What Is True Cost?

Feb. 25, 2014
Figuring out the “true cost” of a product, project or process is important for internal management. It requires a continuous costing approach.

Everyone associated with cost information—whether in operations, sales or finance—has either asked for or been asked for the “true cost” of a product, project or process. The term seems like it should have meaning, but does it? Law requires financial statements to tell the truth, and product cost, under the title “cost of goods sold,” is presented on the financial statements. However, when “true cost” enters the conversation, it is usually used in contrast to cost information constructed for financial statements. Why is this?

Financial statement information is produced in accordance with accounting standards, a financial model constructed primarily for the benefit of investors and creditors. The information must be truthful in that it must be based on data collected and constructed in accordance with the standards.

The “true cost” people want is for internal management decisions for which financial statement cost information is known to be inaccurate or insufficient. “Truth” is a loaded word because the natural antonym is untruth or lies; however, a quick look at Wikipedia reveals eight major theories of truth. The most applied theory is the Correspondence Theory, which defines truth as conforming to an external reality. Cost information for financial statements conforms first and foremost to accounting standards. What is the “external reality” for cost information for internal management decisions? The Institute of Management Accountants’ (IMA) Conceptual Framework for Managerial Costing defines correspondence with a company’s resources and operations as the correct external reality for cost information for managerial decisions.

Most accountants will argue that financial statements reflect a company’s resources, but only in a form an accountant can use. The distorting issue for everyone else is the lack of insight into cause-and-effect relationships between resources, processes and products. Financial statements provide very weak causal insights because of generalized allocations. Cost information for internal managerial decisions needs to have much more clarity and differentiation about the strength or weakness and the nature of the causal relationship. Allocations are never appropriate for costing for internal decisions because they distort cause-and-effect relationships.

The way to model costs for management decisions is to map the input quantities of resources that are used to create the outputs for each step of the process. Since the acquisition of resources (labor, equipment, material, etc.) is the cause of all costs, money will logically flow with the quantities of resources consumed. The primary exceptions are the existence of weak causal relationships such as idle time, when no output is needed from a resource, or non-productive time, when the resource is engaged in maintenance or training. Costs with weak causal relationships are relevant to organizational profitability, but they might not be relevant to product cost and many production floor improvement decisions.

The typical approach to determining “true cost” is argument followed by special studies that dissect existing—but inadequately designed—cost information. What is needed is a continuous costing approach that bases it calculations directly on operational resource information, such as manufacturing enterprise solutions.

Costing based on resource flows is not a common design in much of the world. Costing approaches such as Resource Consumption Accounting, the German GPK (grenzplankostenrechnung) approach, and time-based activity-based costing provide increased visibility into resource use, capacity and costs tied directly to resource flows. These approaches take an internal decision perspective on cost, and can be evaluated using the IMA’s Conceptual Framework for Managerial Costing, which defines the principles, concepts and constraints that need to be considered in designing such an approach to costing.