Today businesses are far more complex than legacy accounting systems were ever designed to tackle. Learn how using financial accounting for decision making can put you at a disadvantage. See how we partner with Industry titans like Siemens and cutting edge research institutes like DMDII to provide optimal outcomes in your organization's decision making.
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"'The Trouble with Standard Cost Information for Internal Decisions"
For almost a century now Financial Accounting has dictated how to value inventory and calculate product costs. And for good reason. Standard costing, the method used for Financial Accounting, is easy. Everybody learns it in their accounting courses, every General Ledger software does it, and we all understand it. This easy button is truly easy...
So, if you must use the easy button for Wall Street, the bankers, and regulators, then why not use it for other things at hand, right? For example, when looking for guidance in making internal decisions about products or customers just use the standard costing information that is already calculated. What’s not to love about a universal easy button?
Now, you might object to the harshness of this criticism. Standard costing is a trusted method used by so many for so long. However, keep in mind, we are talking about two very different worlds here: In one world we have aggregated historical financial information compiled for external use and not for the purpose of running daily operations; sort of like the role of a corpse in an autopsy.
In the other world? We have a real living breathing running business that requires constant decisions to keep it going and homing in on the stated target.
The diverse information needs of these two opposing worlds inform our criticism of Financial Accounting costing information. Here are six examples of the problems with using “easy button” information for internal decision support:
- The data is not causal - the easy button operates based on a totally different set of principles than what is required for effective internal decision support. FA adheres to the matching and periodic principles, which do not provide managers clear cause-and-effect insights to guide their analysis, extrapolation, and logical reasoning in the decision-making process.
- Standard costing uses generic driver-based spreading of overhead: traditional standard costing is famous for its percentage allocation of operations overhead. The perils of this approach, including assigning too many costs to high volume products and too few costs to low volume products, are well documented. But there is something else the easy button hides. Namely, idle or unused resources. Idle resources have nothing to do with the products actually produced. But the easy button nevertheless spreads these costs arbitrarily to current production, further distorting the information necessary for good decision making.
- Information stops at finished goods inventory valuation - standard costing does not include any product costs beyond production and placement in finished goods inventory. Product costs commonly incurred after production include customized services, different channels’ costs, and distribution and warranty costs. Companies with any of these dimensions in their offerings and go-to-market strategy need anything but an easy button!
- Performance is based on variability - this works fine as long as you make only one product (e.g., Model T Fords and all of them are black!). In the 21st century products and services are customized, and product portfolios are a blend of technologies with more complex and less complex products. Products with different complexities consume variable factory overhead in different patterns and proportions. When it comes to cost behavior, the easy button has no clue about the actual marginal cost of a decision to change output.
- Very little predictive capability– when you’re not modeling costs based on principles that reflect actual cost behavior, it means the cost model and its information cannot be used in predictive tasks or to accommodate the crucial managerial activities of planning and simulation.
- Standard Costing encourages dysfunctional behavior – standard costing with an emphasis on absorption measurement encourages overproducing to reduce unit costs and increase product margins, which leads to too much inventory accumulating storage costs in the warehouse. Or another favorite, writing up sales orders to use the older and less efficient production line with the lower unit costs due to fully depreciated equipment rather than the newer and more efficient production line that includes depreciation expenses
The easy button simply cannot satisfy internal decision support needs. In corporate America, this realization has been dawning at least since Activity Based Costing (ABC) caught on in the late 1970s. But the extent of standard costing’s shortcomings were not fully recognized until the accounting community, and its global accounting bodies adopted a set of principles for Management Accounting for the first time.
At Alta Via, we are humbled to have played a significant role in this coming of age of management information to properly run a business. The principles of MA open up a whole new world in the areas of decision support and execution optimization of an organization’s strategy. For example, do you want to know your most profitable product or service mix? Would you like to generate next year’s budget by running your planned sales through a cause and effect costing model? Better still, would you like to know the avoidable costs for any decision you face?
These principles have enabled Alta Via to introduce a set of artificial intelligence (AI) tools that answers these and other pressing management questions. Leave the easy button where it belongs. It has a legitimate function in financial accounting, but that legitimacy does not include the requisite support of internal decision-making. Talk to us on how to consistently achieve optimal decision outcomes and leave your competitors to fumble with the easy button that couldn’t.
See how it works (RCBM)
Alta Via is a Mindsphere partner, Mindsphere is Siemens' industrial Internet of Things platform. This platform allows for manufacturers to integrate data from multiple machines and sensors into a centralized database. This allows Mindsphere partners like us to provide Siemens customers with insights previously thought impossible due to cost, financial and otherwise.
Alta Via connects shop floor and top floor data for our customers, providing insights into your company. Finding your most profitable products and services as well as your best (and worst) customers. This level of transparency in an organization offers a huge competitive advantage over your competition who is operating, at best with rough estimates and historical data.
Learn more about Mindsphere(Coming Soon)
DMDII (Digital Manufacturing and Design Innovation Institute) is a partnership between UI Labs, the US Department of Defense and manufacturing technology businesses.
"DMDII has invested approximately $90 million in more than 60 applied research and development projects in areas including design; product development; systems engineering; future factories; agile, resilient supply chains; and cybersecurity."
View their high tech plant in downtown Chicago and see how Alta Via's proEO integrates with the technology from multiple manufacturers providing key decision-making data.
The RCBM is one of the many tools at your disposal with a proEO installation. Using advanced accounting and data science techniques the RCBM allows you to simulate a variety of scenarios and track your avoidable and unavoidable costs. No longer will your accounting department be taking days, weeks or even months for projections, simply plug in the assumptions and the RCBM will generate a report for you on the fly.
Tune your production volumes, increase or decrease your margins and generate profitability reports in real time with the profit maximization tool. Did the shop floor report they can double production on a certain item at the same or greater margins while all else remains the same? Plug those values into the profit maximization tool to see how it will affect your bottom line. Or the inverse, supply chain issues slice your margins on certain items? Plug in the reduced margin and see if spinning production up or down will stop the bleeding.