As a manager you need to determine the appropriate metrics to use in gauging the performance of your business. The question is how do you pick the right variables? Are you using the right one(s)?
The question often isn’t even debated because contemporary management accounting principles have remained fundamentally unchanged since the 1920s. No one seems to question them.
We know accounting in various forms has existed for the better part of three millennia. Examples, going back to the Chaldaean-Babylonian Empire show some of the most basic business code. Basic accounting tables records, going back as far as 2600 B.C. were captured in clay or stone tablet.
Early accounting was straight-forward. Your business (quite often You = The Biz) was simple. You bought input materials (e.g. a cow), added value to them (e.g. butchering), then sold them to someone (e.g. steak!). How successful you were was as simple as the difference between what you sold the product for and what you paid for the original materials.
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Starting in the late 1800s businesses began to grow dramatically. They remained focused on a single product offering, added ‘employee’s, started tracking costs, and developing “cost/unit” type measures. This allowed initial efforts to improve a company’s efficiency.
Moving into the early 20th century, much larger corporations started to develop. Think of companies like Ford, General Motors, Du Pont, and the railroads. These companies now started to face three core issues: decentralization due to sheer size; multiple products (or sub-businesses); and, hierarchical management. In response, they developed new methods of accounting to enable their leaders to effectively ‘manage’ their businesses. Management Accounting was born. (Relevance Lost: The Rise and Fall of Management Accounting by H. Thomas Johnson, Robert S. Kaplan, ISBN: 0875841384)
For the most part, management accounting remains anchored in its century-old origins. Even as businesses and their products have evolved, the fundamental basics of accounting have not. Thomas J. and Robert K. suggest a reason. When management accounting was developed, it was done so to enable leaders of the time to more capably manage their organizations: decide how to allocate resources; motivate and evaluate managers; and, evaluate success. Then came managers who led ‘by the books,’ (think Bean Counters), and over time the core understanding of what management accounting was intended to do, was lost.
Today, management accounting has a second focus, or a competing one at the least. For publicly traded companies in particular, the drive is to provide documentation so outsiders can evaluate the company’s performance. This in turn leads managers having tunnel-vision, driving their actions to meet annual, quarterly, and even monthly targets. (Let’s discount the significant productivity loss in reporting processes, validating, and defense thereof.)
The question becomes, ‘…did we make the quarterly numbers?’
It should be, ‘…have we made the company more successful?’
Quite often, the core over-arching metric used to determine ‘success’ is Revenue. Did the company ‘sell’ more this period than last? Yes, or No? Revenue, on its own, is an important metric, yet useless if used in isolation.
On the surface, growing revenue suggests greater success. Unfortunately the related increase in cost associated with the additional revenue is often discounted, misrepresented, or misunderstood. You also need to understand if it is Gross Revenue or Net Revenue (e.g. is there a lot of returned product offset against the gross?). For managers with even moderate P&L (profit & loss) experience, this is of course overly simplistic.
Look at a contemporary software business. Products take multiple accounting reporting periods to deliver. The resources (e.g. development staff) may also be shared across multiple products. The result is expenses spread over periods (accrued) and offset against future revenue.
In practice, it becomes more difficult to specifically identify costs belonging to specific products. Instead, some costs are simply ‘assigned.’ Let’s say your product is a SaaS (web-based software) offering heavily dependent on internet connectivity. The company may elect to simply assign all telecom costs to your product since it uses the lion’s share of network bandwidth. We begin to see how an understanding of ‘costs’ become fuzzy. This is hardly a one-off example within a company.
If clarity of cost becomes fuzzy, what does that say about using revenue as a measure of success?
Talking with Ian Sacks (Profit Makers) recently, he pointed out that revenue is the end outcome of collective efforts up to that point. As a result, “…revenue is an effect, not a cause!” This means that, if you are no longer seeing costs clearly, your input, then revenue’s value also becomes less clear, less useful.
In addition, we live in a time of financial accounting—designed for outsiders—taking a dominant role; with management value playing second fiddle. As a manager, if you haven’t already, you need to step back, look at the activity you’re responsible for, and ask yourself: Are the metrics we’re currently relying on really the best ones for driving our success? How am I, really, determining Success?
(photo credit: Cornell University Library)