When looking at organizational costs, it is indisputable that operational metrics are leading indicators of cost performance. Indisputable, perhaps, but not widely known and infrequently used to manage the organization.
Sadly, in most organizations, financial results attract the focus of management attention even though they are lagging indicators. To make matters more frustrating, operations can have rock solid data of improving efficiencies for days or weeks leading up to the financial statements, then operations is asked to explain why they didn’t reflect in financial results. Why is manufacturing on the hot seat? It’s typically accounting standards and systems that create nearly indecipherable timing or computational differences from the clear reality of operational performance.
The most well-documented example of this is inventory reduction during a lean implementation. As inventory decreases (a very good thing), most companies experience an increasing cost of goods sold during the inventory reduction period(s) because of the accounting conventions associated with inventory valuation. Every accountant should know this; it’s taught in accounting courses (and I’m going back 25 years), but it still kills many lean initiatives.
Another common example occurs when manufacturing achieves increasing efficiencies in production over a period—meeting production targets with less labor and equipment utilization. The financial period closes and product cost hasn’t changed from the prior period, and now manufacturing is under pressure from the CFO and senior management to reduce product cost. What’s going on? First, the sales targets should have been increased as soon as the excess capacity started to be realized, putting some heat on sales and marketing. Second, manufacturing shouldn’t lay off or reduce the hours of personnel who have successfully achieved efficiencies. Third, the CFO should be on the hot seat to explain why the organization’s costing doesn’t reflect the realities of operations in a more strategic and logical way.
There are many more examples of bad financial metrics and the consequent bad decisions that happen when days or weeks of positive operational metrics are obliterated by after-the-fact financial statements. What can be done? There is a range of solutions, but the key to all of them is that manufacturing must stand up for quality and efficacy of its key operational measures. Manufacturing almost certainly has more metrics about its performance than any other component of the organization, including finance.
The most comprehensive solution is to implement an advanced cost management solution that begins with a model of operational resource quantities, clearly delineates the uses of resource capacities (in a manner that recognizes idle capacity and doesn’t reallocate it into product cost), and allows costs to logically and clearly reflect operational performance. The problem is this model won’t comply with accounting standards, and will require the CFO to maintain extensive reconciliations to explain the differences—in particular, timing differences between operation improvements and when they will show up as good financial statement results. Costing approaches such as Resource Consumption Accounting (RCA) and capacity-sensitive applications of activity-based costing are examples of appropriate advanced cost management solutions.
Another potential solution is to ensure senior management agrees that key operational metrics are valid indicators of manufacturing performance. The important part is to ensure the CFO is responsible to explain the nature and timing of the financial statement impact of the agreed-upon operational metrics. It may also be necessary to establish some new management paradigms, such as making sales and marketing, product R&D, or even general management (in the case of over-purchase of capacity) responsible for taking action on excess capacity costs and some accounting standard-based product cost reductions.
>>Larry White, CMA, CFM, CPA, CGFM, email@example.com, is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.