The Flaws of Averages: How Not To Model Your Cost System
Dec 09, 2013
I was in a meeting last week with a potential costing client when I heard a saying that I had never come across before: “have you ever heard the story of the army that drowned in a river that was an average of three feet deep?”
Of course I came back to the office and googled it to find the source, and here is what I came up with: http://flawofaverages.com/FOA%20Highlights/Highlights7%20F4.1.htm
According to Mr. Sam Savage, it’s not an army but a group of statisticians. Of course! In case you are still lost, the overriding theme here is that you cannot effectively manage your Company if you are using grand averages to tell you what you need to know. For this group of statisticians, the first part of the river was shallow, and the other part of the river was deep which resulted in a grand average of three feet which is manageable!
Apply this to the costing world. Most of the Companies that I am called to are in the following position(s):
- Monthly financial statements that show an overall profit or loss and are often inaccurate
- Lack of systems or utilization of systems that does not provide essential information
- Little or no detail of product cost by product/ customer/ territory/ or other segment
- If there is detail, it is often very misleading and does not reconcile to anything and is generally based on a foundation of misunderstood work centers, allocation theories that missed the boat, and sometimes a disassociation from the reality of how resources are truly being consumed.
So, decisions are being made using the profit and loss statement each month. What good does that overall gross profit margin tell you? Assuming you have done a good job of correctly identifying your costs, it gives you a GRAND AVERAGE which is pretty much useless if you want to make effective decisions for the future strategy of your company.
- Do you know which product or family of products is causing your gross margin to increase?
- Do you know which product or family of products is losing money causing your overall grand average to be lower?
- Do you know which “losing” jobs are ok to maintain because they are part of an overall “winning” group to a customer?
- Can that grand average profit margin tell you which customer or product to “cut loose”?
In case you haven’t said it already, I will do it for you. NO, that grand average cannot give you any of those answers. If you can associate with any part of this scenario, then your company is not operating at its maximum potential. It is time to implement a new costing theory that is transparent, accurate, built on solid facts and assumptions, and provides results that will identify and understand WHAT is driving your overall grand average.
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