Relevant Costs: What Are They?

Knowing relevant costs would be extremely useful to manufacturing and other operating managers. How are relevant costs defined?

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In the financial reporting world, costing is done to conform to financial standards. The customer for this information is investors and creditors, not internal managers. Accountants and finance personnel often tell operating managers that internal cost-based decisions need to incorporate “relevant costs.” This, of course, means your company’s financial system is producing “irrelevant costs” for internal managers’ decision support—something not normally stated. Knowing relevant costs would be extremely useful to manufacturing and other operating managers. How are relevant costs defined? Where are relevant costs generated and maintained? Can a system be created to provide relevant costs?

The term “relevant costs” means costs relevant to the decision at hand. Specifically, is a cost avoidable or unavoidable when the resources necessary to operationalize a solution are engaged? For businesses that focus their costing system purely on financial statement compliance, relevant costs are typically determined using a special study. An analyst starts with some general ledger numbers, and in the best case, goes out onto the factory floor and identifies gaps between those numbers and the resources actually engaged. In the worst case, finance turns the exercise into a guessing game for manufacturing by judging their analysis of relevant costs rather than assisting.

Unfortunately, comprehensively modeling relevant costs is impossible and impractical. Relevant costs differ for each decision. Modeling the relevant costs for all the decisions managers in a company might make would require hundreds or even thousands of models (one per decision type). Instead, advanced cost management approaches focus on modeling resources and operations to capture cause-and-effect relationships. Systems that model costs based on operational relationships allow for a much more straightforward determination of relevant costs for a decision.

What constitutes a cause-and-effect based cost model? First, full cost models that include generalized allocations of overhead, support and/or administrative costs to product do not. The most effective cause-and-effect based models begin with a non-financial model of resource quantity flows through processes. The nature of the relationships is tracked as resources are consumed by intermediate and final outputs. For example, a machine maintenance department (MMD) consumes a fixed amount of floor space, and machine XYZ consumes 50 hours of MMD time for basic maintenance (fixed) and an additional 10 hours of maintenance for every 500 hours the machine operates (proportional to output).

Cause-and-effect based models do not allocate idle/excess capacity or other non-causal costs; non-causal costs are attributed to the level of the organization that has the ability to manage the costs. For example, the costs associated with excess/idle plant capacity must be remedied by sales/marketing creating more demand or identifying a new product. (Manufacturing managers should be incented to create idle/excess capacity by improving efficiency.) The ultimate test is whether the model is a very realistic reflection of your organization’s resources and processes when the operational flows are turned into dollars.

The most comprehensive guide to the principles and concepts that need to be applied to create cause-and-effect based cost models for internal decision support is the Institute of Management Accountants’ Conceptual Framework for Managerial Costing. A good rule of thumb for determining if a costing approach is cause-and-effect based is whether resource capacities, including excess capacity, is immediately available from the model, not a secondary calculation or special report. Approaches such as resource consumption accounting, German management accounting methods (GPK), and some forms of capacity-based, “pull oriented” activity-based costing are normally your best bet.

>>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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