“Cost Accounting is enemy number one of productivity.” – Eliyahu Goldratt
“First I kept the cost accountants out of my plants, but I found this was not the solution…It wasn’t the cost accountants that were the problem, but all these ideas about the efficiency of an operation.” –Taiichi Ono
The relationship between Accounting and Operations historically has suffered continual strain. There has been much discussion in industry and academia on the relevance of accounting information to operational decisions. There have also been a number of “improvements” proposed, e.g. ABC accounting, throughput accounting and lean accounting. We propose a truce and an approach that will provide mutually aligned efforts using current GAAP methods for accounting. The key is in understanding each function’s model of choice and how they both relate to the goal of the business—achieving highest possible cash flow and profitability over the long term subject to the values a company embraces.
A primary function of accounting is to reconcile revenues with expenses. The Accounting Department does this because it is legally required to provide financial statements that:
These are all highly utilitarian tasks and the employment of accounting principles underpins much of the success that modern civilization has had through the advance of industry. Certainly there have been abuses but to quote Alexander Hamilton, “If the abuses of a beneficial thing are to determine its condemnation, there is scarcely a source of public prosperity which will not be speedily closed.1” Resolving the conflicts between accounting goals and operational goals will lead to much improved productivity in both areas.
A central conflict between the two functions stems from the standard costing model accounting uses for allocating revenues to expenses. The standard costing model is stated as:
Unit Cost = Variable Cost + Fixed Cost/x
where “x” is the number of units associated with the fixed cost. The unit cost is used to determine total expected cost based on volume of units produced and then managers are measured to their variances from expected cost. The unit costs are also used in financial statements for all the purposes listed above. The conflict occurs because the standard cost model implies that producing more units will ultimately lead to lower unit costs and thereby improve profitability and cash flow. In addition, this model and common intuition promote the idea that employing capacity at highest possible utilization levels, preferably 100%, will result in the best possible financial performance for a company. While the standard costing model is fine for allocating revenues to expenses, it is not a good operations performance model. Therein lies the opportunity for a truce in the “war” between Accounting and Operations and a productive path forward.
A fundamental problem with the standard costing model is it does not take variability into account. The operations science of Factory Physics® concepts describes the fundamental relationships between inventory, response time, capacity and variability. For more detail see Chapter 3 in Factory Physics for Managers. For a quick blog post explanation, click here. A fundamental relationship between utilization and time is described by Kingman’s equation, also known as the VUT (Variability, Utilization, Time) equation. Unfortunately this relationship is not widely understood in Operations, much less in Accounting. At a recent industry conference, participants were handed a blank sheet of paper and asked to draw the relationship between cycle time (the time a job takes to be completed from the first step of a routing to the last, for instance, fabrication-assembly-test-packaging). The results were documented on a flip chart and are shown in the following picture:
The red line highlights the correct relationship but this same type of confusion has been demonstrated by thousands of participants tested on fundamental operations science relationships during Factory Physics workshops and training sessions. This would be like a physicist not knowing the implications of E = mc2 or a home owner not understanding the relationship between the mortgage interest rate and their mortgage payment.
The following graph provides both the VUT equation and a graphical interpretation of the interaction of variability, capacity utilization and cycle time in the real world.
Note that cycle time blows up sooner with more variability. The gold star represents perfect performance: 100% utilization at nominal process time (t0). One of the laws of operations science is that work will not be released to a production or service process at 100% utilization over the long term. Because of variability, releasing work at 100% utilization eventually results in such poor performance, increased cycle times and inventory, that something will be done to work at less than 100% utilization to get performance back to acceptable levels. So the appropriate level of utilization depends on the amount of variability in a process and the desired response time. A job shop typically has a tremendous amount of variability and a planned utilization of 70% would make sense to provide acceptable response times. For a commodity operation, a higher level of utilization would be targeted—maybe 85%. This is where the opportunity for a truce occurs.
It is Operations’ responsibility to demonstrate this relationship to Accounting and help determine the most profitable level of resource utilization for a company. If this relationship is not understood, what typically happens is that those controlling the purse strings (Accounting) determine the performance expectations and targets. Since Accounting’s model of performance is the standard cost model, this often leads to 100% utilization targets, chaotic and less profitable performance.
In summary, the standard costing model is a good, though not perfect, model for allocating revenues to expenses—ABC accounting is just a more detailed approach to standard costing. Throughput and lean accounting show some promise but waiting till GAAP are amended could be a long wait. The point is to stop fighting over the standard costing model. Companies should use accurate operations science models to get best possible throughput and response time with minimal investment in capital (machines, people and inventory). Once that is accomplished, Accounting can happily allocate revenues to expenses however best suits financial reporting requirements. In the end, Accounting and Operations should pull together for best possible performance. – ESP
1The Papers of Alexander Hamilton, vol. 14, p. 314, “Report on the State of the Treasury at the Commencement of Each Quarter During the Years 1791 and 1792,” February 19, 1793.