In the last blog post, we highlighted the dangers of a weakening Standard Costing model caused by the changing ratio of direct to indirect cost. We briefly discussed the implications of not knowing what your product cost actually is.

In short, accountants traditionally allocated a smaller pool of indirect cost against a larger pool of direct cost. Now however, because of modern manufacturing practices and automation, in many cases, the indirect cost has outstripped direct cost. That means the simple relationship between direct and indirect cost, which underpinned the old approach has broken apart. As a result, the traditional costing method used to quote and price new business is increasingly incorrect and unreliable.

The implications of this shift go beyond pricing your product. Consider the following inventory management and cash flow problem.

Imagine that the CFO runs a spreadsheet model and discovers that the company has too much money tied up in stock and must reduce inventory by 10%.

Just cutting production and purchasing across the board runs the risk of creating chaos. So, the problem then arises, which 10%? To answer the question, management must work out which products can best cope with reduced inventory, so they don’t hurt the business. The inventory value of work-in-process at different stages of manufacturing contains different levels of direct and indirect cost. They must decide where to reduce the 10% of cost to hit the target.

If they reduce specific raw materials, then they must know which products use those materials and in what quantities.

If they reduce finished goods, they must know customer order patterns so they can assess what can be reduced without jeopardizing the on-time delivery and seasonal demand.

If they reduce subassemblies, they must have accurate book values, know in which products they are used, and what configurations offer the best build flexibility.

Moreover, they want to know what impact the changes will have on plant and labor utilization, which will affect overhead absorption.

Getting it wrong can have serious repercussions, and while you must have data to make good decisions. If you don’t know what additional data to collect and what to do with it, collecting ever larger amounts can make things more difficult.

The ability of traditional management tools to address these issues is being stretched thinly. What we need is better analytics to accurately handle this level of complexity, and do it fast enough, to make a difference.

The absence of this ability is an increasing challenge placing tremendous risk on the business. It is the root cause of more and more company failures.