Allies for Manufacturing Can Help Improve Cost Information

Aug. 18, 2015
Quality cost information will help your organization make good decisions about product profitability.

We often think of sales and marketing as being focused on price and revenue, but their activities involve significant costs that represent opportunities to improve profitability and refine a product’s pricing. Many other organizational components can benefit from having their activities more causally aligned with core value creation. Let’s explore the state of cost information and the value of improving it. The ultimate goal is to have quality cost information so the organization can make good decisions about product profitability.

Marketing is very interested in product pricing, and a well-established structure exists for analyzing selling costs from the price perspective. Price waterfall diagrams typically begin with list price and subtract various discounts and concessions to get an invoice price; then subtract credit rebates and terms to get a net price; then various costs traceable to a product such as commissions, marketing, customer specific, merchandising, shipping, wholesaler warehousing, etc. are subtracted to get a pocket price. At this point, marketing subtracts fixed and variable product costs to determine a “pocket margin.”

Accounting and sales systems normally track the discounts, concessions and rebates that are reported on financial statements. Other costs are often aggregated into selling, general and administrative (SG&A) costs on financial statements. This means marketing may have to initiate tracking of costs to collect important information on customers, distribution channels and salesperson performance.

The pocket margin covers all the non-production and non-product-specific selling costs of the organization and profit. These costs are typically tracked for budgetary control and overall profit management, but are reported as SG&A costs on financial reports. Companies seldom make an effort to track how they support sales, marketing and manufacturing, but where cause-and-effect relationships exist, the opportunity to gain tactical and strategic insight into improvement opportunities is lost.

Manufacturing product costs are traditionally broken into direct materials, direct labor and overhead (which might be broken down into fixed and variable). Product cost is important information both strategically and tactically. Variable cost represents the low price limit for a product (no contribution to fixed costs means a product should definitely not be produced). Insight into product cost is critical in making marginal and incremental decisions about special order pricing/profitability, product improvements, sourcing decisions, and production improvements and investments.

Product cost is important to accounting because it is needed for external financial reporting and taxes, so accounting will calculate a product cost to comply with those requirements. The level of detail can vary widely from including numerous complex standards and cost variances to a very basic average product cost. However, very few manufacturers find cost information calculated by accountants for financial statements useful, regardless of the level of detail.

Critical cost information affecting profitability, and possibly pricing, is often not available to sales/marketing and manufacturing when accountants limit their work to financial statement costing requirements. Strategic costing based on internal management decisions and cause and effect is needed to create the cost information that provides actionable and insightful performance feedback.

Costs from all areas of an organization—marketing, administration and manufacturing—will be distorted for decision-making if non-causal allocations are applied to costs. For example, growth in idle/excess capacity is the initial result of improved efficiency anywhere in the organization. If the costs associated with idle/excess capacity are allocated to product or categorized as SG&A and not tracked separately, improvements and new capacity will not be recognized.

Manufacturing personnel are not alone in the quest for more relevant and actionable cost information, but the skillset to create them is a different skillset than traditional financial statement reporting. Advances in the collection of marketing and manufacturing data require a new paradigm based on cause and effect for design of cost information systems for the benefits to be fully realized.

>>Larry White, CMA, CFM, CPA, CGFM, [email protected], is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.