Manufacturing personnel are very familiar with the inaccuracies and problems associated with product cost and overhead distributions. When problematic cost information is used for business decisions such as pricing, product mix, marketing focus, outsourcing or capital investment, concern increases from irritating and troublesome to profit and business survival.
This article outlines a few key points manufacturing businesses should use as indicators that a cost system oriented around financial reporting should be supplemented with costing that is more focused on advanced decision support. I use the term “supplemented” because financial reporting is required, but it is not the correct view of cost for internal operating and business decisions.
Let’s look at some common indicators that costing for your operations is creating significant business risk.
Arguments or debates about cost information and/or financial reporting is the primary purpose of your only cost system. Years of experience may have numbed you to arguments, but improved manufacturing systems and metrics information are increasingly meeting resistance because of dated cost methodologies. Don’t accept conflict as normal—better costing approaches exist that will reflect operational information.
Production is considerably more automated today than when your cost system was installed. Automation is handled poorly by traditional cost systems, which were designed to support processes with primarily direct labor or machine time. This creates product cost distortions and flawed capital investment analysis.
Indirect costs are a larger portion of your total costs and/or overhead rates have increased significantly. This situation clearly indicates a costing system is spreading a large portion of costs “like peanut butter” across products without essential cause-and-effect analysis. Product cost is likely highly distorted, with some products being under-costed and others being over-costed.
Customers’ demands vary widely from “high maintenance” to “no problems.” Traditional product costing normally doesn’t incorporate downstream distribution or customer support, more sales or marketing time, and sometimes not even setup time and complexity. Customer costing is not part of traditional product costing; it was designed for a homogeneous customer environment.
Some of your products are much more price-competitive than others. This is a clear indicator your customers are “bargain shopping” because of product costing based on distorted overhead and inaccurate cost-based pricing. If you are under-costing some products, the market will often flock to buy these, and will avoid the products you are over-costing. Failure to remedy this situation has destroyed manufacturers.
Customer demand for add-on or custom requirements have increased substantially. A traditional costing system normally doesn’t incorporate design engineer services, the costs of smaller, custom runs, and greater customer engagement time. This means the costs are added to all products through overhead or too general income statement expenses. Either way, it is free to the customer making the demand. Additionally, the value of investing in more flexible manufacturing equipment and processes may be hidden from investment analysis. Underpriced products and failing to modernize are both substantial business risks.
The solution to these problems is to implement a cost system for your decision support needs. Cost systems focused on decision support must generate costs that reflect causal resource and process relationships. They must be based on an operational model of your organization and extend well beyond the limits of a traditional product cost system to incorporate R&D, design, sales and marketing, distribution, service, and any part of the business that has a causal relationship impacting product cost. You will still need a simple cost system that complies with financial reporting standards, but it should be separate from your decision support system with reconciliation to the input data and output data.
>>Larry White, CMA, CFM, CPA, CGFM, firstname.lastname@example.org, is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.