How is Your Marginal Cost Information?

Written by Larry White

When I think of marginal costs, what frequently comes to mind is the recollection of some college instructor stating that marginal cost was impossible to calculate…or maybe that was marginal utility in economics.  The point is, if costing is done with a purely financial statement focus, an accurate and comprehensive marginal cost is nearly always impossible to derive from standard full product cost.  Too much information on organizational support resources and processes is left out of product cost and cost pools are typically “allocated” with a weak or noncausal driver for many of the costs.  Estimating marginal cost will normally require a special study shored up with operational and financial assumptions to compensate for the lack of detailed data.

Organizations should always have accurate marginal revenue and cost information readily available, but most do not.  However, when the economy has storm clouds on the horizon, the creation of marginal information becomes much more important.  Accurate marginal cost information is a challenge to most organizations, but marginal cost information is needed for effective economic decisions throughout an organization, particularly on a day to day basis.  A costing approach that can efficiently produce accurate marginal cost information improves organizational transparency and the consistency of profitable decision making.   Operational and financial information on fixed and proportional resource consumption and capacity information is the critical information in calculating an effective marginal cost figure.

Let’s examine the elements of modeling and the steps information necessary to create effective marginal cost information.  Remember the Profitability Analytics Framework builds an operational model then a financial model.

Element 1:  Incorporate key operational characteristics of economic activity into the costing approach/model

• Step 1.1: Accurately depict the organization’s flow of operational processes and resources in the model. 

o This step requires the organization’s productive and support resources be logically grouped into resource pools, the causal relationships between them mapped, the outputs identified, and the operational resource consumption mapped.  This step is done in operational quantities.

• Step 1.2: Reflect cause and effect relationships accurately.

o   In this step, the relationships are quantified in resource terms.  Each resource pool has an output it provides to other resource pools or outputs.   Where resource pools support themselves and other resources, activities, or outputs, the reciprocal relationships should be quantified.

• Step 1.3: Accurately depict the nature of input-output relationships of resource quantities.

o   The resource quantities in a resource pool need to be further depicted with their fixed and proportional relationships to outputs.  Each resource pool and sometimes the resources within the pool have a unique relationship with its output.  That output and its characteristics (fixed, variable, or other) become an input for another resource pool, activity, or final output (where it is consumed), and the fixed and proportional relationships may change as a result of that consumption if the output supports another resource pool. (Proportional (variable) relationships tend to become more fixed as they move through a process.)

• Step 1.4: Link the quantitative flow of goods and services to money.

o   After the quantitative model is built, apply monetary values to the resources and the input/output flows to obtain the cost of the process and final managerial objectives/outputs.

Element 2:  Structure management information to enhance relevance and use in the organization

• Step 2.1: Evaluate the components of the cost and operational model for only that portion of economic goods and services relevant to the decision at hand.

o   The model needs to be examined for which resources and flows will change because of a decision.  A well-constructed Element 1 model will provide this information for routine decisions and will identify capacity constraints because of its close connection to resource quantities and causality; but larger decisions tend to change processes and resources which may require amending some model assumptions to support the analysis.

• Step 2.2:  Reflect causal relationships and their characteristics relevant to the decision.

o   For smaller decisions, a model constructed on resource quantities and causality will identify the appropriate changes.   However, decision scenarios come in infinite variety, and it is always necessary to logically examine the impacted process and resource relationships.   For example, fixed operating quantity relationships may change due to capacity limits. Currently idle capacity could be used or idle capacity could be created. (Notice, this description doesn’t mention cost relationships because cost is a constraint; resource and process requirements are the driver.)

• Step 2.3: Provide accurate monetary information for all cost categories appropriate to the decision.  When the resource relationships have been defined and evaluated, apply costs and examine the changes.
  

Many internal decision support models advocated by PACE can support these steps because of their use of cause-and-effect modeling of resource and activity relationships; however, when selecting costing approaches, it is critical to conduct detailed analysis to ensure they can achieve the granularity of information needed for marginal or incremental costs and generate information in a timely manner.