Advanced Costing Can Enhance Continuous Improvement

April 13, 2016
What needs to change to create cost information that aligns with operations and accurately reflects continuous improvement efforts?

To the dismay of manufacturing professionals, many accountants don’t understand the dynamics of continuous improvement efforts and don’t provide the type of costing support to take continuous improvement to a higher level of performance. Fortunately, the benefits of continuous improvement are so robust that manufacturing can implement improvements and show enough results to keep finance and senior executives satisfied. But manufacturers often need to keep part of the success story hidden to maintain their flexibility and maneuvering room.

Through the lens of traditional financial reporting, cost information about operating improvements can become highly distorted from operational reality. These distortions occur because of a number of reasons: timing differences when cost savings and/or increased revenue is recognized on financial statements, the lack of immediate positive recognition for idle capacity that can be repurposed, the financial accounting math phenomena where inventory reductions lead to short-term increases in the cost of goods sold, poorly designed budget processes, and many other traditional and required practices associated with financial accounting and external reporting.

To create cost information that aligns with operations and accurately reflects continuous improvement efforts, cost modeling must make causality—or cause and effect—the primary principle guiding cost modeling. Financial accounting and reporting standards have numerous principles, but causality is not among them. The closest concept is a “faithful representation of economic phenomena,” which most manufacturing personnel will agree is a very long way from reflecting resources and operations in a manner that supports effective managerial decisions on the manufacturing floor.

What needs to change? First, most accounting models are monetary models. Cost models focused on decision support need to start with a model of the operational quantities flowing between resources in their processes. Money needs to be applied to reflect operational quantities.

Second, the leading indicator of all successful improvements is an increase in idle or excess capacity—getting more from the resources you have. A cost model that doesn’t identify excess/idle capacity won’t support continuous improvement.

Third, resources are the source of all costs and great care should be given to how they are costed. Using accelerated or straight-line depreciation is absurd; as long as a machine is in operation it should show depreciation. Replacement cost depreciation minimizes cost distortion between old and new equipment performing in the same processes.

Fourth, a cost system must make marginal and incremental costs easy to determine for any change in a process. To achieve this, the fixed and proportional nature of resource quantities and the associated cost need to be traced through a process from intermediate output to the next intermediate output. This will allow clear analysis of the marginal and incremental impact of improvements.

This list can become quite long. The simple fact is that for truly effective decision support, the cause-and-effect relationships between resources in process need to be what drives a cost model. Manufacturing has done a great job of continuous improvement around the world to improve quality and drive down cost. If accounting conventions stand in the way of logical continuous improvement and optimization, they should be set aside as a short-term impediment to long-term value creation.

Advanced costing methods always begin with an operational model of a process or organization and an understanding of an organization’s strategic goals as their guide to create cost information. This is the approach recommended by the Institute of Management Accountants’ Conceptual Framework for Managerial Costing. Costing approaches that start with the general ledger are prone to distortion because the typical general ledger is a tool for traditional financial accounting and doesn’t contain operational information on resources and processes. Continuous improvement is an approach to long-term value creation; financial accounting and reporting is well known to promote short-term behaviors that often conflict with and impair long-term value creation.

>>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.

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