Chapter 6 – Looking for costs in all the wrong places

Your current cost system is not providing information that meets the demands of your operating teams.  Your CFO is upset because your cost of sales and inventory levels are growing at a faster rate than sales, trends that were not included in the Company’s financial forecast. What do you do?

The analysis of direct costs, especially as they are expressed on a per unit basis, is critical to understanding your business, regardless of whether you are a service, retail, or manufacturing enterprise.  How much does it cost to build a truck, deliver a customer to their destination, or provide an answer to a query on the internet?  To answer these questions requires an understanding of each dimension of result-producing activities and their specific share of your overall cost burden.

The problem with analyzing costs together as well as their inter-relationships is the high cost of analysis, especially the wrong analysis.  You can choose the wrong tool.  Your calculations can rely on faulty assumptions.  Or you can ignore valuable data.  Each of these errors lead to poor strategies and, ultimately, results. They take valuable and essential cost data and misuse it.

Let’s first start with the tool.  Cost analysis starts with the capture and organization of all input costs for each output producing activity.  Unless you want early retirement, you will quickly recognize that this work cannot be performed manually.  System tools are needed to record costs of inputs and then reconcile the inputs to actual costs results.

Choosing the right tool is a goldilocks problem.  Mistakes choosing cost systems result either from spending too little on a tool that cannot scale with the growth in your business or from spending too much on sophisticated technology that promises state-of-the-art capabilities but costs as much as your annual revenue and may not effectively integrate with your other system tools.  Unfortunately, many managers react to this problem by installing systems they have worked with in the past, regardless of the circumstances or consequences.

Next, traditional cost accounting analyses of labor standards and cost variances make two important, and often improper, assumptions.  They assume that the production process is labor-paced; if labor works faster, output will increase.  The computations often erroneously assume that labor is a variable cost.  Cost variance reports are usually prepared on a monthly basis and are often released days after the end of the month.  As a consequence, the information in the reports may be stale and therefore less useful. Also, analysts often calculate variances that do not significantly impact costs. And, most importantly, a focus on individual cost center variances incentivizes managers to take actions that ensure favorable local variances but are not in the best interest of the company.  For example, a manager may implement a crash course effort to increase output not needed at the end of the month simply to avoid an unfavorable labor efficiency variance.

Finally, managers often focus exclusively on cost variances or the resources required to track the variances.  They do not review backlog, capacity and throughput during production or processing activities.  Why are these non-financial measures important?  Every deviation from frictionless throughput, or “one-piece flow” is either a constraint or waste.  Both conditions can cost your company money.  Constraints cause valuable, expensive, and scarce resources to be underutilized.  Waste overloads operations with expensive and unneeded costs.  That is why there is a genuine need to ask:  What benefits does non-financial cost information bring to our business?  And how accurate is cost information without this data?

So how should your particular company capture and organize cost information?  How do you collect accurate per unit costs?  How do you sort out the few important variances from the many? What are the constraints of your systems?  What information do forecasting, supply chain and compliance managers use, and what tool or method best identifies defects?  How do non-financial measures such as backlog or capacity predict financial outcomes?

Do not blindly answer these questions by settling for what works for others or what has worked in the past. Judge every piece of data and analytical tool on its impact on your company and overall organization.  A holistic understanding of throughput may be as important as analyzing the costs of your manufacturing subsystems.  And rapid identification of mistakes that occur in the manufacturing process may be better addressed by reviewing cycle times than reviewing cost variances.

There will always be a need for tracking inventory levels because managers need to know the stock level of each item of inventory in real time.  Nevertheless, the typical solution of using the Standard Cost method to analyze your business may not be effective, especially if you outsource your production.  Doing the work manually is sure to fail.  What you need is a process and a system that can deliver this information as you grow.  Avoid getting bogged down in a mindless transactional work.  Eliminate cost analysis that does not pinpoint the cause and effect of core problems.  Place as much, if not more, attention on non-financial measures as your financial measures.  And do not pour money into a state-of-the-art cost system that will make the same mistakes you are making now, only faster and on a bigger scale.

Takeaway questions –

• If you outsource your production, have you analyzed which cost method is more cost-effective to utilize?
• What non-financial measures do you use to manage your supply chain?
• How often do you audit your cost data.  Are standards outdated?  Do wrong price amounts exist for average or standard costs?
• Have you encountered a similar problem? How did you deal with it? Share your story.

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