Exactly What Constitutes Savings?

Nov. 30, 2012
The benefit to manufacturers of a resource based cost model is the visibility and correlation of financial and non-financial information. When a planned level of production is met, new opportunities for growth or savings can be realized.

Operating personnel, especially in manufacturing, frequently face the issue of defining savings. It is a contentious issue between operations and finance that can produce suboptimal results. The operating view is that any decrease in workload or increase in the ability to produce output is a benefit to the organization and should be counted as savings.

The hardcore finance answer is: If expenses aren’t reduced (normally this means cash outflow cut), there are no savings. The logic of this answer is correct from a particular perspective, but does such an answer help the organization?

>> Cost Information Essentials: Read Larry White’s recent column on cost information and see how cause-and-effect modeling is the right approach for manufacturing. Visit http://bit.ly/slant106

The fundamental job of operations managers is to create excess capacity by becoming more efficient at producing the organization’s goods and services. Operations should be given credit for every step in that direction. The business as a whole needs to make decisions and take action to use capacity made available from improvements in operations. Of course it’s not just operations that should be striving for efficiency, every area of the business should.

The need to invest
The flip side of becoming more efficient is that businesses also need to continuously invest in new products/services, new technologies, new markets, and new management techniques to maintain and grow their market position. These efforts require resources. It is logical that the human resources who have successfully improved current operations should be leading candidates for further improvements. Beyond human resources, using existing equipment and space leverages infrastructure and minimizes the need for new capital. 

Effective costing approaches that are tightly integrated with operations, such as Resource Consumption Accounting, contribute pivotal information to this longstanding issue between operations and finance.

First, operationally focused cost models identify resource capacity and its consumption by productive and necessary nonproductive use (for example: maintenance). Resource capacity that is not consumed is clearly identified (in operational quantities and cost) as idle/excess capacity.

Excess capacity may or may not result in the traditional finance definition of savings, and that determination depends on the specific nature of the resource capacity involved, the company’s strategic situation, and the company’s management philosophy. But idle/excess capacity should always be visible for real time or near real time analysis and decisions about how to address it.

Second, idle/excess capacity should never be arbitrarily allocated to (and hidden in) product/service cost. Idle/excess capacity has no causal relationship with product/service cost and is properly assigned to the internal organization— ideally, at a management level that has the broad authority to adjust operations, sales, and/or marketing to generate value creating or profitable uses for the idle/excess capacity.

Again, visibility of options and opportunities is what highly effective cost and operational modeling provide.

Averages hide details
Traditional accounting measures build their financial reporting and control models from a monetary point of view. This means the details of operations and resources are substantially lost in averages and allocations, which are all too easy to create in the highly malleable and operationally disconnected monetary view.

Cause and effect relationships between resources and processes are lost in most financially generated cost models. Cost models based on resources and operations ensure the nature of the operational quantities consumed, or not consumed, are reflected in non-financial and monetary quantities for organizational metrics. Cause and effect relationships are rigorously maintained.

The benefit of a resource based cost model is the visibility and correlation of financial and non-financial information. When a planned level of production is met, increases in idle/excess capacity costs are an operational success and provide the business with the opportunity to leverage that success into new opportunities for growth or harvest savings, as the business situation requires.

>> Larry White, CMA, CPA, CGFM, [email protected], is the Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org), which seeks to connect cost information to operational business performance metrics.