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In Evaluating Cost Reducitons, Look at Total Cash Flow Costs Rather Than Accounting Costs

By Donald Mitchell

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Published: 26Jul2008
Word count: 414
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Business people know that their job is to earn a profit above the cost of the capital they use. To do that, you often have the choice of spending an imaginary dollar to save a real one and vice versa. Which should you choose?

I favor reality over the imaginary, as most people do. Cash is the reality, and the accounting is the imaginary.

Accounting is a homogenized, convenient way to learn how a company did in overall profitability. The more detail in which you examine accounting-based costs, however, the more likely you are to draw the wrong conclusions.

For instance, accounting "standard costs" of providing an offering will not match what your actual costs are. If you improve the throughput of your system, for example, you will often see your average accounting costs per unit rise as more standard costs are incurred while actual cash costs per unit fall. For an excellent discussion of this phenomenon, see The Goal by Eliyahu Goldratt.

Another problem is that if you want to move from out-of-date equipment to more effective ones you often have to take an accounting charge. Actually, you have already incurred the cost of this charge when you bought the equipment.

You are just now being required to take all of the expense because you don't plan to use the equipment any more in the future. That's probably part of the reason why GM was slow to replace its painting processes.

Business thinkers now find that Activity-Based Costing is an improved way to comprehend the cash costs that you incur if you operate in one way versus another. Performing this analysis can be very helpful to you in understanding the potential of different business models.

It's important to look at the cash flow consequences across the whole enterprise, not just in one small activity area. Otherwise, a savings in one area may just balloon total costs.

There are still those pressures to deliver more "accounting" profits. How might that be done? Conservative managements have learned to hold a lot of extra assets that can be sold at a profit anytime some more near-term earnings are needed. That keeps those who like accounting results happy . . . and the tax man. You end up paying taxes sooner than you would otherwise.

But if you run a private company, forget about accounting earnings and improve cash flow: That's the true bottom line.

Copyright 2008 Donald W. Mitchell, All Rights Reserved

Donald Mitchell is chairman of Mitchell and Company, a strategy and financial consulting firm in Weston, MA. He is coauthor of seven books including Adventures of an Optimist, The 2,000 Percent Solution, and The Ultimate Competitive Advantage. You can find free tips for accomplishing 20 times more by registering at: www.fastforward400.com

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