If what matter is the flow of what comes in the back, what is added to it, and what goes out, we should measure those things. We should move from Management, Cost or Financial Accounting, to Simplified Operational Accounting: real time thermometers of how the relationships within the system are functioning, right now!
First, we need to move all support functions into expense and not cost of goods, (inputs) then all in process and finished goods inventory, where this applies: inventory is support, what is important is the flow of value throught the money making machine. I cover this in more detail in the materials linked to below.
Then we need to measure flow, what some call throughput, and others dollar contribution. Subtract cost of inputs from sales, and anything else that truly varies with sales, what is left over is what you pay your bills with an make profit from. Everything else is support as it supports making money, it does not contribute to the flow. Measuring the flow through, or throughput, will help you optimize the effectiveness of your whole system, it gives useful feedback.
Though this is not enough alone to remain in business, as this applies only to your closed system of production. You also need to be looking to the horizon. Looking in the rear view mirror is important, but fixating on it, the way cost accounting does, means you are only looking at those behind you until they pass you and you miss the potholes in front of you.
The second important operational report besides a thermometer for optimizing flow, is to know if your processes are under control. If not, they are chaotic and unpredictable. How can you manage the unpredictable? You can't!
How do you know if things are in control, use control charts!
Inventory is Evil, but Sometimes Necessary!
Another problem with cost accounting is that it treats inventory as an asset. Inventory is a liability, not an asset. While skype®ing with Louis Schultz the other day, he said: “Inventory is evil.” I couldn’t agree more, inventory is evil! But, can it sometimes be a necessary evil?
Any amount of inventory more than what you need to keep production flowing to meet demand, freezes money. Money frozen is money you can’t use, is money you don’t have; money that is losing value; money that could be making you more money.
Cost accounting leads companies and banks to think it a good idea to arrange financing based on inventory, for instance. What security is there in frozen money, evaporating value every minute.
With cost accounting there is no simple way to add up the losses because it treats the losses as if they don’t exist; it’s an asset, remember? How many dollars are tied up in inventory in products that don’t sell? How many hours of work that went into processing them? How many “specials” will need to be done to try and move product people don’t want? How many products will break, lose flavor or rust, or disappear over time? How many potential customers lost because they associate your company with the less than optimal product they bought on deep “inventory reduction” discount. How many customers come back asking for the same discounts on the rest of your products, erodig your margins? How much of your time cost is spent working to make products that lose money by sitting in inventory? How many resources wasted maintaning and counting it.
Hiding losses is not a way to survive, but a way to lose your business. The more efficient and timely conversion of raw materials to sales, the less time your money is tied up, the more turns your dollars can make and the more profit. I call this the repeater effect.
What is needed is an accounting system that provides useable information for those who create, build and deliver the product or service you sell, the only thing that generates revenue, not one for the people that sit in the accounting and executive offices.