# Keep it Simple

We have created an entire generation (or two) of managers who are very savvy with cost accounting models. They know exactly how “costs” and “profits” are calculated, and they know exactly what inputs to manipulate in order to make the numbers as good as possible.

They know, for example, how “inventory turns” are calculated, that “average inventory” is determined by end-of-quarter snapshots, and how to turn off production and pull in next quarter’s sales to starve the system for a week. Of course, anybody can also claim reduced oxygen consumption by holding his breath when it is being checked.

I put the terms “costs” and “profits” in quotes because one of the features characteristics problems(?) with modern cost accounting is that the models are complex. They are that way, not because costs are complex, they aren’t. They are that way because reporting is complex. They are that way because managers want to be secure in a fantasy that they can have a unit cost for every unit of production. “This product cost \$4.72 to produce.” And once they have that number, they can calculate margins, forecast profits.

Here is the rub: That \$4.72 cost figure is the result of a process that answers “What is 1+1?” with the statement: “It depends on your assumptions.” And by the time the PowerPoint Rangers are done with the summary, those assumptions are long buried and forgotten.

That unit cost figure is valid only for a certain level of production, because it includes allocation of costs that do not change as production levels change. Other costs that do change, change in non-linear ways.

There are lots of way to allocate fixed costs. Depending on which one you use (especially in multi-product operations), can completely alter the profit / loss numbers for a particular product.

So, while all of this cost accounting stuff is necessary to report taxes, and to report to the shareholders analysts, we forget that it is just a model. Aside from the top line (total sales) and the bottom line (the actual money we can keep), everything else is just someone’s representation of where the money actually went.

Here is my admittedly simplistic take.

A manufacturing company makes profit by adding value at a higher rate than they incur costs.
The value they add is the difference between what they pay for the parts and raw materials that are transformed into the final product, and the actual, real, cash-across-the-table revenue they get for the product when it is actually sold to a real customer who does not work for the same company. (This has nothing to do with internal transfer pricing, etc. because that is all just shuffling things from one column to another for the benefit of the cost accounting model. Until you actually cash the customer’s check, you have not sold the product.)

Since the idea of “unit cost” is really an artifact of whatever particular cost allocation you choose to use, then the idea of “unit margin” is equally dubious.

When I ask the finance folks to tell me how many units I need to sell to break even, they start by calculating a margin, then dividing the cost of operation by that margin, and presto!, break even.

Bzzzzt. The rub is that the margin per unit is only an estimate until the period is over, total costs are added up, and total margin is allocated across production. To use estimated margin to determine a break-even sales level is a circular reference.

But I can calculate how much value is added to each unit. [What can sell it for] – [What I pay for the pieces].

My break even is even simpler. Assuming that 100% of the value-add is allocated against the cost of running the factory (Total monthly payroll, total utilities, total everything except what I paid for what I will sell), until 100% of those costs are covered. With luck and good management, that happens before the end of the period. The total value add of the next unit is profit. And the total value add of every other unit after that is profit. This holds true whether you do it for a hour, a day, a week, a month, a year.

Now I can take projected sales, and determine, at any given rate of production (which drives a lot of the fixed costs), when I break even, and how much profit I can expect. Isn’t that what we are after anyway?

Why does everyone make it so complicated?

And yes, I know it is more complicated than this, but it isn’t THAT much more complicated.

## 2 Replies to “Keep it Simple”

1. Karthik Chandramouli says:

The logic of “contribution margin” (i.e., profit after variable cost) is that we can understand what is the relative value to produce or sell one more unit of product A vs. product B.

So, while I like your approach to explain the concept of a breakeven point (which, I agree, is poorly understood even by many Finance practitioners), the more useful analysis is to understand the contribution margin of various products or product families.

2. Actually my key point is that calculating the contribution margin of one product over another is fraught with difficulty.

When allocated fixed costs are very high; when costs which are actually fixed are calculated as “variable;” then the margin calculation becomes highly sensitive to the allocation scheme used.

It becomes even more complicated when sales of one product are partially related with sales of the other in some way.

While it would be nice if everything were as cut and dried as the accounting textbooks make it out to be, there are actually very few absolutes beyond “How much more money did we take in than we spent?”

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