Cost and Profitability Models for Industry 4.0

The traditional model for financial accounting and reporting is not up to task in the digital era. However, even though the potential for profitability is high, the financial reporting model has proven to be highly resistant to its challenges.

Larry White, Resource Consumption Accounting Institute
Larry White, Resource Consumption Accounting Institute

Digital manufacturing produces massive amounts of data. Citi Global Perspectives and Solutions: Factory of the Future said, “A connected factory is estimated to generate 1 petabyte per day, equivalent to 1.05 billion minutes of MP3 songs or 160 million books.” It is truly impressive that manufacturing execution systems (MESs) and manufacturing operations management (MOM) systems are prepared to use this quantity of data to create information. Finance and accounting systems have a long way to go before they can effectively connect and create usable decision-support information for digital manufacturing. Most of today’s costing systems provide only minimal financial reporting requirements such as direct labor, direct material, and overhead—often spread by direct labor at infrequent intervals.

A new approach to financial decision support modeling is needed for the digital era. The traditional model for financial accounting and reporting is not designed for the task, and it cannot be fixed. Why? It reflects financial reporting rules and time periods; effective decision support requires models that reflect causality and real time. Unfortunately—for many manufacturing businesses—the financial reporting model has proven highly resistant to challenges about its efficacy as a management tool, even in the face of its diminishing usefulness for internal decision support.

The importance of modeling is best captured by two quotes from the book, “Cost-Benefit Analysis for Executive Decision Making,” by Alfred R. Oxenfeldt, a long-time professor at Columbia University School of Business. First: “The validity of our decisions depends upon our perception and understanding of reality. Good decisions require good models, and the caliber of our decisions reflects the quality and validity of our models.” Second: “An error in estimating the magnitude of an effect usually is far less serious than mistakes due to wholly overlooked consequences.”

These statements contain an important message for finance and accounting today—particularly in manufacturing. It is well known that the audited financial reporting model creates the wrong data and information for most manufacturing decisions because of the distorted allocations and valuations it allows and even encourages; and the segregation from product cost of many costs with clear causal relationships to products and customers. To support good decisions, a consistently available managerial cost model must be built that reflects the causal relationships for manufacturing resources and operations. Information patches—in the form of special studies, consultants, or even a great plant financial staff—isn’t a sufficient system for developing an effective decision-making culture for cost, profitability, and enterprise optimization.

Finance often struggles with the trade-offs between a quick win that shows immediate value and making a substantial investment in a comprehensive managerial costing system. The quick approach seldom leads to building an effective managerial costing system or culture. Often, organizations simply keep building quickie models until they milk all the easy wins…then they move on to the next initiative. As a result, the foundation for good, cost-oriented decision support information for the long term is never established.

The potential for cost information, to improve decision support in the data-rich digital manufacturing environment, is enormous. The integration of design flexibility into the production process, the flexibility of modern production resources, the increasing role of support and IT, and greater connectivity to customer needs require complex modeling to manage costs and determine profitability. Operational systems are making this leap, and would benefit from the integration of new monetary models that provide a clear and timely picture of the costs and value being created. The need for finance to think far beyond the financial statement and create new models has never been greater. The term being used for cost models focused on internal decision support is managerial costing. Manufacturers should encourage their financial staffs to build their managerial costing skill set and step up to the opportunities of digital manufacturing.

 

>>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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