How Companies Calculate Costs Matters
Calculating costs in business existed long before the SEC was formed or GAAP was established. Cost accounting in business used to be handled by those involved in the work or business operations. In most corporations today, this is handled by the finance department, and cost accounting is no longer directly connected to business operations. Today, accounting practices serve investors more than the business itself, making it harder to understand real costs, improve value delivery, and leading to employees paying the price when cost cutting efforts emerge.
Budgeting, funding, and costing tend to flow vertically through the company structure, rather than horizontally as work flows through an organization in the form of information, data, and materials. Johnson and Kaplan, in their book "Relevance Lost: The Rise and Fall of Management Accounting,” argue that accounting systems have become increasingly irrelevant to operational business decisions. Costing used to be tied to operational workflows, but financial reporting rules have taken over, severing the link to real work. Oversimplified costing practices, such as cost centers, hide operational problems, making it harder to understand the true costs of running a business. Fine tuning operations now is like trying to drive a car while sitting on the roof.
Business operational workflows contain defects. A defect occurs when something goes wrong as people work. Two teams are not in sync on what is expected and what is delivered. Work is late or inaccurate impacting leaders' decision making. Doing the same work over again or not knowing what to do, are some examples. These imperfections cost companies time, money, and resources. Cost center accounting is blind to the details of workflow defects. There is no way to isolate the cost impact of these deficiencies, nor their impact on revenue delays or reductions. As our world has become more complex, so have business operations. For example, designing an electric window for a car is 1,000 times more complicated than it was when electric windows were just wires, motors, and levers. Today, there are a few hundred semiconductor devices and hundreds of millions of lines of code managing the internal operation of an automobile. The design, execution, and orchestration of operational workflows have also become dramatically more complex, and this trend will continue. Additional complexity and change mean more defects lie ahead. Unfortunately, cost center accounting can't help leaders with this increasingly important aspect of running a business.
If you think the cost offset between cost centers and something like Activity Based Costing is small, think again. Business operational workflows can have a defect density of 50% in complex workflows, and I have seen higher. This means that in every other step of a work process, something goes wrong which drains resource capacity. The impact can be low like a 5 minute delay in work or it can be costly like delaying a product launch enabling competition to take market share. Costing the horizontal flow of value or activities in workflows provides a way to improve budgeting and funding at the activity level. This gives leaders tremendous insight into the real costs of running a business. In fact, it can increase return on investment by increasing profit and reducing investment.
Effective costing needs to be done in parallel with the flow of value in an organization, so companies can optimize operations for both cost and value delivery. Activity Based Costing better aligns with operations, but it is not the predominant method used by corporations today. The good news is that if you use cost center accounting, your competitors probably do too. The bad news is that if they don’t, and they better understand how to control costs and increase the delivery of value, that spells trouble for your company in the long run.
How Leaders Lead Matters
At Flow Accel, we recommend Management by Means (MBM), not Management by Results (MBR). MBM comes from Johnson and Broms' book, “Profit Beyond Measure.” MBM leaders believe the best way to get results is to focus on the Means, or how work is done. They focus on building the operational capability to deliver the financial results they desire. MBM leaders own the results and the operations needed to achieve them. This enables the people doing the work to spend more time on how to deliver more value with less effort, rather than wasting time trying to map work activities to operating margin. MBR leaders believe the best way to get results is to focus on the results. They tend to set objectives and incentivize employees to meet them and only help when huge problems get escalated. MBR leaders make the organization responsible for their part of the results and the operations to achieve them, even though, in the end, they are accountable. MBM leaders will see the value in Activity Based Costing or something similar, so they can use real, connected data for decision making. MBR leaders might not see the value in Activity Based Costing since they are disconnected from operations altogether. Budgeting and funding the horizontal flow of value through an organization will enable leaders to be more effective, especially as change accelerates and the way work is done becomes more complex.
Activity Based Costing can help leaders and the finance organization dial in budgeting, funding, and better control costs. If product quality becomes an issue, the team can review how product development activities are funded. Once the root cause of a product problem is identified, an assessment can determine whether anything should change based on that new learning. If the problem occurred because a team lost testing resources, the finance team, along with leaders, can now make adjustments to address the resource gap. They can also take a broader look at product quality activities to determine whether any other adjustments are needed. Costing the value stream also brings time into the equation. If an activity takes a significant amount of time and resources, that cost will stand out rather than blending into some high-level aggregated number. If a value assessment highlights which activities contribute most to revenue, then money can be shifted toward those activities to enhance revenue. Today, most leaders don’t have this option.
How Leaders Control Costs Matters
Most importantly, cost cutting efforts can now be dialed in by evaluating areas that affect costs and revenue, rather than applying a straight percentage cut to a cost center. Straight cost center budget cuts can cripple a company's ability to deliver value to customers. Not only that but cutting costs without understanding how this impacts workflow activities is cruel to people. They usually bear the burden of working nights and weekends, missing out on family events, such as a school play, and dealing with increased stress as they try to overcome the cost cutting efforts for their company.
The best way to beat your competition, navigate complexity and change in today’s world, is for leaders to roll up their sleeves and get down to work on the ground with their people. Then they can see the emergence of complexity, change, and will better understand where cost and value live. Relying on abstracted external financial reporting rules makes it harder to run a business and can negatively impact people in the organization. There is a better way.
Do something today to improve your work-life balance. You won’t regret it. Have a great day, and good luck with your work-life journey.