Financial Reporting versus Costing: Which is Right?

When attempting to calculate the cost of products and services, people often cite practices used for external financial reporting. Then they attempt to use these practices for internal decision making. Perhaps in an ideal world, this may be a valid path. However, we live in a world far from this ideal. In our world, external financial reporting and internal decision making are often in conflict. Why?

External financial reporting is concerned with how a reporting entity looks to external stakeholders. To this end, external financial reporting must follow rules coming from historical practices, public accounting boards, stock exchanges, auditors, and government agencies. These rules attempt to ensure consistency and comparability though time, across companies and even across industries. These rules change gradually, if at all. A rule change must go thru a long convoluted process before acceptance. Meanwhile, many voices must be heard and compromises negotiated. In the end, we may or may not like these rules, but they are the rules and must be followed. If we attempt to change a rule, be ready for a very lengthy process and be prepared to not get what you want. Don Quixote’s quest comes to mind. If you break a rule, well… we won’t go there.

On the other hand, internal decision making is only concerned with making good decisions. Those making the decisions are the ones making the rules. Consequently, if they don’t like a particular rule because it does not help make a good decision, the rule can and should be changed. Rather than citing specific rules, let’s suggest several guidelines:

  1. Cost must follow cause and effect. I like to make a distinction between cost assignment and cost allocation. Cost assignment incorporates cause and effect. Cost allocation is simply spreading cost regardless of causality.
  2. Relevance. If a cost is not relevant to the decision being made, don’t include it. For an extreme example, the company’s CEO is actually quite expensive. The CEO carries a lot of responsibility and is compensated accordingly. But what relevance is the cost of the CEO to one product versus another? Will we need more CEO if we promote one product over another? Will we need less CEO if we discontinue one product?
  3. Cost is the monetization of operating results. In other words, cost is a symptom of some operating decision. Cost is a reflection of capacity decisions. Cost is a symptom of process effectiveness and efficiency. If you don’t like the cost, fix the underlying operating reality. As a symptom, cost can lead us to find an operational hot spot that needs priority attention.

Essentially, external financial reporting and internal product and service costing should be considered as two mutually exclusive objectives. Reality suggests we cannot ignore the requirements for external financial reporting. However, using external rules for internal decisions will usually lead to poor decisions and low profits. Fortunately, good internal decisions will result in better financial performance, aka profits, reported to external stakeholders.