When I was getting my PhD in engineering, my previous experiences and studies suggested that it would be important for me to be able to explain any ideas I created from an engineering perspective to financial types, and to do so in their language. This led to my initial studies in accounting.
As I learned accounting techniques, many things did not make sense to me. Why do costs go down as I create more output? Why isn’t there just one cost that represents the creation of a product or the execution of a process or service? I began by looking at things—profit, costs, cash flow—from an engineering perspective. Borrowing ideas from thermodynamics, fluid mechanics, and system dynamics, I created a model that I thought should represent costs, profit, and accounting data. I thought the model was quite sound, but accounting predicted quite different results.
The big difference was how costs were handled. The model I created was based on the assumption that costs represent cash flow—money leaving a company as expressed simply in Exhibit 11.1. I found this was not true, so I sought to correct this for my own analysis purposes.
Exhibit 11.1 This model represents the simple flow of cash. Anything that comes in is cash revenue, RevenueC, and what leaves is costC. The difference is the cash profit
With the model I developed, costs were defined as money leaving the company. According to this definition, money leaves the company because I paid for something, and only when I pay for something. If this is the case, money leaves only when there is a financial transaction involving a cash payment. There are three types of transactions:
1. Buying capacity
2. One-off scenarios
3. Obligations
Capacity represents the largest expenditure for almost all businesses. I define capacity as what you buy in anticipation of demand or use. This includes space, labor, materials, most information technology, and equipment. When you step back to think about it, this financial number is significant. It is also the cost that costing approaches seek to allocate or assign. Think about this for a minute. Accounting significantly skews the understanding and management of your largest expenditure.
One-offs represent activities when one buys goods or services once. The one-off represents a clearly identifiable transfer of goods or services for cash. An easy way to compare the differences between capacity and one-offs would be to consider a situation where you have a grounds crew to take care of landscaping versus hiring someone from the outside. You buy landscaping equipment, storage space, and landscaping employees in anticipation of using them. Regardless of whether you use what you buy or not, you pay to have them. This is capacity. A one-off would be having a company come in, and you pay them to perform landscaping services. Similarly, capacity would be your ability to make local phone calls. One-off would be an individual long-distance call.
Obligations are simply transactions that involve an exchange of cash, but not for a good or service—something you are obligated to pay. An example would be paying taxes. You’re obligated, by law, to pay taxes based on earnings.
The purpose of the three descriptions is to help you understand that transactions buy different things for different purposes. Consider the phone calls example. Local service would be like buying capacity. You pay to have it to use. Long-distance calls are one-offs, each being determined by the attributes of a specific call. You are obligated to pay the large taxes on your bill based on your use.
With one-offs, since there is a clear relationship between costC and what was purchased, there is rarely ambiguity. With capacity, however, there is ambiguity when calculating costNC because of the arbitrary relationships required. Because capacity is the largest expenditure and because you cannot create a direct cost relationship that isn’t arbitrary between the capacity you buy and what you create from it, I will focus the rest of the book on helping you understand capacity, how to assess its use, and how to manage it.