Is Your Product Cost Missing Important Information?

Advanced cost models that reflect causality improve decisions about quality and cost in manufacturing and the rest of the organization.

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Nearly every manufacturing manager has been directed to reduce product cost by some monetary or percentage amount. It’s a task that is simply stated, but because of the intricacies—really distortions—associated with most costing systems focused on external financial reporting, it’s also a task that is far from clear in execution.

You can improve the efficiency of your workforce, but unless you terminate or move people outside the “direct and overhead” cost pools that feed product cost, those savings won’t be recognized. The surest savings is reducing material waste, but that can be convoluted by raw material inventory calculations or resistance from purchasing. The typical response is to “game” the cost reduction by moving expenses to products that aren’t cost reduction targets. Not exactly ethical, but neither is the measure of success for the assignment. The simple fact is that product cost, as defined by accounting standards, is not designed to be an internal management metric.

If product cost were designed for internal management decision support, it would encompass more than direct labor, material, machine and production support costs. The fundamental principle for creating cost information for decision support is causality. Let’s look at other costs that have an equivalent cause-and-effect relationship to product costs. Product and production design; most marketing; product liability insurance, warranty and other post-delivery support; distribution and delivery; order processing; collection; selling, including salary and commissions; product discounts; and many purchasing department costs all have equivalently clear causal relationships to product costs. In addition, costs like payroll processing, personnel administration, health and safety staff, and other support staffs have reasonably clear indirect support relationships to production resources. None of these are included in the financial statement definition of product cost, but they must be covered by product revenue.

It is possible to incorporate all these costs into a more comprehensive product cost for internal decision support using advanced cost modeling approaches. However, it is not acceptable to report product cost this way on regulated financial reports. You may be asking: What is the benefit to the organization? First, a comprehensive product cost would allow a wider range of managers and employees to understand their value impact on product cost and thereby greatly enhance the focus of the organization. Second, advanced cost modeling enables manufacturing process disciplines to be applied to other areas of the organization. Though this often meets with resistance, manufacturers know that if you can’t define a process, then it probably isn’t under control. Third, all components of the business would gain a greater respect for the dynamics of cost, revenue and investment when their operations are faced with planning and budgeting for market fluctuations and the pace of the business cycle.

Once management starts to think causally about costs throughout the organization, insights expand. For example, some manufacturing and non-manufacturing costs are driven by specific demanding customers and should not be lumped into every customer’s product cost. The same is often true of some distribution channels. Another benefit is that excess or underutilized capacity can be identified on resources throughout the organization, not just in manufacturing, and operating efficiency improved everywhere.

No one understands the problems of traditional, external financial statement oriented cost metrics as well as manufacturers that are the primary target because of law, regulation and financial standards. The challenge is to move beyond financial reporting requirements and build actionable cause-and-effect-based operational and cost models for the entire organization. Advanced cost models that reflect causality improve decisions about quality and cost in manufacturing and the rest of the organization.

>>Larry White, CMA, CFM, CPA, CGFM, lwhite@rcainstitute.org, 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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