Avoiding the Death Spiral: Actual Costs and Excess Capacity

Background

When working with customers around understanding their job, customer or staff profitability we're often asked why we wouldn't apply a staff members actual wages/salary for a month to the jobs that were worked on in that month. This is a natural and understandable question that confuses the two separate worlds of financial accounting and project accounting.

The objectives of financial accounting and project accounting are very different. Financial accounting aims to use a consistent set of rules like Generally Accepted Accounting Practice (GAAP) and International Financial Reporting Standards (IFRS) in order to arrive at a true and accurate reflection of an organisations financial performance for external agencies. Project accounting is not bound by these laws and has the objective of measuring the performance of a project in order to enhance decision making.

'So why shouldn't I apply my actual wage costs in a month to the jobs worked on in that month?' Great question.  The answer is the Death Spiral which was a term coined in 1988 to describe the phenomenon of raising prices and shrinking demand in a product manufacturing setting. The same phenomenon can occur in a professional services setting which is described below.

The Death Spiral

The Death Spiral occurs where an organisation attempts to apply some fixed cost across a variable unit of production. If you're a manufacturer these are your products but if you're selling time for money these are timesheets. The phenomenon occurs where we excess capacity drives up the per unit cost of production and makes each unit appear less profitable which in turn either increases prices to maintain margin, or disincentivises production or sales in order to create more excess capacity... which goes on to drive up the per unit cost of production. Confused yet? Let's take a product based example then then apply it to our professional services practice.

Newspaper Example

Let's imagine a newspaper printer has 3 different products The Sun, The Moon and The Star. The Sun sells for $2.00 per unit. The machine that prints The Sun costs $1,000 per month in depreciation/maintenance etc and can produce up to 1,000 units per month. The Moon and The Star are printed on very similar machines. The per-unit cost of The Sun is $1.00 providing a 50% margin assuming full production.

Despite having a capacity of 1,000 unit per month The Sun very rarely produces that many. In fact it's idle for about 20% of the time producing 800 units per month. So what do we do? Do we apply the same $1,000 monthly fixed fee to fewer units? Most people would be tempted to, and they wouldn't be wrong to calculate the new per-unit cost at $1.25 ($1,000/800 units).

Seeing that the cost per unit has increased Sally the manager of The Sun has a difficult choice to make. Does she:

A) Increase prices to $2.50 in order to maintain my 50% margin? Probably not. Customers are used to paying $2.00 for The Sun. Increasing prices would decrease demand as fewer people would purchase The Sun. Next month we may only have demand for 600 units with the same $1,000 fixed costs would further increase per-unit costs to $1.67 ($1,000/600 units) and we'd be faced with the same difficult decision again. Do you see The Death Spiral in effect here?

So let's explore option B:

B) Sell less of The Sun. Sally's job is to maximise profits with the resources she has. Why print 800 units of the The Sun at 37.5% margin (($2.00-$1.25)/$2.00) when she can print more of The Moon or The Star which have better margins? She'd make more money printing them. The machine that prints The Moon has available capacity of 200 units this month and by printing more of The Moon the per-unit cost of The Moon will decrease from $1.00 to $0.83 ($1,000/1,200 units) which will increase it's margin! Do you see The Death Spiral in opposite effect here?

The Death Spiral in your Practice

'But I don't sell newspapers or manufacture products how does this apply to me?' Great question.

The Sun, The Moon and The Star are you team members. They each have a fixed monthly cost (their wages) which we apply to a variable output (their billable time). If we start applying actual monthly wages to the variable timesheet units each months we will unknowingly have started down the journey of The Death Spiral. Here's how that plays out:

Susan, Mary and Steve all work for Bill's Bookkeepers providing professional services to his customers. We pay them each $1,600 per month and they work about 40 hours per week being 160 hours per month. Their hypothetical per-hour cost is $10.00 assuming full capacity. We charge each of them to jobs and clients at $30/hr.

Susan, Mary and Steve are very rarely at full capacity though. Non-client work is a necessary part of their work week. This might include research, training, internal meetings and other non-billable activities. Susan for example spends 120 hours this month on client work making her 75% productive. We pay her the same fixed monthly salary of $1,600 but split over fewer productive units (120). Her hourly cost to a job is now $13.33 per hour ($1,600/ 120 hrs). The jobs Susan works on appear less profitable. Susan's clients also appear less profitable. Bill has a difficult decision to make, does he:

A) Increase Susan's billable rate to $40/hr to maintain the same margin on her time? Customers are used to paying $30/hr and some have fixed price contracts in place meaning we'll need to increase those without to $50/hr in order to earn the same margin on Susan's time. This will mean customers will be less likely to use our services or Susan's services and may opt instead for Mary or Steve who are still $30/hr. Customers may only demand 100 hours of Susan's time next month driving her cost per hour up to $16. Do you see The Death Spiral at play here?

B) Send less work to Susan. Bill's job is to maximise profits with the resources he has. Why hand a job to Susan when we make more money if it's done by Mary or Steve? Next month we schedule Susan 100 hours of client work pushing per per-hour up to $16 and give the extra 20 hours of client work to Mary who has excess capacity and is now doing 140hrs of billable time per month. Mary's new per hour cost is $11.42, Mary's jobs and clients appear more profitable earning her even more jobs the following month. Do you see The Death Spiral in reverse here?

The Unintended Effects of The Death Spiral

By applying a fixed cost like wages over a variable output like billable hours we create unintended effects on our job, client and staff profitability. Once we start on the spiral it's very difficult to climb out of as we take increasingly unprofitable jobs off increasingly unprofitable people and put them onto increasingly profitable people. We thrash those 'profitable' people keeping them at more than full capacity until they burn out and quit. We get rid of those 'unprofitable' people in favour of new people who start on their own Death Spiral journey.

Alternative Costing Methods

Cost is an accounting fiction. Write that down. There is no 'one best way' to measure the cost of something. The method used should be appropriate to the type of decisions being made. The objective of project accounting unlike it's financial accounting brother is to enhance decision making. The costing method used should support this.

By calculating, applying and semi-regularly reviewing a fixed per-unit cost for our staff's time that estimates the direct costs involved in having that staff member work on a job we can avoid the effects of The Death Spiral while still getting reliable job, client and staff profitability reports. When staff work longer, their costs increase and so too should their revenues earned (if they can maintain their productivity and write-off %). We do not want to incentivise working longer. We want to incentivise being productive and effective in our work.

We can also calculate, apply and semi-regularly review a fixed per-unit cost for an overhead apportionment to be applied to each unit to represent the indirect costs involved in producing that unit. It is important though that we don't in either case use a fixed value across a variable number of units.