Are you wondering whether your products and services are profitable? Are you sometimes under the impression that no one in your organization can clearly explain, or even worse, make sense of your costing system data? If this is the case, here are 5 tips that can be discussed with your Finance partner.
Understand the cost dynamic
Literature is unanimous! Management’s understanding of product and service costs is often based on perception rather than on reality. Traditional costing approaches can properly align direct costs to products and services. However, they do very little to substantiate the allocation of indirect costs. These usually end up being applied to products and services via a single driver namely, the number of labour-hours or machine-hours. Today, as the data is being easily captured from various sources (ex: machines, handhelds, scanners, etc.), selecting drivers that accurately reflect resource consumption by product or service can lead to cost results that are different than those anticipated.
An activity based costing (ABC) exercise can also be considered. This method consists in first aligning resource costs into activities and second in assigning the costs of these activities to products and services using various relevant drivers (ex: number of defects, number of machine set-ups, etc.). An ABC exercise is often conducted in parallel to the regular financial costing system, as it does not comply with either generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) in its purest form. However, it can highlight key management information essential to the introduction of very lucrative corrective measures (ex: process changes, pricing changes, etc.).
Keep the model simple
Although production and delivery activities can multiply exponentially, some of them may be grouped for purposes of simplicity. Standardization of cost capture and allocation (with different drivers), at different production and service delivery stages, can facilitate the understanding of the costs. Any result that is not well understood should not be accepted.
Standard costs are de facto used for budgeting purposes. They can also be useful for rapidly generating actual results. They are to be reviewed at least once a year (if not quarterly) to make sure that the variances remain immaterial and understood. The simplicity associated with the use of standard costs cannot outweigh the value of reliable cost information necessary for sound business decision making. Only real actual costing is acceptable from both GAAP and IFRS perspectives.
Communicate the results in an organized and structured fashion
The first step is to identify the relevant audiences and define the scope for which each is responsible. The second step is to generate well designed reports, including what-if scenarios that pertain to the field of responsibility of each audience. Each can analyze the results and suggest measures to optimize the production and service delivery process. Although some key players should master the comprehensive cost model, roles and responsibilities still need to be clearly defined. Not everyone can be expected to understand the overall business activities and related cost model.
Reconcile the production or service cost model with financial statements
Although this may appear tedious to some, I personally always refuse to deliver an unreconciled cost model to clients for the following reasons:
- without a reconciliation to the financial statements, a cost element relevant for business decisions may be inadvertently missed; and
- a cost model can be leveraged for other purposes (ex. defense against dumping allegations, internal audits) and it therefore needs to remain credible in the eyes of other potential users.
Select the right technology
One can go only so far with MS-EXCEL when building a manual product and service cost model. It can become cumbersome and only understood by the person who created it. In an era where management information is key and data is easily captured, an ERP module or a stand-alone costing solution that can be bolted-on to the organization core financial system should be considered. In order to build capacity and manage the constant evolution of business operations, integration should be put at the heart of the overall costing solution design.
Finally, great cost models provide value only when managers decide to act on the information generated. Relevant business decisions should be made in a timely manner in light of results obtained. If a product or service line is identified to consume higher levels of resources than initially anticipated, the question as to whether to review the pricing, to optimize the process or even to abandon the product or service line should be raised and analyzed. By focusing on profitable products and services, one can help improving financial results.