Manufacturing companies maintain a strong focus on cost management, particularly product cost, which impacts all manufacturing costs. The pursuit of cost reduction is necessary and valuable, but it can lead to poor tactical and strategic decisions if pursued in a manner that overlooks the real goal: creating and maintaining value.
Value has two perspectives. The first readily springs to mind: profit, increased market value, and wealth for the financial stakeholders. The second perspective is less obvious: moral, legal, ethical, social and general societal values that allow owners and employees to take pride in the organization. Values of the second type can enhance long-term financial success—or destroy it if they are missing or misdirected.
Cost measurement and management affect both types of value in significant ways. Consider the budget process in your organization. Is it a negotiation, a game of liar’s poker, or an open, fact-based discussion of operating requirements for realistic planning scenarios? You know negotiations and liar’s poker waste resources, but the negative impact on organizational values of these poor practices is often overlooked. Another example—cost management in areas like worker and consumer safety, environmental issues and product quality—is extremely sensitive. Resources should not be wasted, cost improvements should always be explored, but decisions should be fact-based, relatively unpressured and thoroughly vetted.
The greatest risk to financial value creation is when cost management is done with flawed or inappropriate information. This often happens because manufacturing cost systems are typically designed to produce data that conforms only to external financial reporting requirements, not the economic reality of operating resources and processes. A common example is orders queuing for older, fully depreciated production lines; while new, higher-quality, more efficient and safer production lines are underutilized because they carry a depreciation charge that negatively impacts the calculated gross margin on the orders. Outsourcing and offshoring decisions are prone to mistakes. A company might save $3 million in product cost, but somehow neglect to factor in $3.5 million in other costs (not standard product costs) associated with managing the distant producer. Poor product pricing decisions, based on simple (but distorted) overhead rates, have put many manufacturers out of business when they sold losers they mistakenly calculated to be profitable.
Injecting value and values into cost management is surprisingly complex. First and foremost, senior management compensation is often closely tied to short-term external financial statement results. This causes too much reliance on flawed financial accounting cost information and creates pressure for rigid and unreasonable budgets. Second, there is little awareness among accounting professionals of ways to create more effective cost information that reflects resources and operations in a long-term, cause-and-effect manner oriented toward internal decision support.
What’s to be done? First, executive managers need to pay attention to conflict areas in the information they see and use to make decisions. In making operational decisions, financial accounting rules and conventions—except occasionally for real tax savings—are seldom a relevant factor for creating long-term value. Second, internal decisions need to be guided by resource and process decisions with financial impacts calculated in a manner that reflect those impacts. Decisions hinging on overhead or depreciation dollars should be a warning; they might be a factor, but more often they create distortions. Third, executive and management incentives need to focus on the long term. Financial accounting rules create short-term distortions between financial results and operating reality. Fourth, insist on cost information that reflects resources and operations. The litmus test: Can it be clearly related to the factory floor by the average supervisor?
>>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.