Product Cost and Total Customer Cost

Manufacturing managers need to realize they are in a solid position to take the lead in expanding discussions on profitability improvement beyond product cost and into total organizational customer costs.

Larry White, Executive Director of the Resource Consumption Accounting Institute
Larry White, Executive Director of the Resource Consumption Accounting Institute

 

Manufacturing managers are under continuous pressure to manage product cost, also known as the cost of goods sold. This financial metric is reported on the income statement and is the basis for inventory value on the balance sheet. Management’s focus on financial statement performance, usually led by the CFO, often results in a stove-piped focus on product cost when seeking to improve profitability.

It is important to remember, however, that product cost, as defined for financial statements, is only a part of the cost of servicing a customer. Furthermore, standard financial statements do not provide the full cost of servicing a customer, and most supporting accounting systems cannot generate a comprehensive customer profitability metric.

The lack of established, effective customer profitability metrics means most of the pressure falls on manufacturing because the company has the most cost data on manufacturing operations and can easily tie product cost to customers and revenue. However, customer costing and profitability is a cross-organizational metric. The sales force is directly tied to customers, distribution is tied to customers, marketing is customer-oriented, accounting activities such as billing and collections are tied to customers, R&D may be involved in customer requirements, and even senior management might spend time with significant or difficult customers.

Effective customer profitability data requires an advanced costing system design that can collect customer-specific data across the organization based on clear and logical cause-and-effect relationships. This will differ significantly from accounting systems, which do costing purely for financial statement reporting and may lump nearly all the above costs into “Selling, General and Administration” costs.

The difference in profitability between customers buying the same product can be significant, and could be hidden by traditional costing for financial statements. A “good” customer orders standard products, accepts normal delivery times, takes minimal sales force effort, and pays promptly. A “bad” customer wants customizations in product or packaging, demands rush or special deliveries, takes significant sales force time and effort, might want to meet with senior management over numerous issues, and/or requires significant billing or collection effort.

On the manufacturing floor, some “bad” customer costs could make their way to the specific customer’s product cost, but many will be lost in the overhead allocations and consequently spread to all products and customers. Beyond the manufacturing floor, “bad” customer costs are often lost unless selling price concessions are captured.

Manufacturing typically has the most discrete cost data in the organization, and does more than its share to reduce cost and improve profitability. In fact, manufacturing often loses out on investment and budget decisions within the organization because of the fear of increasing product cost. Manufacturing managers need to realize they are in a solid position to take the lead in expanding discussions on profitability improvement beyond product cost and into total organizational customer costs.

A significant impediment to focusing the organization on customer profitability is the existing accounting system, and the know-how to design a costing system to collect logical cause-and-effect related customer cost information across the organization. The solution is knowledge of advanced managerial costing design, not just a new financial system.

What relatively little costing accountants and MBAs learn in college is highly focused on producing external financial statements. Few courses exist that focus on creating purely internal management-oriented costing data. Advanced costing approaches such as Resource Consumption Accounting (RCA), German management accounting methods (known as GPK in the U.S.), sophisticated activity-based costing, and other approaches that incorporate the principles and concepts of the Institute of Management Accountants’ Conceptual Framework for Managerial Costing need to be understood to effectively design comprehensive internal cost and profitability management systems.

>> Larry White, CMA, CFM, CPA, CGFM, lwhite@rcainstitute.org, is the Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org), which trains and advocates for improved cost information connecting operations to business performance.

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