Is Cost Accounting Dead?

Nov 30th 2017
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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:

  1. Profit Beyond Measure by H. Thomas Johnson and Anders Bröms
  2. Lies, Damned Lies, and Cost Accounting by Reginald Tomas Lee, Sr.
  3. 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:

  1. Cost accounting forces relationships that don’t exist.
  2. This causes people to lose touch with operations.
  3. Cost accounting creates meaningless numbers that people consider as gospel.

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.


Replies (5)

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Ed Kless
By ed.kless
Dec 20th 2017 14:00 EST

Well done summary of Ron's presentation on this topic!

If I could offer three additional thoughts that might help others in their thinking on this:
1. Costs are an opinion.
2. Prices justify the future expenditure of costs.
3. Time is a constraint, not a resource.

Thanks (1)
Liz Farr
By Liz Farr
Dec 27th 2017 21:40 EST

Thanks Ed!

When you begin to understand that time is a constraint, not a resource, billing by the hour and using time sheets makes less and less sense.

Thanks (1)
By drrtl
Dec 28th 2017 12:48 EST

Hi Liz! A couple things. First, thanks for mentioning "Lies, Damned Lies, and Cost Accounting" (Please let me know where to send the check! Haha!). I'd agree it's short on focusing on the cash dynamics of capacity. It wasn't really designed to address this. The topic is covered in detail in my previous two books, "Explicit Cost Dynamics" (hard read, but all the details are there for the patient one), "Essentials of Capacity Management," and the forthcoming book, "Strategic Cost Transformation."

Second, you mentioned matching. Two considerations when it comes to matching. First, matching is primarily a financial accounting move and it's dictated by accounting's governing bodies. You'll still have to do that for reporting purposes, but I stay away from financial accounting in my work. However, financial accounting doesn't and doesn't govern what happens with managerial decision making, including managerial accounting and the information it provides.

Second, what's in question is, what are the numbers you're bringing together to match? You could conceivably sell something today you spent money making last year with 2018 payment terms. You can recognize revenue in 2017 although you haven't received any money. You are bringing along costs that happened in 2016, and these costs are, as Ron mentioned, subject to the method of calculating the cost.

So, what is accounting profit? We take revenue, which is money if we have it (or the hope we'll receive it if we don't) and subtract an opinion of the value of capacity consumed. This isn't money. It's like subtracting swimming pools from cement trucks; the math makes no sense, so why we put so much stock is kinda puzzling, isn't it? It's like the business executive drug of choice. When you look at it, it's bad for you and causes you to think and do bad things, but you can't break your reliance on it. You need to have those costs...those profit numbers...more, more, more! Variance? You ran a variance? You're fired! That's not cool, and we have to do something about that.

Happy to discuss more if interested! Have a great day.

Thanks (2)
Liz Farr
By Liz Farr
Dec 29th 2017 11:54 EST

Thanks Dr. Lee!
I agree with you that financial accounting rules are a crazy distortion. Fortunately, I've retired from public accounting so the only financials I have to worry about are my own. Cash and capacity are all I care about now!

Thanks (1)
Replying to Liz Farr:
By drrtl
Jan 3rd 2018 10:11 EST

Good stuff! Now, if we could just help larger companies understand this notion more clearly!

Thanks (1)