Standard Costs Are Not Dirty Words

Manufacturing and operational metrics are often available in real time; operations management places a high priority on immediate response and preventative actions to avoid failures from diminished performance. It may surprise many operations personnel to learn that the same is not true in accounting.

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In the world of financial accounting operations, after-the -act inspections and re-performance of transactions to evaluate quality are standard practice. Statistical process control is not embraced by the financial internal control and audit community. The MESA Metrics Guidebook, published by the MESA International organization, defines metrics as either action-oriented or report-oriented, and this is a pretty accurate description of the different orientations between operations and accounting metrics.

However, leading thinkers are continuously exploring the possibilities to bring financial metrics toward real time and connect with operational metrics. The key to achieving this won’t be installing sensors in the financial accounting system to capture debit characteristics as they wiz by—if only it were that easy.

The key to approaching real time financial metrics will be the creation and use of standard costs that integrate with operational resource measures. The term “standard cost” is probably a dirty word for many operations personnel who have struggled to explain labor, material, overhead and ”whatever else” variances to accountants doing traditional standard costing to value inventory and determine cost of goods sold for external financial reporting.

Standards for decision making
Let’s revisit the idea of standards with a focus on creating information for decision making, not external financial reports.

Whether you are dealing with an operational or cost metric, knowing the standard of performance is very useful information. If new packaging equipment is designed to achieve throughput of 3,600 units per hour, your objective is to achieve that design standard.

For various reasons, you may only achieve a stable rate of 3,000 units per hour on average. For control purposes, you establish 3,000 as your expected standard (while you continue seeking improvements).

This standard requires certain resources to be engaged in the process—labor, machines, maintenance, power, other equipment. Based on these inputs, you can create consumption standards, for example kilowatts per hour. Just as your output units will vary and you’ll investigate positive and negative deviations, inputs will vary and you’ll want to investigate positive and negative deviations.

These inputs are then expressed in their standard costs e.g., $0.15/KwH.  When you identify an innovation that boosts throughput to a new level of 3,250 units per hour, you’ll reset your operational standard, and review the resource mix associated with the post-innovation operations.

These actions go hand in hand “if”—and this is a very important “if”— your costs are linked to operational resources in a quantitative cause and effect manner as described.

Know resource consumption
The cost standards must reflect the resource input standards accurately. The key to real time cost information is to impute cost information based on knowledge of the resource consumption standards (e.g., how much packaging material is used for each unit?) and the fixed or proportional relationship of a resource to the output (i.e. whether resource consumption changes with the output level or not?).

This use of standards allows rapid computation of accurate costs in real-time in the capacity range of your existing operational resources, facilitating economic decision making. 

Neither operational nor cost standards are substitutes for thinking or analysis.  These types of standards form the foundation for advanced cost and operational modeling that can dramatically improve the decision usefulness of cost information.

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.

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