This article explains a few changes in Management Accounting to help drive innovation. This is relevant for following audiences:
- If you are a bold leader or a manager and are not happy with the intensity of your innovation outcomes, try this concept. If you are frustrated because ideas do not get implemented (like new year resolutions) and want to fix accountability with transparency – try it out.
- If you are a CFO who wants to change the negative perception about your community (operating managers consider CFOs as bottlenecks for innovation), try this concept for making changes in Management reporting, become a visible ally of innovation and change the perception!
- If you are a ERP company (SAP, Oracle etc.), consider having a module around this concept and contribute in accelerating innovations in established companies.
- If you are scholar and want to contribute to innovation, read this new concept, help in detailing it, piloting it in a few organizations and publish it!
- If you are the Innovation Head or Chief Innovation Officer/Evangelist, just use this concept and you will soon see changes in organization behavior.
If you are none of the above but continue to read this article and find it provocative/interesting, forward it to your friends and colleagues who belong to one of the above five fraternities.
Understanding Inventories
Profit-loss statement: What is an inventory? In a manufacturing organization, inventory is used to refer to raw material, goods in the factory that have been partly processed and the finished goods that have not been sold yet.
As a manager you know that the cost of buying raw material and expenditure on salaries, electricity, consumables etc. are expenses and negatively impact the Profit-Loss statement. Similarly, higher sales have a positive impact on the Profit-Loss statement. Do you know the financial treatment given to all three types of inventories – Raw materials, Work-in-progress and finished goods? What impact do they have on Profit Loss? These inventories too have a positive impact on the Profit Loss statement as they are reported alongside revenue (or sales). Why do you think we do this? Simply because the revenue is not yet realized from these inventories but the costs to procure the raw material and process them has been incurred and reported in the cost side of the Profit-Loss. The other way to understand this is: To get a true reflection of our Profit we need to subtract the cost incurred in buying and processing the inventories because they are not yet sold.
Balance-sheet: Had these inventories been sold and paid, the cash would have reflected in the asset side of Balance-sheet. Since these (inventories) are not yet sold, they too appear as assets in the balance-sheet.
Innovation projects are also inventories!
Consider innovation projects in an established company – A new product or improvement in the existing product or a new process to reduce cost or help garner a higher market share through some innovative marketing/sales/distribution or a new business model. Most often, such projects neither find an explicit mention in the strategy nor get driven through the Annual business plan.
Organizations begin to spend resources on these innovation projects to implement them – very similar to expenses made on raw material to process them. Like in-process inventory, we have in-process innovation projects. Unlike inventories, the cost spent on innovation projects do not reflect in Profit-loss and Balance-sheet statements. There is no way to ensure that innovation projects are not forgotten; sometimes for convenience. Many innovation projects straddle across multiple financial years and therefore it is appropriate to consider them as inventories. All inventories have a defined future value and so is the case with innovation projects. Inventories that cannot be sold are written off (by declaring a corresponding loss) and are removed from the balance sheet. Similarly, there are innovation projects which need to be shelved during their long implementation journey.
Valuation of inventories
Valuation of inventories is governed by the accounting policies. Inventories are valued at the cost of procurement and the cost incurred on processing them. For finished goods, the market value of the inventory is used for the valuation.
Valuation of innovation projects
Unlike the raw material which has a cost of acquisition, the cost of an idea (the raw material for innovation) is mostly nil. This is the reason why we don’t have an accounting standard for valuation of innovation projects. In absence of an accounting standard, there is no process to record the costs incurred on implementing the innovation projects. Today, all the expenses on such innovation projects are absorbed in the fixed cost of the year, which is part of COGS (Cost of Goods sold). Ideally, we should separately record the costs incurred on innovation projects, which shouldn’t be part of COGS. One may argue that the expenditure on innovation project is usually a small fraction of the overall cost like people, raw material, rent, energy etc. Unfortunately, this very argument discourages companies to spend resources on innovation projects – They do not want to increase COGS because of innovation projects.
I would have still accepted this argument if the benefit to cost ratio of innovation projects were similar to the revenue-cost ratio of current business. Innovation projects are supposed to deliver disproportionate outcomes!
Benefits of this change
Organizations’ memory is very short (new-year resolutions). Managers and leaders seldom remember innovation projects that were thought, presented and sometimes planned in the long-term plan. After some initial work, the innovation projects are left alone as the attention often gets digressed to projects that are critical for quarterly targets. Capturing and reporting innovation projects as an inventory will necessarily highlight the innovation projects in management dashboard. It will enable reporting of investments and fix accountability to implement them instead of relying on a few passionate people (luck). The advantages of giving innovation projects a treatment like inventories are:
- Will address the issue of amnesia and will keep the innovation projects once agreed (like the raw material once procured) in the active radar
- Will ensure that the sponsors of the innovation project resource their projects as per plan. This will gradually become the culture.
- Will ensure that innovation projects that are considered worthless are consciously knocked off from the innovation inventory. This will encourage managers and leaders to kill such projects early instead of protecting them and increasing the value of inventory and thereby making the killing more painful at a later date.
- Will give the CFO a cleaner COGS without loading the cost of innovation projects
- Will ensure clear accountability of innovation projects amongst senior managers and will encourage multi-year innovation projects with modifications in the compensation structure.
- Will enable CFOs to use the portfolio approach for innovation projects (eg. of M S Dhoni).
I am not suggesting making changes in the Accounting Standards. We should try this concept for Management reporting which I strongly believe will help in accelerating and improving the RoI from innovations innovations.
References:
- http://knowledge.insead.edu/entrepreneurship/are-accountants-and-cfos-killing-innovation-2417
- http://www.pwc.com/us/en/increasing-finance-function-effectiveness/publications/assets/innovation-champions.pdf