This may surprise you, but in a conversation with someone the other day, they let slip they didn’t have a favourite cost accounting technique.
I know…crazy, right?
Now, in fairness, the bloke I was talking to wasn’t an accountant, but I just imagined everyone in the whole world had a favourite cost accounting technique. So the realisation that this was not the case came as something of a surprise.
Admittedly, it would be truer to say that I have two favourite cost accounting techniques, with a 50/50 weighting, and I generally use them in conjunction with one another which makes both of them together more powerful than either one of them on their own.
But, just in case you’re one of the weirdos who doesn’t have a favourite cost accounting technique, I thought I’d write about one of them today. I’ll save the other one for a future article – after all, it’s always good to have something to look forward to…
Although the principles underlying the technique I’m about to explain go back over 100 years, back to when FW Taylor was busy developing his Principles of Scientific Management, it was probably most used in the 1980s and 1990s before being overtaken by trendier ideas.
As is often the case in the world of accounting, however, trendier is not necessarily better, or more accurate, or more bottom-line building.
Fashionable or not, I have never failed to get valuable insights into a company’s cost structure and profitability by applying the technique I’m sharing with you today, even though most accountants have never used it “for real” and mostly can only recall a superficial fact or two about it from a textbook they studied for their professional exams.
Although if you’ve ever worked with me, or for me, I’ve used this technique so often that nowadays I mostly do it all in my head. I rarely make a big fuss about where the insight for all the awkward questions I ask comes from.
So listen. Do you want to know a secret…?
As easy as 1, 2, 3
The secret is that most cost accounting techniques are applied in either a very broad-brush way or in a mechanically, but very specific way. And both approaches are wrong.
Wrong, but surprisingly popular.
People take what looks like “the easy route”, but this leads to many organisations making poor commercial decisions. They have an unrealistic, and inaccurate, view of what their costs really are.
This is so much the case that when I come across an organisation in real trouble, the root cause is often that they’ve made perfectly sensible and logical decisions based on the information they get from their cost accounting system.
It’s just that the information in that system doesn’t reflect either the organisation’s true cost structure or its commercial realities.
Put away the broad brush
To give an example of the broad brush cost accounting approach, a company might work out a charge-out rate for their team of field engineers by adding up all their salaries and dividing that total cost by the number of engineers they employ.
One, but by no means the only, problem with this approach is that the company will lose money on every job they put their more experienced staff on do because the rate they pay their more senior engineers tends to be higher than the average rate used to work out the costing for clients.
Sometimes people argue that doesn’t matter provided that, on average, every engineer is kept as busy as every other engineer. And mathematically, there’s something in that argument.
Except the commercial reality is that your senior engineers will normally be allocated to the trickier jobs, the bigger jobs, the jobs for your more important clients where you wouldn’t be comfortable letting a trainee engineer loose by themselves.
Even if, on average, the costs come out about right (and even then I’d be sceptical) what you’re really doing here is dramatically under-pricing the more complex jobs you do for clients.
A job that ties up a team of senior engineers for several weeks should bring significantly more income into the business on an hourly basis than the same number of hours a junior engineer spends changing filters on less technically demanding jobs.
If it doesn’t, you’re leaving money on the table.
The “mechanically specific” trap
At the other end of the spectrum, a spreadsheet wrangler somewhere allocates every cost in the business, in minute detail, to every product and service, generally under the cover of “being commercial” or “being tough on costs”.
Carrying out that process to some level is worthwhile. But so is knowing where to stop.
And that’s probably long before you allocate 50p in stationery costs to each job because, on average, you do 100 jobs a year and spend £50 on stationery.
But with a barrage of Excel macros, management information systems, and…God help us…Power BI, you’d be amazed at the level of detail you can get to pretty quickly.
I mean, not that it’ll actually be useful in any way, but it’s impressive enough for people who like playing around on spreadsheets.
What too many organisations do is mistake information at that level of detail as a helpful input into management and commercial decisions. It rarely is.
Although it did give me some amusement in a management meeting several years ago when I worked with a business facing £multi-million losses and a likely emergency funding round.
In all seriousness, the single big cost-saving idea from one of the senior managers was to send all our post second class instead of first class.
He had gone to the trouble of working out that second class stamps were something like 30% cheaper than first class stamps. Impressive bit of detail there.
But he was so proud of his 30% saving – well above the 10% target the organisation was trying to reach – that I may have burst his bubble when I pointed out, as gently as possible, that since the organisation only spent £5k a year on postage, even if we didn’t send out a single letter, it still wasn’t going to make much of a dent in a £multi-million black hole.
This information was admittedly very specific. But also pretty useless in the context of the problem we were trying to solve.
If you’ve read this far, you may not be surprised to learn that one of the reasons this organisation was in trouble was precisely because they didn’t really understand their costs and how management decisions impacted the bottom line well enough to make the best decisions for the business.
As simple as do re mi
While it isn’t quite a simple as ABC, 123, or do re mi, the principles behind one of my two favourite cost accounting approaches are easy enough to grasp. (Sadly, space doesn’t permit covering the topic in more depth…well, sadly for me. You, dear reader, are probably eternally grateful.)
But here are the guiding principles.
1 – Split your costs the right way
Organisations generally think of costs in two categories – fixed costs and variable costs.
Now, in a pure accounting sense, there’s some truth in that way of looking at the world. However that’s not necessarily very helpful when it comes to commercial decision-making.
Instead, think about your cost as those costs which directly relate to creating something your business sells – whether that’s physical products or services – and all your other costs.
You will find that, as a generality, variable costs are more likely to be part of delivering a product or service, and fixed costs are more likely to end up in the “other costs” bucket. But that’s not a perfect split for a range of reasons, one of which we’ll come onto in a moment.
So, the rent on your factory is not a cost that directly relates to creating the physical products you sell. Even though it’s an important cost for your business, you’d still need to pay the rent even if you didn’t sell a single product.
On the other hand, the sheet steel which gets delivered to be bent, twisted, and machined into your finished product is very clearly a cost that relates to the products you sell.
If you had no orders from clients, you wouldn’t buy any sheet steel.
2 – Get clear on your cost drivers
When I was a CFO, I rarely came across a business which had the level of clarity on its cost drivers that it really needed to make good commercial decisions.
For our purposes here, you can think of a cost driver as “the reason why we’re spending this money”.
If you need sheet steel to manufacture your products, the reason you buy sheet steel is to satisfy customer orders (assuming, for simplicity’s sake, that there is no stockholding to factor in here).
So the driver for the sheet steel purchase was the order from your customer – no order, no steel required.
There is an argument that you only do this for the input costs to your products and services, but I find many traditional accounting systems have all sorts of costs which move around depending on a wide range of different cost drivers, so you’ll get valuable information about your business by doing this in as many places as possible.
If you do, you’ll also find a remarkable amount of cost hidden away in your overheads that fluctuate for all sorts of reasons, all of them unrelated to manufacturing your finished products or services. Until you understand what those costs are, and the activities that they relate to, you don’t really understand your cost base well enough.
Your marketing department will have a range of costs which are driven by their lead generation activity, for example, which will be entirely disconnected from receiving a customer order.
There may be some vague relationship between the two, in that lead gen activity today will turn into clients in 9 months from now, at some expected conversion rate or other. But that’s a weak relationship and if you sell multiple products and services, actually not that helpful (although you should, of course, measure all those things for other reasons).
It’s much better to be clear that the “trigger” for lead gen spend is the marketing department deciding to do some lead gen activity.
Given the likelihood is most leads will not turn into customers anyway, it’s better to accept and understand that purchases of sheet steel are driven by customer orders and lead generation activity in your marketing department is not.
Each of those spends have different cost drivers, each of which needs tracking and managing in different ways.
3 – The “other stuff”
Once you’ve done that, you’ll find a couple of interesting things.
Firstly, if my experience is anything to go by, you’ll discover that when you assemble your products and services based on the individual cost drivers that go into them, you’ll have an entirely different way of looking at your product or service costs than you ever had before.
You’ll discover some wild things – it’s not uncommon to find that the product everyone thought was the most profitable is in fact the least profitable, and some unloved and largely ignored product is in fact a potential superstar hiding in the shadows.
Usually, you’ll also find that there’s an astonishing amount of cost in your business with no obvious cost driver at all. When you find them, ask some really pointed questions about why those activities is being carried out at all, because odds are you can stop doing whatever it is and not notice the difference…except to your cash flow and bottom line.
More importantly, you’ll discover where the inefficiencies in your business are.
Maybe a big chunk of activity, and therefore cost, in your HR Department is driven by the need to performance-manage out poor performers in your organisation.
While by the law of averages you’ll hire someone you wish you hadn’t every once in a while, if this is happening on a regular enough basis to account for a big chunk of cost in your HR Department, odds are your business is doing a poor job on the recruitment front.
Or perhaps the business isn’t paying well enough to attract people with the skills you want so the recruitment team is settling for people who can’t really do the job in the first place just to fill a recruitment quota.
Maybe the business is failing to take action soon enough in the early days of employment, or provide enough training, so that stores up much bigger problems down the line, requiring HR to get involved.
Every time you find yourself saying something like “we spend how much managing out poor performers???” that’s a sure sign that there’s an inefficiency in your business which, if you fix it, will result in a more profitable, smoother-running business, with lower costs.
Back to ABC
In an admittedly very brief way, what you’ve read so far is a high-level summary of some of the benefits of a cost accounting technique called Activity Based Costing, or ABC.
Done the right way, ABC brings a level of insight into the commercial and operational side of your business that’s vastly more insightful than standard management accounting techniques.
The way I do it, I mix it with a little bit of another costing technique, which I’ll talk about some other time. So I don’t use “out of the box” ABC exactly.
But if you’ve never tried this approach before, you’ll discover a lot about your business by just doing an “out of the box” ABC review.
A pretty good place to start is Robert Kaplan (the “balanced scorecard” guy) and Steven Anderson’s book “Time-Driven Activity-Based Costing”.
There are some who say Activity-Based Costing is a complex and expensive technique which doesn’t offer a high enough RoI. But, with the greatest of respect, I’d have to say that whoever came to that conclusion hadn’t seen a good ABC project up close.
Admittedly, I’ve done this loads of times, but give me a couple of hours with a set of accounts and a few people in the business to talk to and I can have an 80/20 model up and running pretty rapidly and inexpensively.
Yes, you can make activity-based costing long-winded, costly, and ultimately pointless. But the same is true of every management technique that’s ever been invented, if it’s done badly enough.
It might not be your thing, and you may, in time, develop your own favourite cost accounting technique – nothing would delight me more. But until then, I’d encourage you to give ABC a try.
I’ve never yet applied it in an organisation and not found at least one game-changing nugget of information or one life-altering perspective emerging from it.
You might be surprised what you find too.