The Dangerous world of cost accounting


​Product cost, product margin, product profitability are some of the terminologies that are thrown about in corporate decision making. And yet, these terminologies deriving from cost accounting principles have influenced top decision making in large corporations to such an extent that the decisions caused major damages (Boeing Dreamliner, for example), without these corporations realizing that their downfall was caused not by some recession or competition, but due to their own methods of measuring their performance & decision making based on cost accounting principles. There is no more worse accounting principle than product cost allocation that causes severely disastrous decision making.

Let me highlight it by one simple example. There are many more, by the way. The example is for an Indian audience. (However, you can always replace ₹ symbol and the Indian names with a $ sign and US names, say if you are in US. It doesn’t change a thing.)

Say, there are 2 companies in the same business of selling plastic chairs. One of them, lets call it Neelkamal Ltd, owned by Mr Arun Grover and managed by his able day-to-day operations manager Mr Sunil Kumar.

And then lets say there’s another company Plastichair Ltd, owned by Mr Jeevan Moolchandani and managed by his young COO, Mr Manav Gupta.

For discussion sake, assume that their products is a same plastic chair with ₹ 1500 as it price tag per piece. Both of them also purchase the plastic chairs from the vendors at same rate of ₹ 900 per piece and they sell the chairs as it is to their customers by stamping their own brand on it. Few labours at total cost of ₹ 45,000 per month do that stamping. With this labour force they are able to sell 100 units of pieces per month. The cost accountants at both these companies have allocated the labour cost into the finished goods(which is the new brand stamped chair) at the rate of ₹ 450 per piece (no variance for further simplicity sake as you can notice), and thus the saleable chair after new brand stamped on it appears at a finished goods value of

₹ 900 (purchase from vendor)+ ₹ 450 (value add) = ₹ 1350 per piece as finished goods.

Finished goods inventory every day is maintained at 30 units(no WIP or raw material by end of day) with which both companies are able to keep a sale of 100 units per month.

The above set of conditons are so far common to both Neelkamal Ltd & Plastichair Ltd.

Now, lets say, Mr Sunil Kumar makes his operations so good at Neelkamal Ltd that without reducing his sale of 100 units per month, he manages to reduce the daily inventory being maintained from 30 units to just 5 units in one month without causing any drop in delivery performance either or without even laying off any labour !!!

While at the other hand Mr Manav Gupta continues operations as it was at Plastichair Ltd.

Who do you think will show the better financial performance and be rewarded by the owner ?

I would have placed my bet on Mr Sunil Kumar of Neelkamal because what he did was superbly exemplary. However, it turns out if Mr Anil Grover of Neelkamal would actually be thinking of firing Mr Sunil Kumar based on financial reports. To understand the huge discrepancy, lets make the financial P&L statement of Plastichair first where they did no change for the month.

Sales of 100 units = ₹ 1500 x 100 units = ₹ 1,50,000

Cost of Goods sold = Opening inventory value – Closing inventory value + Purchases
= (30 units x ₹ 1350)- (30 units x ₹ 1350)+ (100 units x ₹ 900)
= ₹ 90,000 Labour expenses = ₹ 45,000

Net Profit
Total Income – Total expenses = ₹ 1,50,000 – (₹ 90,000+ ₹ 45,000)
Net profit for Plastichair for the month = ₹ 15,000

Now, lets make the financial P & L statement of Neelkamal Ltd for the month where they brought down the inventory maintenance from 30 units to 5 units with same sales of 100 units in that month. Obviously, the purchase requirement would have been only 75 units as remaining 25 units are compensated by same reduction in inventory.

Sales of 100 units = ₹ 1500 x 100 units = ₹ 1,50,000

Cost of Goods sold = Opening inventory value – Closing inventory value + Purchases
= (30 units x ₹ 1350)- (5 units x ₹ 1350)+ (75 units x ₹ 900) = ₹ 101,250
Labour expenses = ₹ 45,000

Net Profit
Total Income – Total expenses = ₹ 1,50,000 – (₹ 101,250+ ₹ 45,000) Net profit for Neelkamal for the month = ₹ 3,750

For Neelkamal Ltd, Sunil brought the profit of Neelkamal to less than 1/3rd of Plastichair’s.

Instead of being rewarded for exceptionally improving the operational performance by reducing the inventory for same amount of sales & without even laying off anyone, Sunil is most likely going to be fired by Mr Anil Grover!!

No wonder, to stay in the good books of Jeevan Moolchandani at Plastichair, the COO Manav Gupta chose not to reduce the inventory at all.

This is the dangerous world of cost accounting which actually discourages a good operational performance !

Theory of Constraints(TOC) amongst its many other successes and solutions, offers Throughput accounting system as the financial accounting system which eliminates such conflicts. The TOC movement challenges some of our most basic assumptions for the good in almost every field of business.

Or if you can’t wait and want to start right away then as a first start valuing all of your inventory including WIP and finished goods at Raw material prices only. See the difference in operational performance in a few months only.

Measurements drive behavior & people, in general, are good !

Blocked Cash


You could be profit making enterprise and yet go bankrupt in no time. Never forget Enron. Till few months before the huge company went bust, its senior executives knew little about the cash situation on the ground. All the time they had an impression that the paper profits which the accountants are showing to them are the unblocked cash available. While it was all blocked !

Do you know how much of your cash is blocked today? Do you measure the blockage?

Receivables, inventory and payables are the items that affect the cash blocked the most. How about your C-Forms ? Where are you tracking their collections? If you are really seeing your receivables only in categories of due, overdue and bad debts, then you cannot hope to improve your receivables. Measurements drive behaviour. Implement a measure that decays the value of your receivables for each passing day unpaid, and see those results.

Inventory is the biggest source of cash blockage. In fact, in Japan inventory is considered evil. Specially the Work-in-process inventory. It blocks not only the cash available but it hides many problems in its pile of unused goods. Are you doing a weekly check of slow moving or dead inventory and then actually taking a decision of scrapping the dead ones? You'll be surprised at the immense benefits that accrue to you by doing this exercise weekly.

Small suppliers are specially short of cash. Treating them as tolerant as big suppliers for late payments to them has its own silent negative effects. Their delivery timelines or worse, the quality of service would be as inconsistent as the timeliness of your payments to them. The purchase or finance department may not realise its impact, but its the production department which gets hit the most. A delay or even a hold up for even half a shift in production more than destroys every cost advantage that your purchasing team won in hard negotiations with the suppliers. Long credit lines with suppliers are as important to release your blocked cash. And for that timeliness of payments for previous committments are far more neccessary

Cash per week, not accounting profit, not accounting cost, must remain the prime unit of measurement of your performance.

Execution is numbers 


A neccessary ingredient of a good execution strategy is agreement on a goal. A numerical goal which is monitored regularly.

Its fun to only act on the vision and sell that vision to employees, customer and investors. However, measurements drives behaviours. Unless there is a measurement which is communicated and shared with all, you are likely to see your vision following by the wayside, and letting the events lead your organisation rather than your vision. And that's when managing execution will itself become your main job rather setting the direction of the whole company and executing according to the vision

For most the companies, that common goal is profit. In fact, for most Indian companies, fortunately that goal is cash profit and not accounting profit. However, for a small companies specially startups, that goal is often not profit but numbers like revenue, customers on board, gross merchandise value etc.

That goal is often not shared with the execution team or if shared it is shared at vastly long intervals, like 3 months. Or worse, the goal is often changed after 1-2 intervals. So sometimes it would be sales, at other times it would be profit, or at other times it would be cash profit, or perhaps number of customers acquired.

Thats directionlessness again.

Agreeing on a long term shareable goal aligned to your vision is the very first step towards evolving an execution strategy. If you can't think of a goal on which you can be consistent about for long, I suggest you take the safest route and aim for throughput output. (Though, net cash in bank through operations would be the safest goal to chase, however perhaps you would not like to be so transparent about your financials.)

Having a goal and sharing it weekly with your execution team is the first step towards team building that'll drive your execution.

Vision is about passion and conviction in the product. Execution is always about numbers.

Sales? Really?


Your sales persons shows what is called as a PO that he has recently won from a new client. The employees jump with joy as the PO is of a significant value.

Amazing ! This is a fairly common scene across companies whenever a win comes in.

In reality, every good businessman knows that a PO is nothing more than a piece of paper most of the times. It contains an order to be delivered on credit in a lot of cases and it has terms which a lot of sales people don't care to go through

Even when the terms in the PO are favorable to the seller, yet these terms are unenforceable simply because you can't count on the judicial system at all to enforce your contracts

Cash is the real king in the business. As long as your PO hasn't brought in the cash alongwith it, the PO is a compromise. And compromise often lull you into further compromises.

Credit sales though a life line for many a businesses is often assumed as an inevitable fact of doing business. That's not true. Too often you would see your competitor's taking advance cash with PO.

Its the reputation(or the lack of it) of your products and the timeliness of the services that raises the ability to get cash advance alongwith your PO.

The timeliness of delivery and quality of products can be easily improved in a short time by following simple principles of focus and agreeing on a numerical goal of your company.

pAgain, this requires change in mindsets. Assuming that drastic improvements in quality and timeliness in short time are impossible is a bad assumption.

The POs arrival in the sales persons inboxes can be greeted with a real joy then because they would perhaps arrive with lesser credit or even better with cash in bank. As they say, profit is an opinion. Cash is a fact ! And that is real sales.