Financial Information for Operations: Mission Impossible?

I can’t recall the last time I spoke with someone from manufacturing operations who was happy with available financial information.

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Even worse, I can’t recall the last time I spoke with an accountant for a manufacturing company who said operations was happy with the financial information that he or she provided.  What’s wrong with this picture? Shouldn’t people managing operations have useful financial information? Where is the problem—operation’s ability to understand, or finance’s ability to provide useful information?

The problem rests with finance, but not your finance department. It largely rests with the accounting profession. The finance department’s consuming objective is to produce financial information in accordance with generally accepted accounting principles (GAAP) for audited financial statements, which are, if you’re a publicly traded company, provided to the Securities and Exchange Commission (SEC) and shareholders.

The problem is that this highly regarded information is designed for a particular audience—investors and creditors operating in the capital markets choosing between company level investment alternatives. GAAP information is not a model of the business designed to satisfy the needs of internal managers and employees. In fact, the joint International and U.S. Financial Accounting Standards Board’s conceptual framework, which forms the basis for standards, makes the assumption that managers and employees of a company can get whatever information they need elsewhere. Therefore, internal needs aren’t of primary concern in financial reporting standards. This logic and focus on external financial statements dominates requirements for financial accounting systems.

The result is that nearly all costing methodologies are designed first and foremost to feed external financial statements. Product cost is gathered and recorded in fairly broad categories—direct labor, direct materials and overhead (all else).  Typically, this is done with cost pools, which while auditable as a process, become rapidly disconnected from physical operational resources or processes.

This information becomes the basis for inventory valuation and cost of goods sold.  Furthermore, inventory values are then subject to averaging or other calculations acceptable for external financial reporting. Several other principles of financial reporting, such as accruing by reporting period and matching revenue and expense, also contribute to impair the usefulness of financial accounting information to managers and employees.
   
Engineers help accountants

The financial crises of recent years have focused more attention on financial reporting and less on managerially focused accounting. Management accounting is the area of accounting that supports creating information for internal decision support, and its coverage in accounting and general business curricula is diminishing while the focus on financial accounting, reporting and the control structure for external financial reporting has exploded. The result is increasing difficulty finding accounting professionals with the knowledge or orientation to improve internal managerial costing information. Interestingly, some of the greatest gains in management accounting knowledge have come from the engineering community.
  
Creating more useful financial information is possible. The solution rests in building a model of operations and applying a cost measurement approach that focuses on the decision-making needs of managers and employees as the primary customer.

The best approach I’ve found for cost measurement and operations modeling is called Resource Consumption Accounting (RCA). Its core principle is that decision-making is based on making inferences from cause-and-effect relationships of how an organization’s resources are consumed, and then maintaining those relationships in the operational model and when costs are applied. RCA places a premium on understanding resource capacities and costs, generating high-quality marginal information, and applying the principles of logic and the scientific method to create decision support information that is meaningful to managers and employees.

Larry White, CMA, CPA, CGFM, lwhite@rcainstitute.org, is the Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org).

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