The Distorting Influence of Money in Cost Modeling

Building a financial internal decision support model requires significantly different thinking than traditionally taught approaches to cost modeling.  First, if you are an accountant, you need to recognize you have a unique view of the world.  That view is centered on reducing everything to monetary value.  It’s an important view and an important skill, but designing an effective internal decision support model requires you put money aside for a while and focus on what happens first - operations.   What’s the problem?  Money is highly divisible (obviously into dollars and cents), and few resources are as divisible.  Think about an overhead cost pool in traditional standard costing.  You were taught it was a pool of cost or money that could be allocated to product using a “logical” driver.  The driver equation substitutes for the complex resource relationships that compose the reality of use and actual outputs of the many resources lumped into an overhead cost pool.  This approach is necessary for the general needs of required financial reporting to external stakeholders, but it provides limited useful information to your company’s operations personnel….and worse, often significantly confuses them.  If such financial measures are tied to performance measures, personnel will likely make suboptimal decisions for no other reason than to avoid allocations from the overhead formula.  

Effective financial internal decision support models design begins by first tracing resource consumption in operational quantities between logically designed pools of resource using cause and effect process flows.  One resource pool’s output becomes the input for other resource pools or cost objects through one or more processes.  Each resource has fixed and proportional relationships with its inputs and outputs.  These characteristics flow through the process and are often transformed (variable/proportional cost become increasingly fixed) by downstream consuming resources. 

After the quantitative model is built with operational data, money can be applied to match the resource flows.  Some resource pools produce output with a very weak or no causal relationship with any downstream productive process or final output.  This type of consumption and the related cost is assigned to a level of the organization that can exercise control over the resource, and not assigned beyond that (assignment stops where causality becomes weak or stops).  The result of stopping cost assignments where causality ends makes the model both highly intuitive, understandable, and produces quality decision support information for all levels of your organization because the financial internal decision support model looks like the resources and processes they see in operation.  You may be surprised how much quality operational data your operations personnel have available to support the design and construction of a financial model that could provide them useful cost information. 

Taking advantage of the highly divisible quality of money to force allocations is an expeditious shortcut, but one that is paid for with distorted information that may be used - when the accountant isn’t watching - for bad decisions throughout your organization. Use of the PAF and causality for financial internal decision support modeling is the remedy.