Why Timesheets Focus Firm Leaders on the Wrong Things
Have you ever changed your mind on an issue in which you had a strong belief? What was that process like? Was it a sudden epiphany – a BFO (Blinding Flash of the Obvious) moment – or was it a more gradual and incremental process as you increasingly wrestled with the matter?
I write as a reformed CPA and cost accountant who has changed his mind on the value of timesheets and cost accounting. According to philosopher Amélie Oksenberg Rorty, a crucial principle for coming to know the truth is, namely:
“Our ability to engage in continuous conversations, testing one another, discovering our hidden presuppositions, changing our minds because we have listened to the voices of our fellows. Lunatics also change their minds, but their minds change with the tides of the moon and not because they have listened, really listened, to their friends’ questions and objections.”
Well friends, let me share with you some questions and objections with respect to the importance of keeping track of time in your firm. My goal is not to have you think like me, but rather to think with me. But, think you must.
The Four Defenses of Timesheets
Hourly billing and timesheets are inextricably linked – you cannot discuss one without the other. The reason is that both use a common denominator: time. There are four primary defenses of timesheets:
- We need them for pricing.
- We need them for project management.
- We need them to evaluate the efficiency of our team members.
- We need them for cost accounting – profitability per client, or job.
I will briefly deal with the first three of these defenses, but I want to focus on the last one, since it possesses the most influence in getting firms to maintain their timesheets, even if they have switched to fixed or value-based pricing.
The Pricing Defense
Clients buy outcomes, not hours. No one cares about the labor pains; they want to see the baby. Yet, professional firms not only measure the labor pains, but also bill for them in six-minute contractions. Yet, being a professional means taking responsibility for providing a result, not delivering a series of tasks. It’s one of the reasons hourly billing is unprofessional – it atomizes everything into a task, distracting attention away from creating an outcome.
If you diagram hourly billing, a form of cost-plus pricing, it would look like this:
Service → Cost → Price → Value → Client
Value pricing inverts the above chain by recognizing the economic fact that the client is the ultimate and sole arbiter of value:
Client → Value → Price → Cost → Service
Thus, value pricing turns the order of cost-plus pricing inside out. The costs do not determine the price, let alone the value. It is precisely the opposite: the price justifies the costs that can be profitably invested in to make a service desirable for the client at an acceptable profit for the firm.
Firms that value price do not ask, “What prices do we need to cover our costs and earn a profit?” Rather, they ask, “What costs can we afford to incur on this project, given the price obtainable from the client, and still earn an adequate profit?”
The Project Management Defense
Project managers distinguish between “estimated effort” and “duration.” Why does a matter that we estimate to take roughly one day to complete sit in the firm for three weeks? Duration is where the bottlenecks occur, not estimated effort.
Like FedEx, firms should measure turnaround time, both at the firm-wide level and team member level. This is what the clients care about. Shouldn’t we use the same measurements the clients do to assess our success?
Project management is about forecasting the future. Timesheets look backwards. By definition, by the time you see something on a timesheet, it is no longer manageable. This is the equivalent of timing your cookies with your smoke alarm.
In reality, time is a constant constraint. Time cannot be hoarded, sold, purchased or traded. Time is not value (the labor theory of value has been falsified), and time is not a cost, as you do not purchase your knowledge worker’s “time” anymore than your clients purchase yours.
The Efficiency Defense
A business does not exist to be efficient; it exists to create wealth for its customers. Besides, we can be efficient at doing the wrong things, and there’s nothing more wasteful. The buggy whip manufacturers were at the peak of their efficiency curves before being taken out by automobiles.
If efficiency was the ultimate purpose of an organization, then perhaps Walt Disney should have made Snow White and the Three Dwarfs. Think of the cost savings – in animator time and speed to market – from removing nearly 60 percent of the dwarfs.
The differences in firm revenue and profit cannot be explained by efficiency, but instead, only by effectiveness in customer service, as well as the ability to create, communicate and capture value. Efficiency is a table stake – the minimum you need to be in the game. Real competitive advantage is built on external effectiveness as perceived by the client, not internal efficiency as measured by firms.
Firms say they want more innovation, but innovation is the antithesis of efficiency. This is why Google allows its technical people 20 percent of their time to work on whatever interests them.
We can be efficient with things, but must be effective with people. Professionals are not only knowledge workers, but also relationship workers, and you cannot forge and strengthen relationships by staring at clocks. No one describes his or her marriage as efficient.
The Cost Accounting Defense
“You can use accounting to describe a business’s external condition, but it offers little insight into the particular inner relationships that determine those results.” – H. Thomas Johnson, “Profit Beyond Measure”
H. Thomas Johnson is an American accounting historian and professor of business administration at Portland State University, and one of the pioneers of the activity-based costing (ABC) movement. Johnson’s book, “Profit Beyond Measure,” is a seminal work, wherein he profiles Toyota and Scania – the latter now owned by Volkswagen Group – as two manufacturers that do not have a standard cost accounting system.
So, how do they do it? Toyota understands price justifies costs, not the other way around. Here is how Johnson explains it:
None of these comments are meant to imply that Toyota does not have accounting and production planning information systems. Of course it does. Toyota has a comprehensive array of information systems, accounting and otherwise, with which to plan, in advance of operations, and to report results of operations after the fact. But, information from such systems is not allowed to influence operational decisions.
Toyota management discharges its responsibility for costs, not by taking arbitrary steps to manipulate operations, but largely in the vehicle planning stage. During the design stage, long before the first penny has been committed to making a vehicle, Toyota has always placed enormous importance on setting and achieving cost targets. To do so, over the years Toyota has developed a famous technique for target costing. Simply stated, target cost is the maximum cost the company can afford to incur to produce and sell a vehicle and still earn a required profit at the price customers are expected to pay.
It seems so obvious to constrain your firm with a final price before you begin to incur any costs, yet this practice is not widely followed in professional firms, despite its proven successes. Costs are, no doubt, important to consider, but the crucial distinction is when they are considered. By its very nature, cost accounting is a historical function, but what is important for pricing are planned costs, not past costs.
Another innovative thinker in this area is Dr. Reginald Tomas Lee, author of “Lies, Damned Lies, and Cost Accounting: How Capacity Management Enables Improved Cost and Cash Flow Management.” He posits three reasons why cost accounting is a bad practice:
- To get a cost, you have to create and force math and relationships that do not exist.
- By doing this, you lose touch with your operations.
- You create meaningless numbers that people consider as gospel (a single representation of an artificial reality).
Many firm leaders claim the only way to calculate profitability per client is with timesheets. But, you don’t need timesheets to know your firm’s costs. Don’t confuse costs with cost allocation, or cash modeling.
The simple truth is that 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 also should prove that allocated costs have nothing to do with cash.
For example, using the above methods, assume Apple calculated that it costs between $10 and $40 to make the Apple Pencil for its iPad Pro. Does this mean that if it doesn’t make one, it will save $10-40 in 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. With cost accounting, depending on the method used, you’ll get a wide range of possible numbers – those are metrics. This explains the old joke about the accountant – when asked what 2+2 is, the accountant replies, “What would you like it to be?”
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.” Yet, cost accounting data is treated as gospel, providing a false sense of accuracy. It is better to be approximately right than precisely wrong.
The important point is that your costs need to be known before you do the job, not afterwards. It does no good to know your cost allocation to the penny if the client doesn’t agree with your value and/or price. When do you want to learn your client doesn’t like your price: before or after you do the project?
Further, the majority of costs in a professional firm are for capacity: labor, rent, equipment and technology. These costs don’t vary with how that capacity is utilized. This is why it’s more profitable to concentrate on pricing for value, not to cover arbitrarily allocated costs. It’s why airlines, hotels and cruise ships don’t use standard cost accounting either, but rather focus on pricing, cash flow and capacity modeling.
Witness how Uber uses pricing to match capacity with demand, with surge pricing being deployed in areas with high demand to incent more drivers into the area. Your capacity is precious, and you should not allocate too much of it to low-value clients, while always reserving some for your best client’s urgent matters. We should never confuse being busy, and at full capacity, with being profitable. Often times, no business is better than bad business.
Consultants to the professions have all sorts of metrics in their toolboxes they claim are the magic bullet for calculating profitability per job, or per client. Yet, these metrics of margin analysis won’t predict the need for additional capacity, 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 team.
Why Your Hourly Rate is Not Cost Accounting
Your hourly rate is not even an accurate cost allocation method. Here’s why:
- It includes profit. There is no such thing as allocating profit in cost accounting. That is profit forecasting, not cost accounting. Opportunity cost has no place in cost accounting either, as it is an economic concept and not a cost accounting concept.
- Even if you remove the profit component from your hourly rate, it still bears no relationship to your firm’s actual costs. Since most firms establish their hourly rates based upon reverse competition – that is, what your competitors charge – the cost component is completely arbitrary. I have yet to encounter more than a handful of firms that actually tie out their cost per hour to the general ledger.
- With the timesheet, you are attempting to run a profit & loss statement on every hour of work logged. This is absurd, since your firm is an interdependent system and cannot be atomized into a series of recorded hours. What matters is profitability across the entire firm, the same logic we use with our investment portfolios, which contain different levels of risk and reward assets.
- The hourly cost allocation gives no weight to the lifetime value of the client, since it only looks at the math of the moment.
These are egregious errors for the accounting profession to commit, given its supposed fastidiousness when it comes to dealing with numbers.
A Simple Thought Experiment
Assume you are a sole proprietorship, and have $100,000 of fixed overhead this year (rent, wages, equipment and more).
Further, let’s assume you plan to work 3,000 hours, and expect one-half of this to be “billable,” and the other half “non-billable.”
The first question is do you divide the $100,000 of costs by 1,500 or 3,000 hours? Forget adding your desired profit, as that is not cost accounting, but rather profit forecasting.
The theory of hourly rates says you would divide by the number of hours you expect to bill, not work, so that is $100,000/1,500, or $66.67 per hour of allocated costs per hour worked.
Let us also assume that you have billed 1,500 hours between January and November 30 of the current year, and you’ve completed all of your work, so you’re looking forward to your month off.
Now, on December 1, a new client engages you to perform 100 hours of additional work that month.
Your cost allocation now becomes $100,000/1,600, or $62.50. Therefore, you have been over-allocating your costs by nearly $5 per hour for eleven months of the year. Allocated costs are obviously highly dependent upon volume of activity.
Now, reproduce this simple example for a large firm with thousands of employees, with clients coming and going, and account for all the fudging in completing timesheets – the eating of time, non-recorded time and all the other games played – and you have an egregiously incorrect cost allocation scheme that bears no relation to operations or reality. Yet, the numbers are treated as if they are gospel, creating an illusion of precision and control.
Further, to add insult to injury, timesheets are not helping you price better, earn more profit, conduct project management more effectively, qualify your clients better, predict the performance of your team members, manage capacity, model cash flow or measure what matters to your clients – and, they are all lagging indicators.
This is exactly what H. Thomas Johnson meant when he wrote that “quantitative measures can only describe [relationships]; they cannot explain them.” We can audit the drunk’s bar bill, but we can’t explain why he’s an alcoholic.
The profession, along with consultants to it, are collectively plunging a ruler into the oven to determine its temperature. The timesheet is the wrong measuring device.
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 from time recording does not deserve to be the apotheosis of pricing, nor does firm management. It focuses leaders’ limited attention on absolutely the wrong things.
This may sound like the ultimate apostasy coming from a former CPA and cost accountant, but like the ancient mythological Greek Cassandra, I must speak the truth even if no one is prepared to believe.
Editor’s note: Ron is presenting this topic at QuickBooks Connect 2017, Nov. 15-17, in San Jose, Calif. For more information and registration details, click here.