Use This Nine Question Quick Assessment to Determine Whether your Organization's Cost Model is Putting it at Risk
IF YOU ANSWER “YES” TO 6 OR MORE OF THESE QUESTIONS, YOUR ORGANIZATION MAY BE RELYING ON A COST MODEL THAT PUTS ITS FUTURE SUCCESS “AT SERIOUS RISK”
Do your organization’s managers spend an inordinate amount of time debating the accuracy of cost information being provided to support their decisions?
Debates over the accuracy of cost information are a rarity at organizations where cost information is based on a logical, causality-based model that “makes sense” to its managers. Accumulating expenses in a few ill-defined pools and then assigning them to products and services using convenient, non-causality-based drivers leaves a lot of room for debate. When there is no logical validity to a cost model, everyone rationalizes costs to reflect a version of “the truth” that best suits their purposes. They do not seek a version that reflects economic reality. Managers try to manipulate cost information to validate emotional decisions they have already made. The result is not only valuable management time wasted arguing about costs, but compromised decision making that leads to wasted company resources and an erosion of profitability.
Is the primary purpose of costing in your organization to support the reporting of financial results to owners, lenders and other outside parties?
An organization’s financial accounting system is designed to report its overall financial position at a specific date and its overall financial performance over a specific period of time. The operative word here is “overall.” Financial accounting systems are not designed to provide accurate costs for individual products or services, profitability measures for customers, markets or product lines, costs of the organization’s operating processes, or data for evaluating capital expenditure opportunities, make or buy options, or purchasing decisions. Most are minimalist systems created to comply with external accounting rules and regulations. Using information from such a system to support decision making is like a doctor diagnosing a patient without the benefit of x-rays, CAT scans, MRIs, blood tests or any other tool that assesses the internal workings of the human body.
Can some of your customers, or customer groups, be labeled as “high-maintenance” while the maintenance levels for other customers are much lower?
The cost of serving customers – whether it be winning their business, administering their work-in-progress, fulfilling and delivering their products or post-sale follow-up – usually varies from customer to customer, market to market, or channel to channel. At most organizations, these costs lie buried in overhead pools assigned to products or services, not customers, or in a pool of general and administration costs spread arbitrarily among all customers. As a result, it is impossible to assess customer, market or channel profitability. Low maintenance customers with moderate gross margins could be more profitable than high-maintenance customers with high gross margins, but this fact will never be known. Additionally, the cost of processes that exist to serve customers will not be measured and, since what gets measured gets done, will not be identified as candidates for process improvement or used as a basis for encouraging changes in customer behavior that can benefit both seller and buyer.
Are you much more competitive on some of your service/product lines than you are on others?
Being competitive on some products/services but uncompetitive on others is a common characteristic of organizations whose costing practices are over-generalized. The result is too much cost being assigned to some classes of products/services while not enough cost is assigned to others. As a consequence, when a target margin is added to the calculated cost of the over-costed items, their price becomes uncompetitive. On the other hand, when target margins are added to the calculated cost of the under-costed items their prices becomes extremely competitive; sometimes so competitive that the product or service actually loses money.
Do your customers demand that more “add on” services or customizations be incorporated into your organization’s basic services or products today than they did in the past?
In today’s business environment, customers often want more than just basic products or services; they want them customized or supplemented with additional services. When the cost of this additional work lies buried in an organization’s overhead rates or general and administrative costs, it does not get assigned to the customer, product or service requiring that additional work. Instead, it is spread among all of the organization’s outputs. As a consequence, prices deemed acceptable for products/services sold to customers demanding the extra effort are underestimated and the profitability of that work overstated. Conversely, higher than required prices are sought from those customers not demanding the extra work putting business with those customers in a less than competitive position and sales to those customers in jeopardy.
Can some of your organization’s business activities be described as “people aided by technology” while others can be more accurately described “technology aided by people?”
Technology has been taking the place of people in performing clerical tasks for decades. More recently, it has been taking the place of individuals performing more complex work. As this trend continues, organizations have less individuals performing business processes and more supporting the technology that supports those processes. This results in growing Information Technology costs; costs that are usually included as “general and administration” or allocated to divisions, departments and processes using a simple allocation base like sales or headcount. Such simple methods of assigning these technology costs make it impossible to accurately measure the cost of the organization’s processes and when process costs cannot be accurately measured, it cannot accurately measure the cost of its products, services, customers or channels.
Have labor-intensive services or operations been replaced with automated or computer-controlled activities since your organization’s cost model was last updated?
In the past, people used equipment to aid them in performing their value-adding work. Today, the value-adding work once done by skilled workers is rapidly being replaced by new technology. Workers are employed to feed the new technology and keep it running effectively. This blurs the distinction between direct labor and indirect labor. Yet most organizations continue to use direct labor as a means of assigning work costs to products and services. As a result, a mismatch develops between the cost of new technology and the products or services it creates. For example, when two people support a piece of high-tech equipment it does not cost twice as much as when one person supports it. Similarly, when one person can operate two pieces of high-tech equipment, it does not cost half as much as when on person is assigned to each one. Without modifying costing practices to accommodate this fundamental change in how work is done, costs will be misstated and decision making will be adversely affected.
Since your organization’s cost model was last updated, have indirect costs become a much larger percentage of total costs or have “overhead/burden” rates increased significantly?
A common characteristic of an obsolete cost model is a significant increase in the overhead rate(s) used to assign costs to product and services. This is the result of indirect costs – the costs of complexity and variety – increasing over time and losing the relationship they may once have had with the base used for assigning those costs to products and services. When overhead rates were relatively low, the error caused by their being linked to an inappropriate cost driver (e.g. direct labor) still existed, but may not have been significant. When those rates are high, any resulting error is compounded causing a serious distortion in perceived product or service cost that could have a major negative impact on the quality of the organization’s decisions.
Is only one basis used to apply all indirect costs to your organization’s services or products? (Note: a single basis might be labor hours, labor dollars, material cost, etc.)
It is seldom the case that all of an organization’s indirect costs are directly proportional with a single assignment base. Utility costs don’t follow direct labor hours or material costs, they are more likely to follow machine hours. Receiving costs don’t follow direct labor or machine hours, they are more likely to follow material quantities or dollars. Warehousing costs don’t follow any of the aforementioned bases, they follow product movement, occupancy and time in inventory. Program launch costs are one-time costs that are incurred to support the entire run of the upcoming program. Most 21st Century organizations are far too complex for the cost of all of its indirect business activities to follow any single base. Continued use of a single base for assigning all indirect costs to an organization’s outputs can result in miscosted services and products and seriously affect the quality of that organization’s decisions.