker was a former cost accountant, so this change of opinion is not one he takes lightly. At QuickBooks Connect 2017 earlier in November, Baker argued that companies should get rid of cost accounting and replace it with modeling and managing capacity.
He cited three books that changed his mind about the usefulness of cost accounting:
- Profit Beyond Measure by H. Thomas Johnson and Anders Bröms
- Lies, Damned Lies, and Cost Accounting by Reginald Tomas Lee, Sr.
- The Goal by Eliyahu Goldratt and Jeff Cox
The promise of these alternatives to cost accounting is better information that management and operations can use to improve cash flow.
One of the co-authors of Profit Beyond Measure, H. Thomas Johnson, is a professor of business administration at Portland State University. He was also an early proponent of activity-based costing (ABC). As Baker reported, a student in one of Johnson’s courses asked him if he’d ever looked at Toyota, which doesn’t use a standard cost accounting system. Instead, Toyota first establishes a price for a new vehicle, then the engineers are given the responsibility to figure out how to manufacture the car below that price.
Curious about these alternatives to cost accounting, I read Dr. Lee’s book. As Baker reported, Dr. Lee’s book describes three problems with traditional cost accounting:
Baker described a solo accounting firm with overhead of $100,000. For the year, the accountant budgeted 3,000 hours total time, of which 1,500 was billable time. Do we divide the overhead by 3,000 hours to get a cost of $33.33 per hour, or by 1,500 for a cost of $66.67 per hour?
As Dr. Lee’s book points out, what the accountant bought with the $100,000 of overhead is capacity. What the accountant does with that capacity has no relationship to the cost of that capacity.
The overhead will be $100,000 whether the accountant works zero hours or 3,000 hours. The accountant won’t save $33.33 by working an hour less, nor will it cost an additional $33.33 to work another hour.
What if the accountant completes all 3,000 hours by November 30, then on December 1 takes on a new project that will take 100 hours? As Baker pointed out, this brings the cost of 1,600 hours down to $62.50. Does that mean that clients who were billed on a cost-plus basis were overcharged by about $5 per hour?
My courses in accounting taught me the matching principle — that revenues should be matched to the expenses needed to produce them. But as Baker reminded us, depending on the costing method used, different costs and profits can be calculated for the same situation.
Thus, costs and profits are not absolute. Accurate cost allocation under any method depends on the volume of customers, accurate recording of time, not on cash flow. This exercise is time-consuming and might not give management useful information to help them improve profits.
If a company has a variance in their costs, what does that tell management about operations? Was the variance due to improved efficiency? A price spike in raw materials? Did they make enough to meet demand, or are they making too many? Or was the costing model a bad choice? Teasing out the reasons is challenging and time-consuming.
In contrast, looking at capacity and managing cash flows seems easier to understand, though both Baker’s talk and Dr. Lee’s book were both short on details for implementing this new model.
My only foray into cost accounting was part of an assignment at a manufacturing business. This company was in bankruptcy, and had been given a lifeline of sorts by a a high-flying, risk-loving venture capital firm which had sunk something like $25 million into the company to keep it afloat.
The CFO was convinced that if we could just figure out the costs, he would be able to make the company profitable by finding ways to make the process more efficient. And he also believed that by using those supposedly more accurate costs in the cash flow projections required by the VC firm, he’d be able to keep the VC investors from exercising their stock warrants and taking control of the company (which they ultimately did).
The simple reality was that cash coming in didn’t come close to covering expenses. Looking back, and with the new insights from Baker’s talk and Dr. Lee’s book, they had spent too much on capacity. There was no way their sales would cover their costs.
Change in the accounting world — especially when it comes to our sacred cows — is slow. Ron Baker has been hammering away at time sheets and billing by the hour for decades, yet many firms still operate that way. These alternatives to cost accounting have also been out there for many years.
Adapting to a new way of looking at numbers and performance will take us a while longer, but I’m hopeful that the new generation of accountants will bring us there.
About Liz Farr
Liz Farr, CPA, has worked in tax and accounting since 2002. Besides tax returns of all flavors, she’s worked on audits of governmental entities and not-for-profits, business valuations, and litigation support. She is also a freelance writer specializing in content marketing for accountants and bookkeepers around the world.