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The incredible shrinking budget

To illustrate the difference between doing what's best for a business and doing what's best for the numbers, I'd like to tell a true story that happened not long ago at Autodesk. I'm singling out this case because it demonstrates both how accounting can affect decision making as well as the difference between treating the numbers as a master versus simply as a reflection of the underlying reality.

I attended a meeting in early 1989, where I heard a discussion of how, over the coming year, it would be necessary for Autodesk to reduce its sales and marketing budget to lower and lower levels. Walking in from the outside, I found this more than a little puzzling. After all, weren't we in the midst of a still-unbroken series of sales and earnings records? Wasn't this year expected to be the best ever? Weren't we finally achieving substantial sales of AutoCAD to the large companies and government?

True, but there was this little matter of accounting, you see. From time immemorial, most copies of AutoCAD have been sold by dealers. To simplify the numbers, assume the retail price of AutoCAD is $1000, the dealer pays $500 for it, and all sales by dealers are at the full list price. So, for every copy of AutoCAD that ends up in a customer's hands, Autodesk gets $500 and the dealer gets $500. Autodesk reports the $500 as Sales, deducts expenses, pays taxes, and ends up with earnings, say $125, corresponding to a margin of 25%.

But suppose, instead, we sell the copy of AutoCAD to a Fortune 500 account: Spaceley Sprockets, perhaps? In that case, the numbers look like this (again simplified for clarity). Autodesk ships the copy of AutoCAD directly to the customer and invoices Spaceley Sprockets for the full list price, $1000. However, the sale was not made directly by Autodesk; the order was taken by one of our major account representatives, the equivalent of dealers for large accounts. When we get the check, we pay a commission to this representative. Assume the commission is $500.

Regardless of who bought the copy of AutoCAD, the financial result, the fabled ``bottom line,'' is the same. There's one fewer copy of AutoCAD on our shelf, and one more installed on a customer's premises. Autodesk receives $500, and our dealer or representative gets $500. But oh what a difference it makes in the accounting! In the first case, where Autodesk sold the copy of AutoCAD to the dealer, that was the whole transaction; whatever happened to the copy of AutoCAD after the dealer paid for it has no effect on Autodesk's books. Autodesk sells, dealer pays, end of story. But in the second case, when Autodesk sells to Spaceley Sprockets, that appears on Autodesk's ledger as a sale of AutoCAD for $1000. The instant the $1000 shows up, however, we immediately cut a check for the commission, $500, and mail it to the representative, leaving the same $500 we'd get from the dealer. Same difference, right?

Not if you're an accountant! In the first case, Autodesk made a sale for $500 and ended up, after expenses and taxes, with $125, and therefore is operating with a 25% margin (125/500). In the Spaceley sale, however, the books show we sold the product for $1000, yet wound up only with the same $125. So now our margins are a mere 12.5% (125/1000). And if we only kept $125 out of the $1000 sale, why that must mean our expenses were 1000-125=875 dollars! Of that $875, $375 represent the same expenses as in the dealer sale, and the extra $500 is the representative's commission which, under the rules of accounting, goes under ``Cost of sales.''

Or, in other words, comes out of Autodesk's marketing and sales budget.

That's why the marketing budget had to be cut. To the very extent the major account program succeeded, it would bankrupt the department that was promoting it. If we were wildly successful in selling AutoCAD into the big companies, Autodesk would make more sales, earn more profits, then be forced to cancel marketing program after marketing program as the price of success! All because the rules of accounting would otherwise show falling margins or a rising percentage of revenue spent on ``cost of sales.''

The purpose of this discussion is not to complain about the rules of accounting. You have to keep score somehow, and while one can quibble about this or that detail, as long as the rules are applied the same from company to company and people don't lose sight of what's really going on, there's nothing wrong with the way these different transactions are recorded. After all, business is supposed to be about making money, and after all the adding and subtracting, Autodesk made the same $125 from both sales.

Instead, what disturbed me so much about this incident was the way management seemed to be taking their marching orders from the accounting rules rather than the real world. Budgets were actually being prepared on the assumption that marketing and sales efforts would have to be curtailed to offset the increased ``cost of sales'' from the major account sales anticipated over the year. Think about it: here we were planning for what was anticipated to be and eventually became the best year in Autodesk's history, and yet were forced to cut our marketing and sales as a direct consequence of its very success. Carried to the absurd, if the major account program astounded us and began to dwarf dealer sales, we would have to lay off the entire marketing and sales department to meet the budget.

This bothered me.

It seemed to me that what was called for here was not a plan for the orderly dismantling of marketing and sales department, but rather some effective outreach marketing of the company's own plans to the shareholders and analysts. Rather than sitting in our offices and assuming that changes in the numbers would be interpreted in a certain way, what was needed was to contact the analysts and major shareholders and, if necessary, go visit them in person and explain precisely what was going on. In essence, we'd be saying something like this. ``Look, for years you've been hoping we'd crack the Fortune 500 in a big way, and we think we're going to pull it off this year. But because of the crazy laws in the US about pricing, we have to structure the transaction like this, and so every time we make a new sale, it looks as if our marketing budget went up when in fact nothing of the sort occurred. We know you're concerned about eroding margins, but we can't afford to pass by the Fortune 500 because of an accounting rule, and neither can we let our success there kill off our existing marketing and sales efforts. Here are our forecasts with and without the Fortune 500 program; you'll see how much it will really contribute if it works. To make things clearer during this period, every quarter we'll break out the effects of this accounting rule in our financial reports so you can see we haven't really let our cost of sales get out of control.''

There are two different ways management can react to a problem; either passively: seeing their freedom of action constrained on all sides by history and expectations, or actively: looking at how best to deploy the enormous assets of the company to do what must be done. This incident illustrates how much outlook can affect outcome.

I don't know what ultimately happened in this case. I was so appalled by what I heard that I vowed to never attend another management meeting, and I never have.

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Editor: John Walker