Profit has Little to do with Making Money
Everyone talks about profit, and we assume that profit and making money are synonymous. The question is: Are they? Making money represents the amount of money you generate. It is cash and timing based. How much money you make is determined by the net cash you bring in over a given time period. Determining how much cash you generated should be tied directly to when you spend and receive cash. You cannot talk about how much money you made this year by considering what you’re going to spend next year and what you received last year. This notion is critically important. If you want to know how much money you have or expect to have you must consider the cash that comes in and leaves during the time period considered. It doesn’t make sense to think about managing cash flow when the timing of cash transactions is eliminated from consideration. Remember this line.
We generally calculate profit using the profit equation. This general equation is well-known to all in business and in many other aspects of life. That equation is
The assumption, again, is that profit is synonymous with making money. For profit to represent making money, though, the timing and cash flows have to be in alignment. They aren’t. There are six reasons why:
1. Revenue recognition
2. The practice of costing
3. The definition of costs
4. Believing efficiency and waste reduction lowers costs
5. Misunderstanding inventory value
6. Depreciation
Each of these will be mentioned briefly here. However, because of the depth of the issue involved, each topic has earned its own chapter.
The first idea that challenges whether profit can represent making money is revenue recognition. The rules of financial accounting allow flexibility for when you can recognize money from sales transactions.1 Assume, for instance, that we are looking at the current calendar year to report your financials. You may sell something today, but not receive payment for it until next year. If you recognize the revenue this year and use this information to calculate profit for this year, but you haven’t received the money, there is a disconnect between revenue reported and cash you’ve made.
Costing supposes products, services, and work activities have financial values associated with their creation or execution. The assumption is that this financial value has ties to money spent, therefore affecting cash. If costs go up or down, that change will directly affect cash and profit. Interestingly, different approaches can look at the same expenses and use of resources, and calculate different costs. The idea you can calculate different costs from the same data and information should suggest that costs do not represent cash. If they did, there would be one cost because you spent your money and transacted business one way.
I used to ask myself, “What is a cost?” Costs can be money spent on an item you buy. In this case, there is a financial transaction. A cost can also be a financial representation of the consumption of capacity. For instance, when you calculate the cost of a meeting or to process an invoice, you are assigning a dollar value to the use of something you’ve already bought or agreed to buy, such as an employee’s time. There is no financial transaction involved with the meeting or the invoice; hence, no exchange of cash, but many consider this cost to be the equivalent of a cash transaction. The notion that there is no cash transaction associated with certain types of costs suggests there can be a disconnect between costs and cash.2
We are taught, and therefore assume, that increasing efficiency reduces costs. This is often the basis for many types of activities related to process and product cost reductions. It is assumed that by increasing our efficiency, our costs will go down. Common examples are lean, Six Sigma, and waste reduction activities, where the objective is to lower costs by becoming more efficient. The question is: Does efficiency affect cash? The answer is: Not directly. It can enable changes in cash. More on this later. For now, consider your own salary. If someone makes you 10 percent more efficient, will you be paid less? The answer is: No. But you now have more time to do other things. If you use space more efficiently, will your lease costs decrease? No, but you have more space to use for other things. When companies talk about increasing efficiency with lean and Six Sigma projects, they will quote huge savings in costs. These costs, more often than not, will not be realized in cash, directly, and in many cases will not even make it to the financial statements as a cost savings.3 This creates a disconnect between proposed cost savings from efficiency improvements and how these savings translate into cash flow savings.
Companies spend money when building inventory. For example, they have labor they are paying for, materials that they bought to use, and they have the space they paid for to build the inventory. However, it is a very real possibility that the money spent building the inventory today will not be included in the cost calculations for profit today and will not be included until a subsequent accounting period.4 In other words, it is possible you can spend money today and it will not go into your profit calculations until years later. This creates a potential disconnect between when you spend cash and when it is used to calculate profit.
When you buy something that is depreciated, the rate of depreciation has nothing to do with the amount and timing of your cash payments. This creates yet another disconnect between profit and making money.
In the end, profit, from a reporting perspective, is a calculated value, created with many assumptions that abide by guidelines created by governing bodies. Those rules and guidelines create a scenario where accounting cannot represent cash flow.5 Remember the statement regarding timing that I asked you to remember in Chapter 2? Here is where that statement comes into play. Making money has only to do with whether you are bringing in more money than you are making in a given period. If your objective is generating cash, profit is the wrong proxy to use to help you understand whether you are making money or not. Let’s understand these more.
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1Generally Accepted Accounting Principles, or GAAP, allows income statements to be prepared on an accrual bases. The accrual process provides guidelines regarding the timing of recognizing revenues and the reporting of expenses, irrespective of when the cash transaction takes place.
2Complicating this further is the notion of unexpired and expired costs. Let’s say you buy something. Whatever part of it you realize benefit from, it is now an expired cost. If you have not realized benefit from it, the cost is considered unexpired. So the cost is determined not when you spent the money but when you received value from it.
3Reginald Tomas Lee, “How we Overstate ROI on Improvement Projects,” Cost Management, November/December, 2015.
4Another example of accruals.
5This is especially true when using accrual accounting.