Manufacturing is always under pressure to lower product cost and explain a variety of cost variances. The reason is that manufacturing resources are included in cost of goods sold, or product cost, on external financial statements, while distribution costs, cost of sales and marketing, product research and development and many other costs with clear causal relationships to the cost of producing and selling a product are not.
Financial statement information is just one perspective or model of an organization and it’s designed for external shareholders and creditors, not for the demands of internal managers. However, financial statement information dominates management decisions. Using it as the sole source of cost information can lead to poor decisions—such as over-production to manipulate inventory levels to meet financial-statement-based incentive measures, or shorting spending for manufacturing improvements.
Manufacturing operations always collect much more information than other areas of the organization. This column typically discusses improving cost information with a focus on manufacturing, but manufacturing managers should be aware of their superior position creating information for the organization on the cost of products and operations. This insight is useful when making a case to improve the quality of manufacturing cost information, pushing for more balanced and strategically valuable analytics across the entire organization’s value chain, and defending manufacturing against additional demands for trivial information.
Improved cost information for manufacturing requires advanced costing methodologies that are able to define and track the operational capacity and costs of discrete resources, the fixed and proportional causal consumption relationships between resources and their direct output (normally well below the final product level), the non-causal relationships that need to be assigned to organizational levels, and idle capacity at the discrete resource level.
This type of cost information is radically different in design and perspective from financial statement information. However, the benefit of an operationally focused cost model is huge: full visibility of the cost of human and physical resources in the entire value chain; the ability to make marginal and incremental decisions, such as make/buy, outsourcing, and special orders without the delay of special studies; and clearer communications about the economic impact of all operational decisions and improvements. Once the cost model infrastructure is created for manufacturing, it is available to the entire organization.
The Big Gap
When advanced managerial costing models are implemented, anything beyond manufacturing typically requires extensive remedial analytical effort to identify even rough estimates of cost and operational data. The biggest gap is normally in sales and marketing where virtually no resource-specific operational or cost data is collected despite the clear causal relationship to product and customer profitability.
Modeling causal relationships using solid operational data throughout the organization results in clearer product cost and profitability information. It will also stop many types of “gamesmanship “ that can be played using financial statement product cost, and allow cost and profitability to be evaluated along many dimensions: product, customer, distribution channel, and others based on your business needs. The manufacturing focus on hard data and process improvement will benefit all areas of an organization.
It is extremely frustrating to be asked to collect cost data that won’t benefit manufacturing and know that later you will be asked to explain changes and differences in that information. These requests often focus on some nuance of cost of goods sold. Manufacturing should proactively push a broader and more strategic definition of product cost and profitability that include all the resources consumed in the value chain. This will raise the level of the debate, highlight manufacturing’s strengths and contributions, and identify gaps in organizational cost and profitability information that can facilitate strategic improvement.
>> Larry White, CMA, CPA, CGFM firstname.lastname@example.org, is the Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org). which trains and advocates for improved cost information connected to operational business performance.