Timesheets are Terrible Cost Accountants

In general, there are four defenses for maintaining timesheets:

1. We need them to price.
2. We need them for project management.
3. We need them for team member performance evaluations.
4. We need them for cost accounting.

We here at VeraSage have proven, without a doubt, that every one of these defenses is incorrect, and that there are superior methods and tools for each of these objectives.First, prices are set by value, not hours, even within the context of competition. After all, none of us buy the cheapest of everything, which proves there is room in all markets for price searching by sellers to take place.Second, anyone who spends a day listening to Ed Kless teach project management cannot possibly come away thinking that "time spent" is more important than "duration"—that is, turnaround time—from a project manager's perspective. Duration is where the bottlenecks occur, not time spent.Third, anyone who has studied nearly every single private business, or a Results-Only Work Environment (ROWE), knows timesheets are not needed to conduct performance evaluations for team members.Yet, it's the last defense I really want to bury, once and for all, in this post, which was inspired by an excellent article by legal consultant Allison Shields in the May 2011 issue of Law Practice Today."Thaaaar She Blows"When it comes to customers and profitability, another adaptation of the Pareto Principle applies. Run a Pareto analysis on your customers, ranked by revenue and you will most likely find approximately 20 percent of your customers generate 80 percent of your revenue. But what about profitability?Professors Robin Cooper and Robert S. Kaplan of Harvard Business School have shown the result of their analysis of an insurance company's customers, resulting in what author Matthew Stewart in The Management Myth calls "The Whale":The_Whale.pdfKaplan then explains:

The shape of the curve occurs in virtually every customer profitability study ever done, in which 15 to 20 percent of the customers generate 100 percent (or more) of the profits. In this case, the most profitable 40 percent of customers generate 130 percent of annual profits; the middle 55 percent of customers break even, and the least profitable 5 percent of customers incur losses equal to 30 percent of annual profits.

There's an old joke about the perils of hourly billing: You work 12 hours, bill for 8, and get paid for 6. My good friend and colleague Ric Payne (Chairman of the Principa Group of Companies) has added this to make the joke even less funny: "and you actually make a profit on 4."Ric has confirmed Kaplan's finding with empirical evidence from accounting firms. Using historical timesheet data, Ric constructed a macro in Excel that allocated actual costs—not the inflated "hourly rate" of the firm because that rate includes a desired profit, and hence is not cost accounting—to each customer based on hours.At least Ric has used the timesheet as it was originally intended—as a cost accounting tool. Since most firms have this data, why aren't they utilizing it in this manner to determine which customers to fire, or at least increase price?Most firms simply use the time and billing system to invoice customers, not as a profitability tool. I have yet to see a firm fire a customer, or increase their price, because of timesheets, for if they did, realization rates would not consistently be below 100 percent.When confronted with an analysis such as this, most partners will dismiss it by saying something to the effect of, "Oh, we know we lose money on some of our customers. But they are acorns who will grow into great opportunities one day."This is not bad logic, per se, as a firm should look at the total profit from a customer over its lifetime. The problem is, if this is so, then why the pretense of timesheets being used to measure profitability? What decisions do you make as a result of timesheets? Do the benefits exceed the costs? Once again, this is the illusion of control.I argue that firms already know where their customers are on the Whale, without even looking at the analysis. However, if the analysis provides impetus to leaders of the firm to shed their unprofitable customers, then by all means it is worth undertaking (Ric has kindly offered to make his Excel Macro available on his Blog).Timesheets are a Cost Allocation ToolWhen we show the Whale, people claim the only way to calculate profitability per customer is with timesheets. Really?First off, you don't need timesheets to know your firm's costs. Look at your income statement. Don't confuse total costs with cost allocation.Give me half a day, maybe less, with your income statement, revenue per customer, and allow me to interview your team, and I will allocate your costs over any time period you want, and the result will be the Whale.Let's get over the idea that any cost accounting—be it timesheets, Activity Based Costing, or any other method—requires 100 percent accuracy. The simple truth is, cost accounting is full of arbitrary allocations and errors, and if you don't understand that, you've never been a cost accountant.Cost accounting just has to be close enough, and the important point is that your costs need to be known before you do the job, not afterwards.This is why Japanese manufacturing (especially automobile) companies utilize Target Costing, not standard cost accounting. They are about 40 years ahead of American companies with this practice.This is an enormous difference, since value drives price, and price drives the costs you can incur to earn a profit you can live with. It does no good to know your cost allocation to the penny if the customer doesn't agree with your value and/or price.Further, costs are largely fixed in professional firms. This is why airlines, cruise ships, hotels, etc., do not engage in low-value cost accounting, but rather concentrate on yield management—that is, pricing for value, not to cover arbitrarily allocated costs.Why Your Hourly Rate is Not Cost AccountingHowever, I want to dive deeper on this issue, because the above logic doesn't seem to convince many CPAs.Your hourly rate is not even an accurate cost allocation method. Here's why:

1. It includes profit. There's no such thing as allocating profit in cost accounting. That's profit forecasting, not cost accounting. Opportunity cost has no place in cost accounting either, as that is an economic concept, not a cost accounting concept.
2. 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 chare—the cost component is completely arbitrary. I have yet to encounter more than a handful of firms that tie out their cost per hour to the General Ledger.
3. 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.
4. The hourly cost allocation gives no weight to the lifetime value of the customer—and the lifetime value of the firm to the customer. Our colleague Paul Kennedy has illustrated why this is so more brilliantly than anyone I have ever read.

These are egregious errors for CPAs to commit, given our supposed fastidiousness when it comes to numbers.And when you compare this costing method to target costing—or price-led costing—you realize timesheet allocation is suffering from what philosophers call a deteriorating paradigm—the theory gets more and more complex to account for its lack of explanatory power.This is why many firms will allocate the same dollar of revenue three or four times, based upon different criteria—from origination to realization to cash collections—which is overly complicated and not a great use of limited executive attention.But Wait, There's MoreHere's a Gedanken (thought experiment).Assume you're a sole proprietorship, and have $100,000 of fixed overhead this year (rent, wages, pencil lead, etc.).Further, let's assume you plan to work 3,000 hours, and expect one-half of this to be "billable," and the other half "nonbillable."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's not cost accounting but profit forecasting.The theory of hourly rates says you'd divide by the number of hours you expect to bill, not work, so that's $100,000/1,500, or $66.67 per hour of allocated costs per hour worked.Let's also assume that you've billed 1,500 hours between January and November 30th of the current year, and you've completed all of your work, looking forward to your month off (you were able to get all your work done early because you took Ed Kless's excellent project management boot camp).Now, on December 1st, a new customer 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've been over-allocating your costs by $5 per hour for eleven months of the year.[It's even more absurd if you originally divided the $100,000 by 3,000 hours worked (not billed), even though you no longer have the $5 per hour over-allocation issue. Why? Because, then, to which customers do you allocate the 1,400 "nonbillable" hours? And how do you determine that allocation? This is why cost accounting is full of arbitrary assumptions].Multiply that by more and more employees, account for all the lies in timesheets, the eating of time, non-recorded time, and all the other games played, and you have an egregiously incorrect cost allocation scheme that is incredibly elastic, not accurate.And, to add insult to injury, timesheets are not helping you price better, conduct project management more effectively (or even efficiently, for you Taylorite disciples), qualify your customers better, predict the performance of your team members, or measure what matters to your customers—and, they are lagging indicators.All this said, what's the point of timesheets?As Ed Kless says, "If you suck at what you do, bill by the hour..."And I would add, given the logic of the above, "...and keep timesheets."If you think the above is flawed, please let us know where.This debate is getting stale, and we should have moved on a long time ago, since there are many more important issues for the professions to deal with rather than wasting time on a deteriorating paradigm.