The Measurement Trap
The numbers we inherit were designed for a different economy. They now actively mislead.
The gap between precision and accuracy
Financial statements are precise to the penny. They’re also increasingly wrong about what matters.
In the 1950s, earnings explained around 90% of stock price movements. Today, that number has collapsed to 50%. This isn’t noise — it’s signal. The market is telling us that accounting no longer captures what creates value.
The reason is structural. Accounting was designed for an industrial economy where value resided in tangible assets: factories, machinery, inventory. You could count these things, depreciate them on a schedule, and the numbers meant something.
That economy is gone. Value now comes from intangibles — patents, brands, customer relationships, software, organisational capabilities. Accounting doesn’t know how to handle them. The result: a widening gap between reported numbers and economic reality.
This essay is about that gap — why it exists, how it misleads, and what to measure instead.
The intangibles problem
The distortion is systematic.
If you build a brand internally — invest in marketing, customer experience, reputation over years — accounting treats it as an expense. Current profits take the hit. The asset doesn’t appear on your balance sheet.
If you buy a brand through acquisition, accounting capitalises it. Suddenly it’s an asset, proudly displayed. Your balance sheet looks stronger.
The logic is backwards. It incentivises buying capabilities rather than building them — exactly wrong for sustainable competitive advantage.
The same pattern applies to R&D, employee training, software development, and customer acquisition. These are investments that generate future returns. Accounting treats them as costs that reduce current profits.
The consequences compound. Balance sheets understate asset bases by missing intangibles. Profitability ratios (ROE, ROA) are overstated because the denominator is too small. Capital allocation gets distorted — too much flows to mature companies with tangible assets, too little to growth companies investing in intangibles.
Financial statements obsess over factories and inventory (commodities available to anyone) while ignoring the sources of actual competitive advantage.
The cost accounting trap
The problem runs deeper than intangibles. Cost accounting itself distorts reality.
Consider “product cost” — one of the most common numbers in business. Managers use it to decide pricing, product mix, make-vs-buy decisions. It feels objective.
It isn’t. Product cost is a mathematical phantom. You never pay money to a product. You pay wages, rent, materials, utilities. These get allocated to products through formulas that are ultimately arbitrary.
Change the allocation method and product costs change — without any change in economic reality. A product that looks profitable under one allocation becomes unprofitable under another. The “cost” is an artifact of the accounting system, not a fact about the world.
This matters because cost accounting drives behaviour. Managers optimise for metrics that don’t reflect value creation. They chase cost reductions that look good locally but destroy throughput globally.
The classic example: keeping machines busy. Cost accounting rewards high utilisation — spreading fixed costs across more units lowers “cost per unit.” So managers keep everything running, even when there’s no demand. Inventory piles up. Cash gets trapped. The constraint sits idle while non-constraints overproduce.
This is efficiency theatre. The numbers improve; the business gets worse.
The throughput alternative
Goldratt proposed a different framework: three measurements, nothing else.
Throughput — money generated through sales (selling price minus truly variable costs, primarily materials). This is the rate at which the system generates cash.
Inventory — money the system invests in things it intends to sell. This is cash trapped in the system.
Operating Expense — money spent converting inventory into throughput. This is the ongoing cost of running the system.
That’s it. No product costs, no allocations, no phantom margins.
The shift in perspective is profound. Value is realised at the moment of sale, not during production. “Adding value” to a product before it sells is an illusion — you’ve added cost, not value. Value only exists when a customer pays.
This reframes every decision. Instead of asking “what’s the product cost?” you ask: what is the impact on throughput, inventory, and operating expense? The first question invites allocation games. The second forces clarity about cash.
Cash over profits
The finance perspective sharpens the point further.
Accounting profits can be manipulated. Provisions, depreciation schedules, revenue recognition, stock option expensing — these involve judgement calls that shape reported numbers. Two companies with identical economic performance can report very different profits depending on accounting choices.
Cash can’t be manipulated. You either have it or you don’t.
This is why sophisticated investors focus on cash flow statements rather than income statements. Cash flows avoid the distortions of accrual accounting. They show real economic capacity — the ability to invest, repay debt, return money to shareholders.
The mantra: revenue is vanity, profit is sanity, cash is king.
For managers, this means tracking cash generation, not just accounting profits. A business can be profitable and broke simultaneously if cash is trapped in working capital. Profitable and Broke makes this concrete — working capital constraints kill growing businesses that look healthy on the income statement.
Future over past
Accounting looks backward. It characterises what already happened — historical costs, past revenues, accrued expenses.
Finance looks forward. The value of a business is the present value of its future cash flows. What happened historically matters only insofar as it helps predict what will happen next.
This distinction changes what you measure.
Accounting asks: what were our margins last quarter? Finance asks: what margins can we sustain, and for how long?
Accounting reports: we earned this much profit. Finance asks: did we beat our cost of capital? A profitable business that earns less than its cost of capital is destroying value, regardless of what the income statement shows.
The value creation imperatives are clear: beat your cost of capital, sustain the gap for many years, and reinvest at high rates. These prescriptions correspond directly to strategy — competitive advantage, barriers to entry, growth opportunities.
Constraints over averages
Cost accounting optimises averages. Throughput thinking focuses on constraints.
The difference matters because systems don’t behave like averages. In any dependent system with variability, a tiny fraction of variables determines almost everything. The constraint — the weakest link — sets the pace for the whole system.
Improving non-constraints doesn’t improve the system. It creates excess capacity that can’t be used, inventory that can’t be sold, costs that don’t generate returns.
This is why Hidden Bottleneck matters. The constraint isn’t execution speed — it’s decision speed. Weeks disappear waiting for approvals while the operational machine sits idle. Cost accounting doesn’t see this. It measures utilisation of resources, not throughput of value.
Constraint thinking asks different questions. Where is the bottleneck? Are we exploiting it fully? Is everything else subordinated to serving it? These questions cut through the noise of local metrics to focus on what actually limits performance.
What to measure instead
If the default numbers mislead, what should you measure?
Cash flow, not accounting profit. Track cash generation, cash conversion cycle, free cash flow. These tell you whether the business can fund itself, invest in growth, and return money to owners.
Throughput, not product margins. Evaluate decisions by their impact on system-wide throughput, not phantom product costs. Ask: does this increase the rate at which we generate cash through sales?
Leading indicators, not lagging reports. By the time earnings are reported, the market has already priced in the information. Focus on the metrics that precede financial results — customer adoption, pipeline velocity, retention rates, constraint utilisation.
Return on capital, not just profitability. A business earning 8% on capital in a world where capital costs 10% is destroying value, even if it reports healthy profits. The hurdle rate matters.
Constraint performance, not average utilisation. Measure what’s happening at the bottleneck. Protect its uptime. Accept that non-constraints should have spare capacity — keeping them busy 100% of the time creates queues and destroys flow.
The information test
Goldratt drew a sharp distinction: data is any string of characters describing reality; information is the answer to the question asked.
Most measurement systems produce data, not information. They track everything but connect to nothing. Dashboards proliferate while basic questions go unanswered.
From Data to Information makes the point: data only becomes information when it passes through a decision process. Start with the decision you need to make. Work backward to the evidence required. Everything else is noise.
This inverts how most companies build measurement systems. They start with available data, build dashboards, then wonder why decisions don’t improve. The right sequence: define the question, design the decision process, then pull the required data.
The question matters more than the precision of the answer. A rough number that addresses the right question beats a precise number that addresses the wrong one.
The practice
This isn’t abstract. It’s operational.
Audit your metrics. Which are accounting artifacts versus economic realities? Product costs, allocated overheads, “fully loaded” rates — these are accounting constructs. Throughput, cash flow, constraint utilisation — these reflect economics.
Follow the cash. When a decision looks good on the income statement, trace the cash. Does it generate cash or consume it? When? Working capital effects, timing of receipts, capex requirements — these matter more than accrual profits.
Find your constraint. What actually limits performance? It’s rarely what you think. Often it’s a policy, an approval process, a decision bottleneck — not a physical resource. Cost accounting won’t reveal it. Throughput thinking will.
Measure forward, not backward. What are the leading indicators for your business? The metrics that move before financial results change? Customer health scores, pipeline quality, constraint efficiency, cash conversion — these predict; accounting reports confirm.
Kill phantom metrics. Any number built on arbitrary allocation is suspect. If changing the allocation formula changes the answer, the number doesn’t reflect reality. Question it.
The gap persists
The 40-point drop in earnings relevance isn’t noise. It’s a structural shift.
Markets have adapted. Investors use alternative data — app downloads, satellite imagery, web traffic, real-time sales signals. They track leading indicators that precede financial results. They focus on cash flows and strategic metrics that accounting doesn’t capture.
Accounting standards haven’t caught up. They add disclosure requirements without restoring relevance. They focus on preventing fraud (important) while ignoring the bigger problem: irrelevance.
Managers caught in the middle face a choice. Manage by the numbers accounting gives you, and optimise for metrics that no longer reflect value creation. Or build your own measurement system — one that tracks throughput, cash, constraints, and leading indicators.
The first path is easier. The second is right.
This essay synthesises ideas from:
Connects to Library: Theory of Constraints · The End of Accounting · How Finance Works · The Haystack Syndrome
See also: Reading Guide for the complete collection of Field Notes.