Cautionary words on modelling

Modelling operational structure, particularly costs

A significant management accounting topic is that of costing, the definition of costs and their behaviour, particularly with respect to volume of activity. Understanding and analysing costs to a sufficient degree is essential, but it is possible to concern yourself too much with costs and cost analysis, forgetting that winning sales is vital. The dichotomy of improving profit by cost reduction versus sales increase points to two, sometimes opposing, strategies - a cost reduction strategy versus a sales growth or volume of business strategy.

To paraphrase the Oscar Wilde quote: 'Some executives know the cost of everything and the value of nothing.' Is this too harsh? No, if it means that they are blind to what the costs contribute (or not) directly or indirectly to the service or product and whether or not the costs can be recovered.

The fundamental strategic significance of costs is that they erode margin, whether direct costs of service provision or production or as necessary indirect or overhead costs. The business objective is clearly to minimize costs of whatever type and incur only those necessary for the present and future of the business in question. This last statement raises the point that it is possible to improve results immediately by cutting costs that do not affect immediate results; for example, expense on research, training staff and marketing.

Savagely cutting costs, particularly those that contribute nothing to present output, can be described as a short-term strategy.

Modelling the future

If we knew the future, strategies would succeed, but 'the future is unknowable', that lovely quote. What we can do is make our best estimates of the future, income, costs and cash flows and study the effects of changes in our assumptions. This will at a minimum assist us in understanding the risks inherent in any chosen strategy or may well lucidly point to an erroneous strategy.

Two common types of model for the future are operating budgets and cash flow forecasts used for short-term strategies or with discounting for longer-term investment.

Budget models

One way of considering budgets is as models of the future months and year(s) of activity. It is doubtful that those involved in the majority of budgeting exercises see the process as an exercise in envisaging strategy, but rather as figures either optimized or constrained that will allegedly achieve an objective or target. As pointed out in Chapter 10, the budget process too often is not utilized as it could be to reveal and deliver strategy. For further consideration on budgets as models of the future, see Chapter 10.

Cash flow models

Cash flow forecasts are models of the future and essential for short- and long-term business planning and decision making, particularly in identifying the need for, and ability to fund, a business or project.

Short-term cash flow forecasts are considered as a particular resource that needs to be budgeted and it is dealt with in Chapter 10. Longer-term cash flow models are the core of project or investment appraisal and are studied in Chapter 11.

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