Money Cost Is Not Enough
Especially in extractive industries
The consumption of value is a bigger idea than money cost. Many products have an impact on society that are not accounted for in money accounting transactions … and mostly these impacts are important.
In many situations it is possible to use money cost as a proxy for value consumption. This works acceptably well in small business, but does not work at all well in large scale integrated businesses and large complex businesses that trade across country borders and with many different products and services. Very large corporate organizations are now the dominant form of organization … and many are larger than many national economies!
Oil industry … incomplete records!
The oil industry is doing money accounting and reporting substantial profits which it shares with its stockholders. But value accounting shows that the true economic impact of oil extraction is very different because value accounting takes into account the fact of the depletion of the oil stocks in nature. Responsible full value accounting would call for some sort of very large provision to be made for this depletion so that society would not be “energy bankrupt” in the future.
What is this? In the case of the oil industry, the costs of crude oil production include payments made for royalties, licenses, etc, as well as the costs of exploration, drilling and extracting the oil from the oilfield, and shipping the product to refineries and to market ... but the costs do not take into account in any financial metric the depletion of the resource, and what it would take to replace this resource. This is a huge problem, because the resource being depleted has taken many millions of years to accumulate, and the replacement cost of this is completely missing from the accounting!
Whenever there is economic activity there is consumption of resources that translates into some value creation … which may be more than the consumption of value to create value adding or less in which case there is value destruction.
The consumption of value is a bigger idea than money cost. Many economic activities have impact than are not represented by any money transaction … but are nevertheless very important. In the following example from the oil industry the calculation of cost is only about the money costs, and totally ignores the value associated with the consumption of the natural resource:
Simple Question: What is the Cost?
Some is desire for secrecy … some is just “don't know”
Surprisingly, the answer to this question is rarely known. People who do not know these facts are not managers … they are not managing.
For some reasons experts in community development … and in all sorts of social sector disciplines have little understanding of how much things should cost ... how much things did cost … and the behavior of costs. This is a critical indictment of the experts and the whole of the international relief and development assistance (RDA) community … as well as a lot of government procurement work.
But this is also true in large parts of the private and enterprise sector as well. This is difficult to explain politely, but it seems to be a result of poor understanding on the part of educators and an increasing domination of accountancy and metrics by a legal and mathematical focus rather than a technical and engineering focus.
The cost question ought to be easy to answer!
When cost is known, then a lot is known about performance. In modern society there is surprisingly little information about cost … much more about price.
I have done corporate cost accounting in many settings, and have become sensitive to the need for cost accounting to be relevant to the management issues at hand. In the 1970s Rolls Royce had very precise cost accounting … but the RB211 jet engine development went over cost estimates by hundreds of millions of dollars. Meanwhile, Pratt and Whitney had quite sloppy cost accounting, but knew much more accurately the executive information they needed to know.
Society does not need to have precise cost information, but there should be a good understanding of the underlying costs of everything.
How much did it cost … the money cost?
Knowing how much something costs is pretty basic. Understanding cost and cost behavior is central to the TVM system of metrics. It is appalling how little data about cost is reported, and how little information about cost is understood and appreciated by people with responsible jobs. Because there is so little understand of cost ... cost gets used to justify bad practice of all sorts.
Cost is very basic ... but even though it is a fundamental building block of analytical understanding, it is very rare that the data are presented clearly ... if at all.
Cost accounting is very well established inside corporate operations ... but little of this emerges into the public space. The level of public ignorance about costs ... and the behavior of costs is terrible low. Cost accounting is not particularly difficult ... it is not rocket science! It is facilitated when there are trained staff and there is accounting and MIS system that incorporates costing.
Cost accounting is painfully tedious and difficult when the record keeping is poorly designed and critical data not available. This is a reflection of management competence and priorities. As in many things, more and more does not mean better and better. It is very easy for cost accounting to produce massive amounts of data, and almost no usable information ... on the other hand, cost accounting data can save millions of dollars and produce success rather than failure.
I did a cost analysis of costs on a large pulp and paper mill construction project. About three days work and I was able to show that the contractors were spending twice what the budget allowed ... they had spent 2% of the money and done just 1% of the work. The owner's representative took this up with the contractor ... the critical feedback process ... and a crew of 1,400 workers was reduced to 700 starting next day! This was a cost plus contract ... saving to the owner probably around $150 million in 1966 dollars!
There are two main ways to get at cost. One is to add up the detail, and the other is to drill down from the total. The best ... that is the most reliable ... cost data are obtained when both techniques are used and a similar result is obtained. Another important approach is simply to know the business and to keep eyes and ears open ... it is amazing how much useful information is circulating that helps to determine how much things cost.
More analysis may be relatively easy and useful. What else is known? What are the wage rates of the people working for the organization. A single expatriate is expensive and not cost effective unless he/she is doing important valuable work.
What cost? … How much was done?
This is absolutely basic performance information. Every organization … every economic activity should have these key numbers every day, everywhere for everything. Most well managed corporate business organizations keep the money cost accounting for their activities along these lines and are able to manage their resources for profit maximization very well. But this is not true for most government programs, most not for profit organizations, and indeed for banks and financial sector institutions.
If the decision makers know what something cost, they are also likely to know what it should have cost. This is cost efficiency and important in the management and oversight of an activity.
The institutions of the official relief and development assistance (ORDA) community … World Bank, UN, NGOs, Bilateral government donors and philanthropies … have little or no institutional records of how much things have cost, nor what they should have cost. This is one of the important factors that has made possible the huge corruption and mismanagement of resources that has been seen over years and years.
Money costing is done using data from a money accounting system. The costs are the “expenditures” associated with any specific product or service … with the analysis done usually as an integrated part of the accounting system. All the elements of cost should be included in the cost.
Unit cost is the total cost divided by the number of units.
Without costing … anything goes!
Without costing … anything goes! This is a critical matter, because optimized performance requires that decisions are made with a good understanding of how much things cost … and how much things should have cost.
Knowledge is part of “internal control”. Cost is part of a meaningful system of internal control and where it is missing it is difficult, if not impossible to manage.
When people who are responsible for something do not know what things should cost, and what they do cost, there is a huge problem. These people are being paid, and paid well, but they are not managing! This may be legal, but it is wrong and it opens the door to criminal gain for themselves or for others involved with the activity.
Criminal intent
The World Bank has very comprehensive procedures for the oversight of procurement, its tendering process and the vetting of contracts … but, I would argue, it does not work … and has not worked for the best part of 70 years. It is essentially a legalistic process that is very cumbersome and fails to ask the very simple question at the start and at the end … at the start, are the contractors offering value for money, and at the end, did they offer value for money. If there is value for money … there is no room for corruption. Nobody will ever have the answers to these questions if people do not know what things “should” cost and what things “do” cost!
Government procurement at all levels is frequently compromised. Part of this is because the procurement process is wrong, and part of this is because people do not follow the rules and go about making benefit for themselves.
MTA procurement in New York
What went wrong is not clear … but the escalators at the relatively new subway station at 63rd and Lexington Avenue on the F line are always breaking down. It is a deep station with five banks of escalators from the street to the subway platform level. Almost always one or two are not working … whether or not they are being repaired. I grumbled to one of the maintenance mechanics who laughed at the situation … with good reason. He pointed out that the elevators were the rated for easy duty applications, inside a store, for example … not for 24/7 use in a transport environment. These are OTIS escalators … made by a company that ought to know what it is doing … but bought using a public sector tendering process where the paperwork and legal form … not to mention bribery and kickbacks … are more important than value for money and good engineering. There is almost no way to hold the people involved to account … the contracting process has a form that is open, but the information needed to hold people to account is not easily accessible, if at all.!
The analysis of big projects is often more about political benefit than economic benefit … especially when there are public funds involved.
Port Authority of New York and New Jersey
The Port Authority of New York and New Jersey jointly operate some services associated with transport and crossing the Hudson River between New York and New Jersey … services used every day by many people. They do not seem to be very good at cost accounting … certainly not at the higher levels where big decisions get made. The performance of their infrastructure and services affects the commute of millions of people … and the costs have never (it would seem) been optimized.
The Port Authority Bus Terminal in Manhattan (New York) was rebuilt in recent years … but in spite of a dedicated bus lane, buses crawl for several miles to reach the terminal at a huge cost in bus operating cost and in passenger travel time. A much more cost effective approach would have been a new transfer station from bus to subway on the New Jersey side of the Hudson River.
The analysis of this is pretty clear using the TVM approach … less so using typical government and public sector accounting where the distinction between capital costs and operating costs becomes blurred. High speed high capacity subway service from the Meadowlands area in New Jersey to the existing subway network of New York City would have improved the transports connections measurably. What was done helped at the margin … but not for very long and not by very much.
Original analysis done in early 1980s for the DeCamp Bus Riders Association
Elements
Elements of both cost and value consumption
The following elements comprise the money or financial dimension of costs … together with the complementary value aspect. All the cost elements have a value dimension which is sometimes more significant than the money aspect.
- People cost … with a value dimension that is huge;
- Material cost … consumption of value;
- Land, facilities and equipment cost
- Operating overhead cost
- Admin and general overhead cost
- Financial costs
In the TBM/TVM system there in addition these value elements of cost that do not figure in the money costing system:
- Profit as a cost
- Off balance sheet elements
- Cost of external constraints
Data about elements of cost are important because the elements change in different ways ... have different behaviors ... and create different impact on the community because of their associated value chain.
The purpose of data in the TVM environment is to have data to understand ... and to use this understanding to improve decision making and the quality of life!
People cost (1)
People cost depends on (1) how many people and what skills and job types; (2) the wage rates for each group; (3) the benefit costs associated with each group. The costing is complicated by matters such as training and the use of consultants and service contractors instead of direct paid staff.
People costs vary enormously depending on the mix of local and international staff. Local staff are usually paid much less than international staff. There might be a cost offset to the extent that international staff can do some work more efficiently than local staff due to their knowledge, training and experience.
A profile of salary and wage rates together with present benefits and future cost and benefit commitments, shows a lot about the role of the people dimension in the performance of society and quality of life.
But people cost is also associated with a complex set of value flows. These value flows are critically important in any modern economy, but completely ignored in most financial and economic analysis, or at least only considered in a very superficial manner. Economists use the multiplier concept which comes about in part because of these value flows … but financial reporting includes on the simple money cost.
The value flows start with the value of a person getting remunerated, and how this impact the individual and the family … and in turn how the family money then gets used in the broader economy to pay for things that the family needs … or the family wants.
In turn employment and employment opportunities have an impact on the general quality of life in the community … in improving aspects of quality of life like reduced stress and comfort from job security and financial security.
Material cost (2)
Material costs are a function of a bill of material and the purchase price of the materials. Technical production factors like the scrap factor should be included so that material costs reflect reality. Many production processes require considerably more raw material inputs than there is output because of process losses (in machining, in casting, etc.).
The value flow associated with materials may be positive or it may be negative. The factors are complex. Converting a low value raw material into a high value product using labor and equipment may be a value creating activity for the community … though it may not be. The full value chain for the materials needs to be understood and taken into consideration … as for example when sourcing raw material is associated with obscene levels of toxic waste.
In money profit accounting, the full consumption of value is usually ignored with the effect of overstating profit returns … in some cases by obscene amounts. For example, in the extractive industries the money profit accounting costs only include the money expenditures associated with the extraction … the fact that the materials being extracted no longer exist is not part of the accounting. This is very convenient because the value consumption associated with the materials no longer existing is enormous … and avoided using the excuse that the valuation is subjective and difficult to quantify.
The value flows associated with materials are a critical part of understanding business performance … and community performance.
Land, facilities and equipment cost (3)
In money accounting, land is thought of as a non-depreciating asset … but it is an element in the balance sheet that may have an impact on value performance of both community and the organization. Land is potentially a way to progress, or may be a constraint on performance.
Equipment costs do not behave in a simple way, and care must be taken in costing equipment use appropriately. In many cases, the cost of using equipment may be expressed as a “cost per machine-hour”. Some of the characteristics that must be taken into consideration include (1) the life of the equipment in elapsed time; (2) the life of the equipment based on usage; (3) the utilization of the equipment in any given period; (4) the costs associated with running the equipment such as fuel and maintenance; (5) the cost of periodic major maintenance, etc.
For the community or society the infrastructure is part of this section … and the cost associated with an infrastructure that is highly efficient or very inefficient.
The analysis of big projects is often more about political benefit than economic benefit … especially when there are public funds involved.
Congestion Pricing … or Congestion Costing
New York City tried to introduce congestion pricing in order to reduce congestion in the center of the city … perhaps quite a good idea. The citizenry did not want to [pay the price! But the day to day reality is that everyone is experiencing the costs of congestion every time they try to move through the city. Taking an hour to go somewhere that should take 5 minutes is a very real cost … but not in any accounting!
Depreciation is a part of the cost framework. It is a concept that is derived from the economic life of an asset ... and in this context has nothing to do with tax law and allowable write-offs. The aim of depreciation is simply to relate the cost of using an asset to the activities the asset is used for. If an asset has a three year life, and is used most of the time, each of the year periods should be charged one third of the capital cost. This would give a reasonable result. On the other some equipment has a life that depends on how much it is used (for example, an aircraft). If some equipment has a useful life of (say) 50,000 hours, the hourly cost can be computed and the asset charged to the activity for each hour it is used.
Maintenance is a potentially important part of the cost of the use of equipment and facilities.
Operating overhead cost (4)
Operating overhead costs are costs associated with the supervision and management of operations. They are made up of elements of cost (1), (2) and (3) above, and allocated to specific units of activity. TVM tries to include data about operating overhead cost in the analysis because the productivity of many work activities depends on the effectiveness of the workers at the lowest levels, and this requires good supervision and on the job real time intervention.
Financial costs (5)
Cost of capital employed is the cost of using fixed and working capital. It is calculated by reference to the investment made in equipment, buildings vehicles, etc (fixed assets) and the investment needed for material inventory, work in progress and finished goods, receivables and cash (working capital) that are used for specific activities.
The calculation uses a cost of capital rate that varies depending on the ownership structure of the operation and the goals of this ownership. The cost to “rent” capital may vary from 2% to in excess of 200% per annum. This has become one of the most expensive aspects of modern capital market capitalism.
Admin and general overhead cost (6)
The general overhead cost is similar to operating overhead. It is made up of the same elements and allocated to operating activities o a basis that reasonably reflects the structure of the organizations and activities.
Cost is a key metric ... while it is usually the subject of intense analysis within an organization, it is difficult for the public to get access to cost information. In the corporate for profit business, reducing cost is a way to increase profit ...other things remaining the same. Little is put into the public domain about costs ... but cost is a critical part of performance metrics both for determining money profit and also socio-economic performance.
Profit as a cost (7)
One of the biggest elements of cost in modern business is the cost of capital ... which is essentially the idea that profit becomes an essential part of the cost of product or service. In a system where the computation of (corporate) value is a function of the level of profit and the growth of profit ... then the profit behaves more like a cost than merely being the derivative of corporate performance.
Missing balance sheet components (8)
One of the problems with the modern balance sheet is that “by law” it is possible to exclude important economic and business realities from the balance sheet of the organization. The makes it difficult to know what is going on “in reality” compared to what is being reported.
us It makes sense in financial management terms but should be reflected in the reporting of the business. The rules of financial reporting now provide for this.
Off balance sheet leasing
The history of off-balance sheet leasing is an object lesson in the way financial managers sought to build capacity without being limited by traditional financial balance sheet constraints … but in the process were able to move from sensible to foolish without anyone being able to tell the difference. The rules were changed after it became clear that there was widespread abuse.
Risk is another issue where accounting rules are inadequate so that risk may be ignored in balance sheet reporting. The mathematics of risk do not easily translate into accounting because of the incredibly imprecise quantification of the cost of disaster when the disaster is big. There is no linear relationship between the small risk and big risk … there are multiple exponentially related factors which produce the potential for out of control failure of society when not taken into consideration and planned for!
External constraints are something that have to be quantified and included in the balance sheet reporting for a community. Doing everything right and not getting any benefit from this may be a function of external constraints that should be in the analysis. A framework of governance that works or not is an example of an external constraint that should be accounted for.
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