Any cost can increase, decrease, go away completely, or a completely new cost may be required. This is straight forward, and the obvious solution is to trace costs based on the nature of their “avoidability.” Unfortunately, to do this you must know every decision you will make and tag each cost for all the decisions—an impossible task.
Since it isn’t possible to build a cost model that directly tracks avoidability, how can you get to this important characteristic? The closest characteristic of costs to avoidability is whether a cost has a fixed or variable relationship with the output it produces. This relationship can be modeled and tracked consistently; however, there are a couple of pitfalls when applying this approach.
First, it’s not really about the costs. Costs are a representation of resources. Monetizing resources can and probably will distort their characteristics, because money can be broken into very small units and resources often cannot.
The second pitfall is identifying the output. Traditionally, the characteristics of fixed and variable are applied in relationship to a final product or service, but this hides a lot of information about resources relationships within the production process. For example, equipment maintenance cost may look like totally fixed costs from a final product perspective. However, if you examine the cost of maintenance with maintenance hours as an output, you may discover many costs are proportional to the number of maintenance hours consumed by various machines. This could provide insight into avoidable costs and a range of improvement opportunities.
The third pitfall is a set of traditional assumptions. Variable costs are typically considered avoidable and fixed costs are considered unavoidable which may not be the case. The combination of these three pitfalls creates a vast number of errors that are often confuse business decisions.
Create a cost model
The key to creating effective information about avoidable and unavoidable costs is to create a model of the organization’s resources and costs that reflects the cause and effect relationships between resources as they interact in a productive process. If you start with operational modeling before applying cost, the first pitfall can be eliminated. The more discrete the model, the clearer picture you will have of the relationships between the resources.
Going back to equipment maintenance, what causes the maintenance demand: regular monthly activities, operating hours or breakdowns? And what is the relationship of the various resources in the equipment maintenance work group to the output of maintenance labor hours?
Evaluating fixed and variable relationships at this level of detail overcomes the second pitfall. This is a level of detail operational systems look at routinely, but where financial systems seldom explore. Overcoming the third pitfall requires only thought and understanding if pitfall one and two have been overcome and solid information exists. For example, if you consider investing in new equipment that requires less maintenance, the quantity of maintenance labor hours will decrease. Will it decrease enough to require fewer maintenance technicians? If you don’t decrease the resources, cost won’t be avoided.
Traditional cost accounting isn’t focused on avoidability. Determining avoidability typically involves a special analysis and an ad hoc cost model—both of which are highly susceptible to the three pitfalls. The more mature and accurate costing approaches are grounded in operational modelling, reflect cause and effect relationships, and track fixed and variable relationships at a resource level to produce consistently high quality of decision support information.
Larry White, CMA, CPA, CGFM, email@example.com, 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.