Costing is often a very confusing and frustrating topic with its standard costs, variable costs, fixed costs, marginal costs, budgeted costs, actual costs, relevant costs, etc. Why compound the confusion by reading an article about opportunity costs? It doesn’t even sound like a real cost. But opportunity cost is key to connecting monetary and operational metrics and optimizing the conversion process.
Opportunity cost is defined as a benefit that could have been received, but was given up in order to take another course of action. How does this apply to manufacturing cost performance?
To answer this question, we need to connect operational and monetary metrics on a detailed level—daily or shift operations. For this purpose, we define opportunity cost more specifically as the benefit that could have been received from running your plant or line as efficiently as it was designed, but was given up due to suboptimal performance. Manufacturing enterprise solutions provide the operational data to identify performance issues, but translating the problem into monetary metrics is often challenging for both manufacturing and finance staffs.
What would be the benefit of a readily available monetary metric that everyone trusted for the opportunity cost of suboptimal performance? Let’s answer that question with another question: Which statement would have more impact?
- Performance for the day was 86 percent. We expected to average 89 percent this week, but have been averaging 85 percent instead.
- Today’s performance cost the company $45,000, which is a little better than the $60,000 we normally give up.
The second statement would cause senior management to seriously consider support for an investment to improve performance, and would likely generate an inquiry into moving beyond 89 percent.
Can this be done? The answer is yes, but not with traditional financial accounting metrics, models and systems. Costing for internal decision support requires a monetary model that is built to reflect the operating model of your resources and processes using causality as the guiding principle, not financial standards. The required operational information is readily available in manufacturing systems. Instead of a separate ledger (such as financial accounting’s general ledger), costing becomes a valuation layer on top of existing manufacturing data. And, crucially, operational data maintenance doubles as cost model maintenance. In addition, costing defines consumption relationships into their fixed and proportional components. Proportional cost is key to the opportunity cost calculation because it serves as a consistent measure of the revenue forfeited due to suboptimal performance. (The minimum price for a product is one slightly higher than its proportional cost to ensure a contribution to fixed cost and eventually profit.)
Such an approach to costing provides much more timely and discrete monetary information to operations decision-makers. Once the cost system is in place, the operations team defines its target performance level (i.e., a stretch target) with all corresponding inputs and outputs. This provides the target proportional cost for each product.
During execution, the cost system collects relevant actual data (tons produced, kilowatt-hours consumed) to calculate actual product proportional cost. The difference between the target and actual numbers is the opportunity cost. The operator/decision-maker receives the opportunity cost number (presented as a discrete number, a cumulative number since the start of the shift, or as a trend line) at agreed upon intervals (e.g., every 5 or 15 minutes). Moving monetary metrics into such real-time decision applications provides powerful insights and incentives for improvement and positive change at all levels of an organization. For example, shift-to-shift performance comparisons become much more meaningful in dollars, even enabling gaming between teams or shifts.
>>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. This article was written in collaboration with Anton van der Merwe, principal of Alta Via Consulting.