LeadershipStrategy

Management Accountants: Innovation Projects are Precious Inventories

posted by Ravi Arora April 13, 2017

If you are a bold leader or a bold manager and are not happy with the intensity of your innovation outcomes, try this concept. If you are a CEO who believes in innovation but is not happy to see ideas and promises not getting converted into reality and hence want to fix accountability with transparency – try it out – It will surely give wings to your program. Finally if you are a CFO who wants to change the perception of the world about CFOs (i.e. CFOs are bottlenecks for innovation), make a change in your Management accounting (reporting) and see how quickly the perception gets changed! Finally if you are from SAP or Oracle or something similar (ERP), consider having a module around this concept and proactively contribute in accelerating innovations. If you are none of these but find the article provocative/interesting, forward this article to your friends and colleagues who belong to one of the four fraternities.

Understanding Inventories

What is an inventory? In a manufacturing organisation, inventory is used to refer to raw material, goods in the factory that have been partly processed and also the finished goods that have not been sold yet.

As a manager you know through common sense 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 (Inventory) too have a positive impact on the Profit Loss statement as they are reported alongside revenue (or sales) in Profit-Loss statement. Why do you think we do this? Simply because the revenue is not yet realized from these inventories but the costs to procure & process the raw material have already been incurred and reported in the cost side of the Profit-Loss. The other way to understand this is: We need to subtract all the costs incurred in buying and processing the inventories because they are not yet sold.

Had these inventories been sold and cash collected, the cash would have been reflected in the asset side of Balance sheet but since these (inventories) are not yet sold, these are reported as assets in the balance sheet.

Ideas and innovation Projects are also inventories!

Now think about Innovation projects in any established business. I am not referring to those innovations projects that intend to create a separate product line or a separate business altogether. I am referring to those innovation projects that are intended to bring freshness to the products or add a new product in the existing product portfolio or save cost by trying a new process 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 are stated in the Annual business plan. Unfortunately the accounting system also fails to highlight them.

Organisations spend resources on these innovation projects to implement them, very similar to expenses made on raw material to process them. Similar to the in-process inventory, we have in-process innovation projects. Almost all inventory have a defined future value and so do the 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 many innovation projects which (because they are forgotten) lose value/relevance and need to be shelved mid-way.

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) is mostly nil. This perhaps is the reason why we don’t have an accounting standard for valuating Innovation projects. In absence of an accounting policy, there is no process to record the costs incurred on implementing the innovation projects. The fact is that many innovation projects, similar to inventories, straddle across two or more financial years. Hence it makes sense to give these innovation projects the same treatment as we give to inventories. Today, all the expenses on such innovation projects are absorbed in the direct cost of the year and are part of the COGS (Cost of Goods sold). We need to separately record the costs incurred on innovation projects. One may argue that the expenditure on innovation project is usually very small and would be negligible amongst the other large expenses like people cost, raw material cost, rents, electricity etc. Hence the argument is not to make this extra effort of recording and reporting innovation inventory.

This argument would have been acceptable to me only if costs incurred on innovation projects are not likely to deliver any disproportionate outcomes in future.  Most direct costs deliver proportionate outcomes but for innovation projects this is not supposed to be true!

Innovation projects, by definition, are supposed to deliver disproportionate results. The opportunity cost is very high for innovation projects.

Benefits

The sole reason for capturing and reporting innovation projects as an inventory is to highlight the innovation projects in the organisation, measure their value and fix the accountability to ensure that they are resourced and executed as per plan. I would like to reiterate that I am referring to those innovation projects that make the current businesses more innovative. Organizations’ memory is very short and managers and leaders seldom remember innovative projects that were thought, presented and planned. After some initial work on some of these projects, the attention often gets digressed to some other topics or projects (related to quarterly targets) and the innovation projects are left alone and soon forgotten. Similar to new-year resolutions, the financial new-year usually ushers in new innovation projects, brings hope and excitement and the cycle repeats. The advantages of giving innovation projects a treatment similar to inventories are:

  • Will ensure that the sponsors of the innovation project resource these projects as per the plan
  • 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 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 enable the CFO to fearlessly encourage multi-year innovation projects as the system will make the accountability very clear and transparent. Over time CFOs can extract insights from this process and actively participate in making improvements.
  • Will enable CFOs to use the portfolio approach for the innovation projects. It will give company a method to find the effectiveness of the innovation program.

I am not neither suggesting nor ganging up support to make changes in the Accounting Standards. I suggest we try this concept as Management accounting which I strongly believe will help in accelerating and improving the RoI from innovations.

Are you game?