How many times have you wished or asked for a “relevant” or “true” cost? What this really means is something other than the cost calculated by the financial accounting system for external financial reporting.
It is obvious that the cost figures used for financial reporting are much less than the whole story, but they are critical information to senior executives whose compensation and job performance are tied to financial statement metrics. For this reason, all financial information used in an organization will have to be evaluated for its connection to and impact on periodic financial reporting results. It is a fact of business life.
Let’s take a high-level look at what is necessary to ensure that the internal decision-oriented cost information/systems manufacturers need can be reconciled to external financial statements.
Internal management decision-making cost systems must be based on cause-and-effect relationships driven by an operational model of resources and processes. First resources are identified, then the flow of real quantities of resources through processes is modeled, and finally costs are applied to the flow of resource quantities. The goal is to represent the flow of resources with money in a manner that clearly reflects the causal relationships of the operations and resources modeled. Cost models focused on internal decision support must use different principles and conventions than financial accounting and external reporting. An example is depreciation. The idea of a “fully depreciated” resource is highly distorting for internal decisions; there is always a cost for using an asset until you decide it is no longer needed, so many advanced cost models use replacement cost depreciation.
It is impossible to create a comprehensive list of the differences between an organization’s internal decision support cost model and financial accounting model; too much depends on the nature of the organization’s models. Some of the issues involved:
- How much of the organization is included in the decision support cost model?
- How detailed is the organization’s standard costing?
- How detailed is the organization’s costing for non-manufacturing areas?
The most effective way to build a reconciliation process is to carefully track the differences in how costs are established and applied when the decision support model is established, and ensure it is clear how those costs compare to the financial accounting costing system. Several categories of issues may arise. Here are a few:
- Differences in the amounts. An example is when different depreciation conventions are used.
- Differences in timing. Examples are inventory methods and period costs.
- Differences about what costs are included in the two models.
The key is to map the universe of costs included in the decision support model and where those costs are accumulated (or not included) in the financial accounting system. This mapping will require continual monitoring as resource, processes and accounting rules change. Fortunately, information technology is increasingly capable of multi-dimensional tracking, and with a clear design from the outset, will produce information for reconciliation.
One simplifying perspective to keep in mind is that at the entity level, the reconciliation of the income statement and the decision support focused operating results is simple. For example, the total difference between the two depreciation schedules will also be the differences in the income statement’s net profit and internal cost systems' entity-level gross margin.
Many of the challenges mentioned above come into play only when one tries to compare segmented product profitability numbers. This raises a question: If financial accounting/reporting cost information is suspect for internal decisions, are segmented level comparisons/reconciliations needed?
>>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.