Does Manufacturing Need a Better Costing Approach?

External financial reporting standards are inconsistent with the essential principle for costing for internal decision support: The reflection of cause and effect relationships.

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The signs that your company needs to improve its costing won’t come from the obvious place, Finance. Why? Finance’s most urgent need for cost information is the financial statement presentation of the inventory value and cost of goods sold. This information can be generated by a fairly simple model that places direct material, direct labor and overhead into large pools and allocates the costs “reasonably” and consistently. The simpler the model, the less internal decision support information it provides.

The demands for improving your company’s costing approach will come primarily from Operations and Sales; however, the manner in which these needs will be expressed normally won’t be a straightforward request.

Typical expressions are anger, frustration, gaming behaviors and substantial disregard of financial measures created from irrelevant cost numbers. Invariably, these behaviors become ingrained in organizational culture; people learn to deal with their situation, and they fear that a change would just be different, not better.

Decision support focus
Companies and financial officers that recognize the need for a new costing approach have two options. One is to apply what they learned in their cost accounting courses and create a more detailed traditional standard cost model with more cost pools, more allocations and more variations. This approach has one significant, often fatal defect that simply wasn’t taught in school. External financial reporting standards are inconsistent with the essential principle for costing for internal decision support: the reflection of cause and effect relationships.

The second option is to implement a parallel costing approach, which focuses on decision support. This is often viewed as problematic by Finance since it appears to be another set of books. Finance conveniently forgets that many differences exist (“sets of books”) between financial information for taxes, external reporting and often regulatory reporting. Additionally, Finance is on much less solid ground from a costing knowledge base, since decision support is not the primary objective of required college cost accounting courses.

In most cases, companies will pursue option one. Improvements can be made, particularly if it is applied with awareness of the differences between external financial reporting standards and the application of comprehensive cause and effect modeling. Some techniques associated with the lean accounting methodology provide useful insights into creating relevant information for the production and sales workforce. However, option one has definite limits.

Option two, a dedicated decision support approach, is the only way to achieve seamless integration of operations, resource capacity information, and their financial impacts.

Advanced costing approaches
Advanced costing approaches such as this include capacity sensitive forms of activity-based costing and resource consumption accounting. These approaches should begin with a cause and effect model of operations and the flow of resources in the organization. They rely as heavily on operational data as on financial data.

The principle of cause and effect means that allocations based on generalized drivers cannot occur, as they will distort information by injecting costs into a value stream that don’t have a causal relationship to the operations or resources consumed.

The most comprehensive approaches produce clear marginal information on resource capacity and cost. Marginal information can only be obtained by understanding and tracing fixed and proportional relationships as they move through the value chain.

The International Federation of Accountants (www.ifac.org) produced an information paper titled, “Evaluating the Costing Journey: A Costing Levels Continuum Maturity Model” that provides insight into the capabilities of available costing approaches. Companies with tight margins, large investments in capital (including human capital), complex operations, and longer timelines for investment and development should focus on the right-hand side of the maturity model (page 19 of the IFAC document).

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 accountants’ ability to contribute to improving business performance.

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