Product Cost: Making It Decision Oriented

Product cost is a critical manufacturing metric. And it is a cost about which financial reporting standards provide a great deal of guidance—to ensure that the accountants have met reporting requirements and that the financial statement was audited.

Aw 704 Finance View10

Could there be any problems? For one, there is a problem of perspective. All of that excellent effort wasn’t focused on meeting your operational needs or requirements.

Accounting standards require “full cost,” which, by definition, includes all costs relevant to production of a product, and it is useful for investors and creditors making intercompany comparisons. However, this full cost is not calculated in a manner to support the rigor needed by managers inside the company for decision support.  Managerially useful product costs have two fundamental requirements: the product cost must be built to accurately reflect the cause-and-effect relationships of operational and support resource flows, and it must reflect the
nature of those relationships.

Avoiding a cost

Why is this necessary? There is a saying, “different costs for different purposes,” and it applies in decision support. Different decisions involve new resources or using existing resources differently; however, a well-designed baseline model should satisfy a diverse range of information requirements. The key cost concept for decision making is whether a cost is avoidable or unavoidable, but this can’t be modeled, because it changes for every nuance of a decision.

Instead, in effective management accounting, we model the chain of causal relationships from support resources through production resources to the final product. And we model the nature of those relationships—fixed and proportional, and the quantities of resources used or not used. This information, when overlaid with monetary value, allows managers to logically determine whether a cost is avoidable or unavoidable for a wide range of decisions.

The term for costs developed with strict adherence to cause and effect is “attributable cost.”  Attributable cost is always less than full cost because it is based on causal relationships. It does not include arbitrarily allocated costs. For example, excess/idle capacity has no causal relationship to the products produced. If you have a machine dedicated to making products A and B with 500 hours of idle capacity, what is the relationship of those 500 hours to A or B?  The idle capacity could be used to make product C, and unquestionably, that capacity would not impact the cost of A or B. Why should idle capacity impact the cost of A or B?

The other important characteristic of attributable cost is that its calculation supports the derivation of all other cost concepts—marginal and incremental cost, throughput margins, contribution margins and gross margin—if required. The question often comes up—what happens with the costs not included in attributable cost? How do they get factored into product cost and product pricing?

The answer is fairly simple: the same way that any other organizational cost not in product price gets factored in—through profit margin. In fact, unitizing costs into product cost as a way to ensure that costs are covered is a risky approach to profitability management. You need product costs that only reflect causal relationships and don’t hide the problems or opportunities associated with excess or idle capacity and other production and support costs that don’t have a clear causal relationship to product.

Routinely producing this type of useful marginal costing information is relatively rare in the United States, but has been used as part of production control in Germany since the late 1940s. Resource consumption accounting uses this approach to connect costs with operations in a manner that facilitates decision making throughout the organization.

Larry White, CMA, CPA, CGFM, lwhite@rcainstitute.org, is the Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org), which seeks to advance management accounting’s ability to contribute to improving business performance.

More in Home