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Minnesota Technology Magazine - Fall/Winter 2006

The High Cost of Doing Business

Do you have an iron-clad sense of your business' costs? If not, it may be time to get back to basics.

BY PHIL BOLSTA
Elsewhere in this issue, Phil Bolsta wrote about the value of cultivating solid vendor relationships.

Not knowing your costs can cost you. Big time. After all, costs determine pricing, and pricing determines profits. Failure to calculate precise costs for products and services has turned many potentially healthy businesses into, for all intents and purposes, nonprofits.

Costing can be defined as the process of identifying the costs of a business and of breaking them down and relating them to the various activities of the organization. Cost accounting has three basic functions:

• financial reporting
• operational control and enhancement
• decision-making and strategic planning.

Pinning down costs should be a sky-high priority for every business. "Having a system that accurately and reliably captures cost information is a requirement, not only for us but for management," says Brent Terhaar, a principal with the manufacturing and distribution group of LarsonAllen, a Minneapolis-based full-service professional services firm. "We'd have a hard time giving an opinion on a financial statement without it."

With that in mind, here's a look at three popular cost accounting methods.

METHOD #1: ABSORPTION COSTING

Also known as full costing, this costing model and inventory valuation formula takes into account all manufacturing costs. That includes all materials that end up in the finished product, the labor to make the product, and both variable and fixed overhead costs.

Absorbing and allocating the cost of every resource that contributes to a product sounds simple in theory. In practice, it's a different story. "Let's think about baking a cake," suggests Ramgopal Venkataraman, an assistant professor of accounting at the University of Minnesota's Carlson School of Management. "It's easy to figure out the cost of each ingredient. It gets harder when you try to figure out the cost of running the oven. With a little effort, you can determine the wattage and calculate how much your electric bill will go up over the next two hours. But it becomes more difficult when you try to determine the value you should ascribe to the oven itself being used for two hours. What part of the purchase cost of the oven should you attribute to the cake? That's the problem companies face."

Substitute people for ovens and the challenge can become nightmarish. "A company typically hires people and pays them based on the time they worked," Venkataraman says. "Then they try to figure out what part of each person's salary they should attribute to a particular action. That's called allocation, which is very challenging. That's why we continually try to come up with newer techniques to figure out the most effective method for allocating costs."

With such a broad mandate, it's no surprise that absorption costing data is prone to errors caused by inaccurate capacity usage estimates and the subjective allocation of resources.

METHOD #2: ACTIVITY-BASED COSTING

This model is concerned with more than just pure manufacturing costs. It looks at an organization by function and assigns a cost to all the activities and work processes that go into manufacturing a part, completing a transaction, or serving a customer. When it was introduced in the 1980s, activity-based costing (ABC) revolutionized how companies looked at cost systems and helped many firms improve their competitiveness and profitability. Because ABC acknowledges that costs tied to a particular activity may apply to multiple departments, it encourages a team approach to reaching financial objectives.

The ABC model is popular because it pinpoints which organizational activities add value to financial performance and which do not. "You're basically putting a cost on every aspect of the business," Terhaar says. "Every one of those costs needs to be applied to all of the products the business manufactures, and each one of those products is going to utilize those resources in a different capacity. So it's matching all of the resources within an organization to the particular activities needed to create the product."

ABC allows a company to determine the cost of serving each individual customer. Therefore, the profitability of each customer can also be calculated. These key metrics can then aid in positioning products and services accordingly.

There are other important benefits as well. For instance, when developing an ABC system, every activity needs to be analyzed to determine its financial impact, and the knowledge gleaned while doing so often leads to modifications that improve efficiency and performance.

METHOD #3: LEAN ACCOUNTING

The term "lean accounting" is a misnomer. Lean is a total business management system, not an accounting system. Lean is all about reducing waste, not only in manufacturing production but also in business processes (see "Waste Management," at right). Still, the term has caught on. "Lean accounting" was coined to refer to the type of data that best supports the lean management model as well as the most effective ways to deliver that data. At its highest level, lean accounting follows the value stream. You define what is of value to the customer, which is anything that the customer is willing to pay for. Everything else must be reduced, simplified, or eliminated.

As companies begin to implement lean, their accounting systems will need to change to support the effort. "When a company makes serious progress in its transition to lean manufacturing, and no attempt is made to eliminate redundant transactions, a serious disconnect occurs between operations and accounting," says Mary Connor, an MTI Business Services consultant. "Traditional accounting systems undermine a lean journey because they motivate nonlean behaviors."

Lean accounting is closely related to marginal costing, also known as variable or direct costing. Marginal costing is an inventory-valuation model that concerns itself only with variable manufacturing costs such as direct materials and labor. These costs can then be traced to individual units of finished product.

Absorption costing proponents argue that fixed manufacturing costs should be included in the cost of inventory because those resources are a necessary part of the manufacturing process. "Ultimately, machine depreciation and other fixed costs are expensed on the income statement and included in the cost of a product," notes Terhaar. "But you're not applying the costs directly to a product and not carrying them into your inventory. Time and materials are all you're concerned with."

Limiting cost calculations to time and materials shifts the focus to nonfinancial measures—volume variances, on-time shipments, use of floor space, sales per person—that result in more transparent reporting. That makes cost accounting more accessible to nonaccountants. "If you start measuring the time an order comes in to the time it's delivered, that's quite meaningful to people on the production floor," Connor says. "They can't control what the salespeople are doing, but they can directly influence on-time shipments. Lean accounting is about empowering people to be more efficient in responding to customers' needs. It's more time driven than cost driven, and it encourages alignment with strategic goals throughout the organization."

Connor expects lean accounting to gain even greater mindshare going forward. "In the old days, most financial statements were not very motivating," she says. "For one thing, they often reflected things that most people could not control, such as depreciation. And if you can't control it, you're not motivated to make changes. Now we have much clearer information that eliminates a lot of complexities and supports continuousimprovement initiatives."

The key words are "continuous improvement." Nonfinancial measurements are more likely to uncover the root cause of problems, which leads to process improvements, which lead to lower costs. In essence, reducing costs indirectly through a never-ending pursuit of process perfection takes precedence over the traditional goal of controlling costs. Traditional cost accounting, adds Connor, was anything but exact. "Allocating costs against a product was complicated because it depended on how long it took to get the product out the door," she says. "A lot of costs had to be estimated. Now, to know what your cost is for a certain time period, you simply divide by the number of units you produce."

Lean can be a manufacturer's best friend because it paints a picture of a business' true operating costs. "Lean accounting is getting more popular from a manufacturing standpoint, which makes a lot of sense, because traditional job costing can artificially mislead a financial statement," Terhaar says. "For instance, you can put excess cost into your inventory and delay expensing those items to a future period."

Still, traditional accounting demands its due. "Lean accounting isn't pure accounting, of course; manufacturers just want to work with fewer variables to manage their facility," Terhaar says. "But GAAP [Generally Accepted Accounting Principles] requires that all costs be allocated to a product; and that includes overhead costs related to inventory."

Venkataraman agrees. "I prefer the term 'capacity costs' to 'depreciation,'" he says. "Costs to maintain capacity are indeed important, and if the costs do not consider this, then firms may act as if the capacity is free, only to find out they cannot afford to replace capacity when it comes time to do so. While capacity costs may not be important to consider for day-to-day operations in many situations, it's vital to keep an eye on them as they are often very large costs with long-term implications."

That may be so, but inventory is a dirty word to lean accounting advocates. "We used to want to use our machines at 100 percent capacity, and now we realize that that's no longer a mandate and that we can do things more effectively without aiming for maximum capacity," Connor says. "Today's business world requires more flexibility. What you want to do is only produce to the demand of the customer, not to a forecast built on maximizing capacity.You no longer can afford to produce and produce and end up getting stuck with excess inventory."

WHEN GOOD COSTS GO BAD

No matter what cost accounting model is used, regularly reviewing costing procedures is critical to an organization's survival— especially in the wake of significant changes. Terhaar lists four such changes:

• your primary cost driver (machine hours, labor or materials)
• your overall pool of costs
• addition or subtraction in product line
• capacity level.

Meticulously tracking costs is particularly important for technology firms. "Technology changes quickly and all cost calculations are based on assumptions," Venkataraman points out. "So you always have to go back and reexamine your assumptions and the way you built your cost model. You need to ask some questions: Is this still true? Would we still be doing it this way now if we had a choice? If not, what are our alternatives?"

Take the silicon wafer business. "When companies first started making silicon wafers, from which they made chips, they created a silicon bar and then sliced it into wafers," Venkataraman says. "But there was a lot of wastage: If they needed 100 units, they'd have to make 200 units. So when they calculated costs, they'd take into account that the capacity of their machine was half the stated capacity. Over time, they created better cutting techniques using the same machine, which lowered the wastage rates below 10 percent. But some firms did not change their cost-accounting assumptions to reflect these changes, which led to poor decisions, inflated bids, and missed opportunities to generate revenue. If you don't regularly reexamine your assumptions and recalculate your costs accordingly, you're working with obsolete numbers."

Need another good reason to get cost-happy? Try tax incentives. Companies investing in new and improved products and processes may be eligible for federal and state research tax credits. Here's the catch: To claim the credit, they need to capture their development costs. Although it is not a specific requirement, the IRS prefers that the costs are captured on a project-byproject basis. "Some of the companies that we perform services for actually maintain project accounting by employee," says Keith Koland, a tax director for RMS McGladrey, a Minneapolis-based professional services firm. "But we find that some departments tend not to track their costs accurately, if at all. Sales, management, and quality control are typical culprits. They don't charge their time to the project as it's being developed."

The IRS won't be happy unless every employee contributing to the project has a documented qualifying cost associated with his or her work. "Some costs will qualify and some won't," Koland notes. "But the more qualified cost you put in the bucket, the larger the credit you'll receive for the research activities. Maximizing costs, and doing it legally, is an art. So if a company is going to set up a cost accounting system, it should definitely consult with a tax professional while it's doing it."

A final word of caution: there's no one-size-fits-all solution. "A good first step is to gain a very good understanding of the information you need to manage your business," Terhaar suggests. "Once you define that, you can narrow down the list of choices, do a cost-benefit analysis and make a decision based on how the system works for your circumstances."

Even if your primary cost drivers remain stable, you stay on top of your tax situation, and your cost accounting software is humming along, all the experts agree: complacency kills. "Even if there are no major changes, it's still healthy to regularly review your costing procedures," Terhaar affirms. "Then again, how often does nothing change in a business? Close to never. So evaluate your procedures at least annually to make sure they're still providing meaningful information."

Note: To find out how MTI's Business Services can help with your costing-related issues, click here.

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