Topics

 

If you wish you could assess how well your company is using its money, one possible way to calculate to do it is to determine the ROIC (Return On Invest Capital).

Its most used formula is the following:

 

ROIC = (Net Income – Dividends) / Total Capital

 

Let's now look at the numerator, which can be obtained in various ways.

The simplest and most direct one is to subtract the dividends from the net income of the company.

However, we should also consider that for the formation of net income, the company may have taken advantage of some earnings, not related to its core business, that is, of an extraordinary nature, such as some realized capital gains or those derived from the fluctuation of exchange rates in case of sales abroad.

 

In  order to throw off these potential distortions, the so-called NOPAT is also often used; it stands for Net Operating Profit After Taxes.

 

It is calculated by subtracting from the Operating Income the Income taxes (calculated on the "Total" Income ) and the Fiscal benefit of the Financial Expenses (if any).

 

NOPAT = Operating Income -  Income taxes – Fiscal Benefits of Financial Expenses

 

The Operating Income is also defined in some cases as EBIT or Earning Before Interest and Taxes.

 If you want to understand the real difference Operating Income and EBIT, see the article 46 on this webpage.

 

 

Let’s turn to the denominator.

 

The denominator is the sum of all debts and equity. This value can be calculated in various ways.

One method is to add the book value of a company's equity to the book value of its debts, subtracting the non-operating assets.

 Another way to get total capital is to get net working capital, subtracting current liabilities from current assets.

After that, non-liquid net working capital is obtained, subtracting liquidity from the result just obtained.

Finally, non-liquid net working capital is added to the company's operating fixed assets:

Of course the amount to be considered is the average one of the related period and not what you have at the end.

 

 Having said that, we understand how Roic is the ratio between these two measures, each of which can be obtained differently, so it is always expressed in percentage terms and usually on an annual basis.

 

How do you see whether the company is really generating money from its Operating Management?

 

The answer focuses on the creation of value and that’s why you must compare Roic with the Cost of Capital.

If the former is higher than the latter, then the business is creating value, otherwise it is destroying it.

From the difference of these percent terms you can also achieve the EVA (Economic Value Added) by multiplying it by the amount of the Capital, how we explained when writing about the denominator.

 

Roic under control is very important for every company, although for some industries this value is much more significant than for others.

For instance, companies that have put in place a strategy of important investments and want to check them out over their life.

You know very well that some businesses to pursue their strategy, both a Differentiation one and a Price leadership, should make great investments into machinery, equipment and any other factor that enables to achieve a competitive advantage within their reference market according to the value attributes acknowlegded by their customers.

In other terms those companies are capital-intensive and need some effective metrics to look over the return of these investments.

Roic is very important to this purpose.

 

The best way to put it under control is to check its trend out over the life of the firm (better if together with EVA); as a matter of fact, there isn't a strict reference value of this metric and that's why looking at how it goes along over the time is very appropriate and if compared to the competitors it is more significant.

 

Having said that, I would add that it could be used even better together with other indicators, in order to better assess the state of the company.

For example, I would suggest the creation of an indicator that takes into account the capacity of the company to manage the liquidity whose issues can in their turn affect the operations themselves of the business.

In this regard I proposed in the article 5 the GSI (Global Succes Indicator) considering both the Profitability aspect and the Cash management aspect.

 

On the other end if you want to take into account other value than the accounting-based ones, you could see Roic, GSI and the P/E ratio, i.e. the ratio of the share price to earnings.

When this is high, it would tend to suggest that the company on the stock exchange would be overvalued, but it could also signal a high return on invested capital, that means the shares are premium-quoting, compared to those of other competitors.

 

In other terms this would confirm once more that you have a real competitive advantage since, compared to your rivals, you operate at a higher return and  command a premium price.

 

Many businesses set as main operating profitability measures those linked to the accounting records and even more limited to the short term; that is they don't go beyond the single fiscal period.

If on one side they are easy to be determined, on the other they don't reflect some of the main features a single profitability measure should have in my view and neglect some potential negative behavioural effects.

These features concern for instance goal congruency, motivation, fairness and all of them are referred to the managers that are in charge of the business units.

 

In this article I am going to deal with some of the main accounting-based measures in place with regard to the investments centers where the respective managers are responsible not only for the revenue levers and current costs but also make investment decisions.

Some considerations will be made about the ways one can adopt in order to enhance their informative value and compensate for their flaws.

All of them with an eye at the strategy of both the business unit and the whole group a BU is part of.

 

Let's get started.

 

What is the most common ratio used on Operating profitability measurement purposes?

 

Without a doubt ROI, that is Return on Investment.

 

ROI = Profit/Investment

 

Prior to disserting on this in a strategic slant, some clarifications should be made in order to make the following article as precise as possible and as realistic as we can.

 As you may know it is an accounting-based measure and there are two ways the Finance Managers usually adopt to define both the numerator and the denominator of this formula.

The most used one sees the Operating Income at the numerator and the Total Assets at the denominator: Operating Income/Total Assets.

 

The other is EBIT/Total Assets.

 

Many times these ratios are considered as interchangeable but in some cases they aren't the same thing and have a different meaning.

An example accompanied with an Income Statement will be useful to our purposes.

 

In the table 1 we guess that the company Alfa Inc. doesn't hold any non-operating assets; in this case EBIT and Operating Income will have the same amount

 

Table 1 - Income Statement of Alfa Inc.

  

Revenues	20,000,000 -
Cost of Goods Sold	12,000,000 =
Gross Profit	8,000,000 -
Sales & Mark.	2,000,000 -
Admin.	1,000,000 -
R&D	1,500,000 =
Operating Income/EBIT	3,500,000 -
Interests	250,000 =
Pre-Tax Income	3,250,000 -
Taxes	975,000 =
Net Income	2,275,000

 

In this case both of these ratios have the same amount and will be good at assessing the operating profitability of the Business Unit, that is understanding how good the respective managers were able to put their assets to work.

It goes without saying that in the budget period both of them are also good at setting the operating profitability targets; the extent to which the same managers should be able to put their assets to work in the next period.

 

Let's suppose that the company holds some gold stock, some forward contracts to hedge its exposure to oil or foreign currency or something else.

 

This is just an example that highlights how the company or some of its Business units might hold some non-operating assets that are able to generate investment income.

Turning back to our example, let's guess that the amount those investments yield for Alfa Inc. adds up $ 300,000.

Here is the new Income Statement.

 

Table 2 - Income Statement of Alfa Inc. with Investment Income

 

Revenues	20,000,000 -
Cost of Goods Sold	12,000,000 =
Gross Profit	8,000,000 -
Sales & Mark.	2,000,000 -
Admin.	1,000,000 -
R&D	1,500,000 =
Operating Income	3,500,000 +
Invest. Income	300,000 =
EBIT	3,800,000 -
Interests	250,000 =
Pre-Tax Income	3,550,000 -
Taxes	1,065,000 =
Net Income	2,485,000

 

In this case the Operating Income will be the numerator of the ROI while EBIT should be ignored as a numerator of a ratio that serves as a measure of the operating profitability of the Business Unit.

Of course when one should consider EBIT to see how much one takes out of all its assets, the denominator should include the non-operating assets, too.

 

After removing all doubt about a common misunderstanding of the financial analysts of a company, I will deal with some strategic implications following the use of ROI in the manager performance assessment and in issues related to it.

 

I specify "some" since the implications are multiple and require further "dives" into the reality of the BUs involved and procedures concerned.

 

As of now the dissertation will go along by highlighting some points of this metric related either to its short-term essence or to a peculiar situation of the organization using it; all of them affecting some issues such as motivation, goal congruency and fairness.

At the end the dissertation will focus on some general aspects of its use with regard to the same issues.

 

 

1. Short-term limitation

 

a) Fairness

 

ROI like all the accounting-based measures has a short-term horizon and and when some changes happened recently in the management policy, last but not least change in people with decision-making power, it doesn't help at all assess the direction of the new managers.

As you know the profit you find at the numerator is the result also of the investments made in the previous years when the management and the strategy of the business unit could be different from the present ones.

That means that evaluating the "behaviour" of the manager presently in charge on that basis is not fair enough.

 

How can you compensate for these "flaws"?

 

A potential remedy could be the use of a scorecard the may include the "scores" achieved in the latest fiscal period with reference to some non-financial indicators linked to the objectives of the BU (here is where the Balanced Scorecard fits in with better than any other kind of scorecard).

 

A possible adjustment that concerns only ROI provides the comparison of the latest value to  its average over a largest period and as a result one is able to make all the related considerations.

 

b) Goal Congruency

 

You know very well the most used methods to evaluate a project take into account the discounted cash flows generated by the long-lived assets.

One of them is without a doubt the NPV (Net present value) that considers as a good investment the project that gives after all its duration a positive total after-tax cash flow.

Very often at the beginning of the life of the project the results are not positive in a sense that the cash outflows overtake the cash inflows.

This peculiarity affects the ROIs of the first periods of the tbusiness unit involved by that investment so that the respective managers conflict with the CFOs that in their turn do just their job.

The ways to allign the "points of view" exist and involve some "accounting" adjustments to be made to the assets affected by the project.

If you would like to go in depth, you can write on page Contacts of this website.

  

 

2. Multiple Investment Centers within a company

 

a) Fairness 

 

This element comes into play also when multiple Investment centers exist within a company and/or a group and the respective managers are evaluated according to the ROI "scores".

Each of the BUs involved has their own equipment, machinery and other depreciable assets with their own age.

It's clear enough that the owners of the oldest assets, that do their job very well despite their age, take advantage when the Net Book Value is used for the assets included into the denominator of the ratio being consisdered as ROI, Operating income/Assets.

On the opposite side we find the managers of the BUs that hold the newest assets; it will be them to have the highest denominator and as a result the lowest ROI.

At this point in order to have a correct profitability measure, at the same time fairer and more adherent to the financial measurement needs of the company, it would be appropriate replacing the NBV with another value that could be either the replacement cost or other costs taking into account the current value of the assets and, why not, the specific situation of the BUs involved.

 

Further fairness issues may arise when the BUs have different risk situation and some adjustments should be made. Also for these details you can write on page Contacts.

 

b) Goal congruency

 

When the managers are assessed on the basis of ROI some conflicts can arise between them and top management.

For instance that happens when top management endorses some investments that affect in a positive way the ROI of the whole company but lowers that of specific BUs.

I will be more clear.

Let's guess that there are many investments centers within a company and that top management is encouraging a shared investment in a sense that impacts the profitability of many BUs.

More precisely this project provides shared assets whose utilization is imputable, according to realistic drivers for the cost allocation, to multiple investment centers.

Prior to accepting and endorsing the new investment, the managers of the BUs with a higher ROI than that of the new investment are likely to oppose it because their profitability score will lower compared to the usual value.

On the other side the BU managers with a lower "single" ROI will encourage the new project.

One of the solutions to bring an end to these conflicts is the Residual Income.

 

 

Box 1 – Residual Income

Another Accounting-based measure of the operating profitability of a Business Unit and in particular of an investment center is the Residual Income. It carries with him many of the considerations that we are doing about ROI but it plays a positive role  with reference to the issue of goal congruency just dealt with in the paragraph “Multiple investment centers within a company”.    First of all, let’s define what is the Residual Income like. It is the difference between the Operating Income and a given reward for the use of the Assets of the BU involved. This reward is achieved by multiplying a percent charge by the value of the Assets considered; this charge usually is the WACC (Weighted Average Cost of capital).   RI = Operating Income – r x Assets    r is WACC   Having Said that, it is clear that a manager is evaluated positively just when this difference is positive as well, meaning that a minimum reward target for the  use of the capital has been achieved since the respective costs has been overtaken by the related earnings.   As a result, turning back to our goal congruency context, all the manageres will accept a new project based on the fact that an additional amount will be achieved (in case of positive Residual Income) following its implementation, neglecting the potential lowering of the Bu’s ROI.

 

 

3. Some general considerations

 

a) Motivation

 

Top Management can decide to take advantage of the use of ROI as a financial performance metric to push the managers of the BUs concerned to go a specific strategic path.

Here is an example.

Let's assume that the company is pursuing a differentiation strategy since its top management's opinion is that will increase the market share and revenues and thanks to this lever and in addition to setting a given budget amount to be spent on the most suitable technological assets it wants to make sure this direction is really executed.

It can capitalize on the denominator of ROI, by using as a criterion the Replacement Cost instead of the Historical value.

As a matter of fact the Replacement Cost is higher than any other criterion and as a result it lowers the ROI of the investment centers concerned and assessed on that basis.

At this point the manager would be more motivated to spent his budget on asset purchase since thank to its work the BU will be able to achieve as well a positive contribution margin that will increase the numerator of ROI by compensating for the amount of denominator, always at the same level even when the purchase isn’t made.

Another example could be made about the incentive from the top management to the BU's managers to use or not to use the idle assets according to the strategic goals.

Page Contacts for further details.

 

Which is another potential limitation of ROI?

 

When this ratio was conceived, the large majority of the industries relied mainly on tangible assets and in fact it's clear how much the physical assets are taken into account in all the considerations we made so far.

Nowadays the situation is different and many industries capitalize on the knowledge of their human capital to make profits more than the tangible assets.

It suffices to consider the web-based companies whose products invaded our life.

 

Please not to confuse this with the Know-How that is related to all the information of any kind achieved by the employees trhoughout the life of the business and that gives it an edge over the competitors.

 

In our case the knowledge of some part of the personnel is the key to making the business successful and as a result it should be considered as an asset to be evaluated and to be put at the denominator of ROI.

Many analysts subtract the annual wage expenses fromthe numerator and add it to the denominator. In other terms they capitalize the gross compensation of the personnel involved.

I don't agree fully to this method since it is just as you for each tangible asset (for instance) put at the denominator neither the historical value nor the current value but its annual depreciation amount. I keep in mind something else that goes beyond the target of this article and won't be shown on this reason.

 

One thing is certain, the discussion over the use of ROI and other accounting-based measures as financial performance metrics has many many aspects that one can make and agree to and that's why this website is going to deal with them in the future publications.

 

How many times we heard of the Value Creation as the main success factor for a company!?

 

I cannot tell you how many times I advised about the actions to take in order to avoid as much as possible the mismatch between features of a product or service of a business and its customers!

 

I cannot tell you how many times I advised and wrote about the need in the design phase of a product to take into account the preferences/needs of the customers to be satisfied through the product functionalities by considering their point of view and not only by the feelings/experiences of the top managers involved!

 

Everything is always good and will be good forever but....

 

But are we sure that this suffices for getting the customers to purchase the product/service in some markets where the competition is so high and the entrance of new subjects increase and increase?

 

IN MY OPINION NO, THIS DOESN'T SUFFICE.

 

No because in some market segments the high number of competitors that "offer" similar products/services is characterized by the fact that the differences among what you can find to purchase are very small, about both the functionalities that serve as a means to meet the customer requirements and the sales price.

 

In these conditions the choice of the customer turns out to be almost a random one in the end and the classical scheme that relies on the foundation that all the Value-Add Activities of the business should be carried out and optimized to "ensure" the most desired attributes of the products/services in order to sell them as much as possible is not the only winning move.

 

Before to dissert on a possible solution and the role that a management accountant could play to help a bussiness success, some clarifications must be recalled.

 

First of all, not all the activities of a firm and the related expenses incurred are valued by the market as determinant to go through with the purchase.

 

You can find business-sustaining activities that are essential for the company to exist but that aren't considered and then evaluated by the customers, that is they won't pay anything for them.

You can find other kinds of activities that are carried out to ensure a future yield to the company such as the R&D ones that aren't valued for the present and potential purchase by the customers.

You can find waste of different sort that not only aren't considered by the market but that affects negatively the bottom line of the company in the present and in the future. 

The only business activities that the customers would pay for are the Value-Add ones.

 

The examples of these categories are several and depend on the business industry and in some cases on the market segment they refer to.

 

Secondly, in order to have a more clear understanding of what you are going to find in the following lines, please remind of the great usefulness that may have a breakdown of the market the business operates into, as precise as possible.

 

Having said that, here is a shortened example of the way many companies traditionally go when making use of the most wide data-analytics application of the Customer-driven value approach.

 

In the following table, you have a Revenue and Cost Breakdown (in percentage) of the Value features/attributes referred to each of the customer segments concerned by the product of a company manufacturing pens.

 

Please note that the way the Revenues and the Costs are segmented and broken down is not  explained because this goes beyond the purpose of this article.

 

Table 1 - Actual Revenue and Cost Breakdown and Segmentation of Alpha Inc.

Value features	Writing pen customer Revenues (%)	Writing pen customer Costs (%)	High-end pen customer Revenues (%)	High-end pen customer Costs (%)	Total Revenues (%)	Total costs (%)
Writing quality	55%	36.3%	30%	37.4%	50.2%	36.4%
Model Availability	15%	34.9%	10%	9.3%	14%	31.6%
Brand Name	9%	7.3%	20%	19.6%	11.1%	8.9%
Appearance	7%	7.5%	28%	18.7%	11.1%	9.0%
Price	14%	14%	12%	15%	13.6%	14.1%
Total	100%	100%	100%	100%	100%	100%

 

 

In order to assess how important each Value attribute (feature) is for every segment and how much money a dollar spent on it by the company yields, the amount of the respective revenues are divided by the respective costs (if you want to see better my personal approach to attributing revenues and costs, you can find the article "The cost management and the customer-driven value model"  on page Shops www.thestrategiccontroller.com/2/shop_3813594.html) 

 

Here is the table.

 

 Table 2 - Value Creation Ratio (VCR) of the Value Attributes

Value Features	Writing pen customer segment	High-end pen customer segment	Total
Writing quality	3,17	2,25	3,01
Model Availability	0,90	3,00	0,97
Brand Name	2,60	3,57	2,74
Appearance	1,94	4,20	2,69
Price	2,10	1,31	2,11
Average	2,10	2,80	2,19
Standard deviation	0,84	1,13	0,81

 

Moreover, I want to show some of the classical conclusions that one can make by analysing these data, only for the first segment.

 

 

Writing pen customers (present standing)

 

Recalling the meaning of the Value creation ratios showing how much a dollar spent produces in revenues, we observe,  by looking at table 2, that the most profitable “effort” is found in the Writing Quality feature where 1 dollar spent on the linked activities yielded 3,17 dollars in revenues.

This attribute is followed by Brand name (2,60), Price (2,10) and so on.

The values can be read as a confirmation of the fact that the most important success factor is the Writing Quality but also it can be gathered that the efforts in terms of resources invested  should be lightly increased to better meet this customer preference and increasing the revenues.

 

Why am I writing lightly?

 

Generally, when a Value Creation Ratio is up to 5 points, it indicates the business is nearly aligned with its market and it’s doing well in the search of the value for the customers and revenues rfesulting from it.

When the VCR is low (below 2), it means the money earned is also low and the expenses on the linked activities should be either reviewed to increase their effectiveness, if the preference for that feature is important, or minimized if the preference of the customer is small (according to the result of detailed customer surveys).

I write “generally”, because there aren’t absolute reference number, in consideration of the fact the situation changes from industry to industry.

Without any doubt when the VCR is extremely high, the conclusion  you can draw is that the firm's strategy  isn't alligned, because its investments are not focused on the value features really requested from the market.

At the same way when the VCR is below 1, it indicates the business is losing money because one dollar incurred doesn’t yield even one dollar in  revenues, generating a particular kind of waste, the Waste Activity Expenses for the difference between the costs incurred and the lower revenues attributed.

You can see a new side of the waste in consideration of the external perspective of value, the Customer one.

In our example, the Value Creation Ratio of the Model Availability is 0,9, indicating the firm is spending more than it is appropriate  (+ $ 150,000). This sum will be ranked in the Operating Income Report as Waste Activity Expenses

 

The conclusions about the other segment, High-end pen customer (present standing), and further considerations  are shown on  the article "The cost management and the customer-driven value model"  on page Shops www.thestrategiccontroller.com/2/shop_3813594.html)

 

After the analysis so far explained the most common issue is the individuation of the most profitable segment.

That must be made and intended for several kinds of future decision-making processes.

 Just to these processes the goal of that dissertation is directed but it falls beyond the scope of this article, too.

 

That's why we turn back to its main subject.

 

When the conditions of the market segments are like those I explained earlier (high number of competitors and very small differences among what you can find to purchase, about both the functionalities that serve as a means to meet the customer requirements and the sales price), the solution should consist of the "Invention" of a new value attribute, that is the company should differentiate to the extent of creating a new need of the customers. A need that they aren't aware of at the present.

 

This could concern either a new feature of the product/service or a new and most easy way to access it.

 

Turning back to our example, we should add the Value Attribute "?" to the existing ones.

 

Value features/attributes

Writing Quality

Model Availability

Brand Name

Appearance

Price

?

 

Of course, each industry and business has its own dynamics (for instance according to the different Product Life Cycle duration and the respective stage the product is in and to the technical speed to put in place this "Value Invention") but one thing is certain:

 

 - The role of the Management Accountant will become more and more determinant and his working hours spent on interacting with all the business dpts concerned in the definiton of the new Value Attributes (R&D, Sales & Marketing, Manufactuting, Customer Service,...) increase and increase, mainly in the evaluation of the future impact on the bottom line of the firms that should continuously Invent Value -.

 

Gary Cokins

Carlo Attademo

 

Quality!? 

How many times we hear of this word and the related concepts and standards needed to be met in order to be certified as an ISO 9000 (and following…) organization.

But are we sure about the meaning of Quality? 

Are we sure about its strategic importance for a company to be profitable? 

 

The former question involves some considerations about how we are accustomed to perceiving quality.

Most of us take it as a concept strictly linked to the high performance of making  products and delivering services with reference to the processes to make and deliver them.

It looks like only the business pursuing a Differentiation strategy would embrace the quality concept.

It isn’t always this way.

Quality is the ability of an organization to arrange all of its internal processes and to make all of its products/services to meet (at a minimum) the expectations of its customers. 

That means that even a firm adopting a low-cost strategy can also embed the quality concept into its processes and products/services.

 Last but not least, the firms nowadays are being affected by aggressive competitors to increase the quality standards of their products/services and lower their costs, thus adopting as a result a mixed strategy.

That means that it’s even more insightful how this subject is “across-the-board”.

 

The second question about the Profitabilty?  

 

You can find the full article in the file attached below

 

CFOs very often make the choice of a Cost Accounting and related Reporting System based on the opinions, very detailed and introduced  with in-depth specific topics, of the vendors about the related softwares.

I will be as straightforward as possible.

Most costing system implementations focus mainly on the decision to set either a standard mechanism or not and once this decision is made by the persons in charge of this task (usually the CFOs) great importance is attributed to the role of the software vendors.

In the end many CFOs choose the Cost Accounting and Reporting System related to that software that enables the best business cost breakdown by cost object and gives an immediate perception of those results, considering the information requirements independent on the kind of business processes, products and the strategy of the business.

In other terms they believe to get the most suitable system on the basis of the detail level and visualization ease.

But are that business cost breakdown and its results so easy to be monitored consistent with their information requirements?

 

Please listen to the Management Accountants or to the Controllers that are very knowledgeable  about cost issues and are able to find the right “fit”.

 

In the following lines I am going to summarize the most used kinds of Cost Accounting Systems and related Reporting that a CFO may be deciding to implement into his business according to different criteria.

 

Let’s start.

 

As I said in the lines above, the main choice goes either to a Standard Cost system or to an Actual one, but between those measurement kinds of the costs there is another halfway.

Its name is Normal Costing.

 

Having said that, let’s take into consideration the resources and the related costs  that are the basis of this choice: Direct Labor, Direct Materials and Industrial Overheads (I mean the Manufacturing ones while for the Service Industry those incurred for giving the Services to the customers)

When a portion of them is “predictable” about their  amount as well as the unit cost with reference to each product/service referred to in a reasonable way under given and presumably steady conditions of efficiency of the  manufacturing/delivery processes, the Standard Costing system is fully applicable.

 

Its usefulness goes to the cost control purposes, performance evaluation and continuous improvement when comparing the actual results (costs) to the standard amount and costs set a basis to look at.

 

As to the Actual System all we know that each product/service is charged with the expenses once they are incurred.

Very accurate for the decision-making purposes but it doesn’t allow an immediate perception of how things are going as quickly as Standard System does.

Of course, when there aren’t conditions that enable the Standard Costing adoption, the choice of the Actual one is mandatory

 

Then, what about the Normal Costing System and what are the main reasons leading to its use?

 

Take the case when your products have their own direct materials (also direct labour if the workforce is specialized in that specific make), differing very much from those concerning other products while all the manufacturing processes are instead similar.

In this case the Normal Costing provides the Actual system for the direct materials and an estimated unit cost per product/service of the other indirect expenses.

Whether you are using a Standard Cost Accounting or Actual one or Normal one, you are moving within either a Job Costing System or a Process Costing one or an Operation Costing one.

 

As a matter of fact, another canonical classification concerns the way  one can attribute the costs to the cost objects.

When all the costs are charged directly to the product/service, you will be in a Job Costing method; when you attribute all the expenses to the process of manufacturing/providing the product/service (to be successfully allocated to the products/services), you will be in a Process Costing.

In the end, if you attribute the Material Costs (together or not with the Direct Labour ones or other Special Fixed Costs) to the cost objects and all the others to the process (eventually allocated to the products/services), then you are moving within the Operation Costing.

 

Of course the choice lays in the features of the products and processes and the specifity of the resources consumed with reference to the cost objects.

In making the kind of choice we have indicated, we have neglected the horizon of the business profitability, wheter its strategy is focused on the long term or on the short term.

In the former case the Activity approach comes up as one of the most indicated to meet the information requirements of the management (in particular when the industrial processes are not so uniform when referring to the products/services/customers/distribution channels).

As we all know, when the horizon is the long term, the fixed costs (with reference to the output volume) get much importance and the accuracy of their imputation to the cost objects is lifted to the highest degree.

At this point you can choose for instance GPK cost management technique that is very suitable for the business with multiple cost centers characterized by different capacity-related resources.

It enables the construction of many financial intermediate results, even distinguishing between short-run fixed resources and long-run ones.

If your fixed overheads (with reference to the long term) are the most part of the expenses, then the classical ABC (Activity-Based Costing) is the most appropriate tool, by identifying the right drivers of the consumption of the resources (when the time is the most appropriate driver, the Time-Driven ABC is a further option).

If your intention goes salso to the assessment of the Unused Capacity, a mix of ABC and GPK, the RCA (Resource Consumption Accounting), can also meet your needs.

Not to mention the in-depth applications of the Activity approaches dedicated to the concept of the Value such as the Capacity Cost Management and the Activity- Based Management.

 

In the former case the system is very useful  to many decision-making purposes and very suitable in particular for the businesses adopting a Price Leadership Strategy (when the Price determination follows a mark-up method), by allowing the identification of the time and the costs of the Idle and Non-productive capacity and as a result the potential increase of the denominator (productive capacity) to which dividing the fixed costs and the calculation of a lower unit fixed cost to be charged to each product/service.

The latter is consistent with the value as it is perceived by the customers with reference to the attributes/functionalities of the product/service.

 

Putting aside the traditional dichotomy between Volume-Based methods and Actity-Based ones, we cannot neglect the Lean Accounting System.

That is good in particular when you have many product models whose manufacturing/providing processes are very similar so that you can build some homogeneous bundles (Value Streams) by grouping some of the numerous models, whose profitability can be built and perceived at once through  less detailed reports.

This methodology is also a very good basis for continuous improvement purposes intended to cut waste and improve the efficiency in general of the business processes.

 

Of course this dissertation hasn’t the goal  to analyze each Costing technique as in-depth as possible but to highlight the need for the CFOs to hang upon the professional opinions of their Management Accountants (or Controlling professionals) when deciding the implementation of a particulas Costing method in order to be able to make the best analyses and decisions

As a result this article isn’t the right “place” where listing all the advantages and disadvantages of the above-mentioned methodologies.

 

If you wish to read more about a particular technique you may find some articles on this page and get in touch with thestrategiccontroller.com for further details

As you may have understood after these lines, there are many factors, objective (about the products/services and the business processes) and subjective (about the strategy) ones, to be carefully considered.

This leads to the conclusion that the Rule of Thumb doesn’t exist.