This website covers knowledge management, personal effectiveness, theory of constraints, amongst other topics. Opinions expressed here are strictly those of the owner, Jack Vinson, and those of the commenters.

Cost allocations are not for decision-making

cash moneyJP Rangaswami has an article about a concern he has with cost allocation in regards cloud computer. Allocation is an accounting convention. Unfortunately, most people make a lot of decisions based on allocated costs, rather than actual costs. Here's an intro to what JP discusses in Musing about the cloud and enterprise cost allocation

… for most of my life, I’ve been astounded by the incredible difficulty I’ve had in getting two questions answered: What do I spend? How many people do I have? Over the years, as my career developed in its own serendipitous way, I found myself in charge of larger and larger departments with bigger and bigger budgets. And answering these two questions became harder and harder.

The reason for this confusion is the topic of the rest of his article: cost allocations. He gives some great examples of oddities that come about as a result. I've seen similar things: it's "cheaper" to make a product in one location vs. another when both locations have the capacity. Or it's cheaper to buy an intermediate product instead of acquiring the same product from an division of the company. The list goes on.

The challenge for people is what they should use to help make some of these decisions. I'll point to Throughput Accounting - and I've seen some discussions about Lean Accounting as well. The general idea is to focus on material changes associated with the decision you are going to make. How much one-time outlay will the idea require? Or how much will you get by selling / stopping an activity? In other words, what is the investment changes? How much will the regular expenditures change? Will you actually lay off people? Will you hire people? Do you need more/less physical space to accommodate them (and thus have to pay rent)? In other words, what is the change in operating expense? And, finally, how much more will you make by the resulting change in sales? The Theory of Constraints community calls this Throughput: Sales less the direct cost of making what you sell (i.e. the cost of raw materials).

JP follows the item I quoted above with this statement, which I like as a closer to my thoughts here. I've heard it in other contexts as well - follow the cash.

Perhaps I should have known better. When I was in my teens, my father used to say that the only “truth” on a balance sheet was the cash position; everything else was a “conventional” representation of information. If you didn’t understand the conventions being followed, you had no ability to understand the information presented.

[Photo: "cash money" by ciaoamore]

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