I met Dr. Reginald Lee back in 2015, after he commented on my LinkedIn post about the death of cost accounting. He sent me his book, “Lies, Damned Lies, and Cost Accounting.”

It put the final nail in the coffin of cost accounting. Then, in March 2018, I met Reginald and learned he was working on a new book, “Strategic Cost Transformation.” He asked me to write the foreword. I was honored. He became a Senior Fellow of VeraSage Institute because of the critical importance of his work, and how it challenges the conventional wisdom of the accounting profession.

One last important point: the book recognizes that cost accounting is a necessary function for both tax and external financial reporting purposes (e.g., to value inventory). The book argues that cost accounting information should not be used to make internal business and operational decisions.

The following is the Foreword I wrote to “Strategic Cost Transformation Using Business Domain Management to Improve Cost Data, Analysis, and Management:”

Foreword

Dr. Reginald Lee begins this book by stating, “We’ve been fooled. Bamboozled.” I have a solemn confession: I was certainly bamboozled. I became a Certified Public Accountant, believing it would allow me to do anything I wanted in the world of commerce since everyone kept telling me it was the language of business. I was being taught the importance of proper cost accounting in operating a successful enterprise, from determining a proper price to assessing profit per unit. It was a cohesive body of knowledge, a tangible reality I could grasp and a prism in which the world of enterprise I so admired could be refracted to make sense to a naïve practitioner who believed he knew more than he did.

One of the problems with education is the constant pursuit of practical knowledge at the expense of pursuing answers to profound questions. No doubt we all need practical knowledge to function in everyday life and earn a living to just get by in the world. But, I now realize people are not guided by what they know, but rather, what they believe – their worldview, through which we all refract reality. But, what if what you believe isn’t true?

This idea was made clear after reading C.S. Lewis’s essay, “Transposition,” in which he poses the following question: if you live in a two-dimensional landscape painting, how would you respond to someone telling you that the 2D image was just the faintest reflection of a real 3D world? Having grown comfortable in your 2D world – where the angles and edges and math all jibed – you might respond, “Three dimensions? I have no need for that hypothesis.”

Dr. Lee’s book moves you into a 3D world with his concept of Business Domain Management, comprised of the Accounting Domain (AD), the Operations and the Cash Domain (OC). Most businesses focus their attention on the AD, ignoring the more important OC Domain. Understanding the difference between these domains is crucial, and the first step is the unequivocal distinction between a measurement and a metric.

The simple truth is, depending on the cost accounting method used, you can calculate radically different cost allocations. Here are just several of the many approved cost accounting methods:

• Standard costing
• Total absorption costing
• Average costing
• Lean costing
• Marginal costing
• Activity Based Costing

The above methods will result in a wide range of cost per unit. This should prove that allocated costs have nothing to do with cash.

This is why Dr. Lee argues that cost accounting forces mathematical relationships that don’t make sense, and it confuses metrics with measurements. If you walk outside with two thermometers, you will probably get a relatively accurate temperature reading from each. That’s a measurement. Notice, a measurement is not based on a choice.

With cost accounting, however, depending on the method you use, you’ll get a wide range of cost per unit – those are metrics. This explains the old joke about the accountant, when asked what 2+2 is, he or she replies, “What would you like it to be?” It is how Enron and Bernie Madoff can report windfall profits, while being cash poor.

Furthermore, Segall’s Law applies to cost accounting: “A man with one watch knows what time it is; a man with two watches is never quite sure.” Despite these limitations, cost accounting data is treated as gospel. Yet, it is better to be approximately right than precisely wrong. Cost accounting is precisely wrong, and even new methods, such as activity based costing, are just new ways to be wrong.

Dr. Lee’s distinction between non-cash costs and cash costs is brilliant, not to mention essential for understanding how manipulating costs will not alter cash. The goal is to generate cash profit, not accounting profit. Most costs in professional firms today are for capacity: human capital, facilities and technology. These costs don’t change based on how they are utilized, and yet cost accountants force math relationships that make it appear as if they did, such as cost per hour. The fact is, services and products don’t have costs; organizations do.

Besides, as Dr. Lee makes clear, “You don’t need calculated costs for managerial purposes. The data in the OC domain are precise and unambiguous [measurements]. The AD information is ambiguous and messy [metrics]. OC provides everything AD does without the drama.”

He also points out that the “AD creates information that is dangerous to the untrained eye.” As a former cost accountant, I can attest that it is just as dangerous to the trained eye, providing a false sense of accuracy and control.

Some examples: cost accounting can create cash costs by increasing your taxes by misreporting profit; its worldview creates silos – insidiously known as “profit centers” – the equivalent of a wife giving her husband money. It leads to suboptimal pricing, especially if you use cost-plus pricing, since cost per unit changes with volume (and volume depends on price!), and cost accounting method used. It leads to misleading return on investment analyses, since most investments will not change cash costs. It can lead an organization into having too much capacity, as it nonsensically chases economies of scale and lower cost per unit. See General Motors’ bankruptcy for the perils of this mindset. Dr. Lee, instead, proposes you model your cost to meet actual demand, not a target cost per unit.

Cost accountants have all sorts of metrics in their toolboxes they claim are the magic bullet for calculating profitability per job, or per product/service. Yet, these metrics of margin analysis won’t predict the need for additional capacity, or help you model cash flow, nor do they tell you from a pricing perspective if you’ve left money on the table. Further, these metrics do not help you improve the future performance of your organization. Cost accountants are collectively plunging a ruler into the oven to determine its temperature – it is the wrong tool.

One of Peter’s Principles is that bureaucracy defends the status quo long past the time when the quo has lost its status. Cost accounting does not deserve to be the apotheosis of pricing, nor firm management. It focuses leaders’ limited attention on absolutely the wrong things.

By focusing more on the Operations and Cash Domain, you will be better able to maximize profitability overall, more aligned with a portfolio approach than a profit per unit approach. But, beware: this is not an easy change to make organizationally. The cost accountants and finance types will push back, mightily. Even though they understand cost accounting can be gamed, they will say, “True, but it’s better than nothing.”

Really? It’s as if three friends are lost in New York City, and one happily reports, “Don’t worry, I have a map.” “But, it’s a map of Los Angeles,” says the second friend, while the third says, “Yes, but it’s better than nothing.”

In “Strategic Cost Transformation,” Dr. Lee provides us with the correct map: cash flow and capacity modeling. Engineers invented and led us into cost accounting, even though no one paid heed to their warnings that it was a very inexact method. It is only fitting that an engineer now has not only lit a candle in the darkness, but is also leading us out of a 2D world and back into reality.

Dr. Lee has provided the final nail in the coffin of cost accounting. Ignore it at your own risk. It’s not comfortable, and it goes against everything you were taught in business school and accounting. The difference is: it’s a smarter way to run an organization.

Additional Resources

• My two interviews with Dr. Reginald Lee on The Soul of Enterprise: Episode #200, [on “Strategic Cost Transformation”] and Episode #112 [on “Lies, Damned Lies, and Cost Accounting”].
• Kirk Bowman’s interview with Dr. Reginald Lee on The Art of Value podcast, and Kirk’s interview with me on Reginald’s work.