Cost for Efficiency

By Mike Hart

Traditional cost accounting can lead to bad decision making.  This is because it measures and rewards local efficiencies at the item, job, and work center level, which is actually counter-productive to overall efficiency. 

Cost precision is a myth

The most common mistake in manufacturing costing is to assume that each job has a precise cost.  Taking each job cost as a literal cost leads to poor decision making in regards to job scheduling, inventory, and product pricing.  These poor decisions can have a profoundly negative impact on your overall efficiency that gets translated into longer delivery times, increased inventory, and higher product costs. 

Smaller run sizes are more costly, but only on paper 

A good example of how literal job costing leads to poor decision making is your run size policy on make to stock items.  If your objective is to achieve the lowest unit cost possible, an easy way to achieve that is to increase job run sizes, which spreads your fixed setup cost over more units. 

Increasing your run size lowers the cost on paper for this one product, but at a high hidden cost that gets applied to all your products.  Large run sizes clog up job schedules, tie up work centers and aisles, increase WIP, and reduce your quality.

Setup is really an overhead cost

The assumption that setup cost is a literal cost is what leads to the incorrect decision that increasing run sizes is a good thing.  In reality, setup is more of an overhead cost than a direct cost because you tend to have a fixed payroll cost for setup personnel, regardless of how many setups they perform in a given period.  When you treat setup as an overhead cost, the cost gets spread over all your products so that no one product bears a high setup cost. 

Increase your setups and reduce your run sizes

The far more efficient practice is to reduce your run sizes, even though it will increase the number of setups and create more work for your setup personnel.  Shorter run sizes can have a profoundly positive effect on your overall efficiency that greatly outweighs the extra setups.  Jobs are easier to schedule and get performed more quickly using less material. 

A single shop rate leads to better decision making

A single hourly shop rate for labor leads to better decision making because no single job gets penalized or rewarded based on what workers happened to be used or whether the job was run during regular or overtime hours.   

A single shop labor rate blends all your individual direct labor wage rates into a single rate that reflects downtime and overtime.   With a single hourly shop labor rate you can freely allocate labor resources where and when they are best needed, without regard to cost implications. 

Overhead is an indirect cost 

Another example of how literal job costing leads to poor decision making is to assume that factory overhead is a direct cost.   If your objective is to achieve a target profit margin on each job or product, treating overhead as a direct cost can lead to poor pricing and product line decisions.  

Material, subcontract services, setup, and labor are direct costs.  Even though setup and labor are costed at a single shop rate, which is an “approximate” cost, that cost is still directly associated with each job’s estimated or actual job hours. 

Overhead is different.  It represents the overall cost of running the factory, including managers, supervisors, maintenance personnel, rent, utilities, and supplies.  This overall cost gets allocated to each unit of production, but only on paper.  Overhead is an indirect cost, not a direct cost. 

A job or product can lose on paper, but still be profitable

If you treat overhead as a direct cost, you can mistakenly conclude that some jobs or products are unprofitable because they lose money on paper.  In reality, provided that direct costs are covered, some of those jobs or products may be valuable contributors to your overall profitability, even if they appear to be losers on paper. 

Factory overhead is essentially a fixed cost.  The only way to reduce the unit cost of overhead in your products is to spread this fixed cost over more units of production.  Therefore, any product that covers its direct costs contributes additional units of production that helps absorb your fixed overhead cost.  You are better off keeping what appears to be an unprofitable job or product because it helps lower the unit overhead cost of all your other jobs and products. 

Increasing shop utilization is the best way to lower costs

The most dramatic way to lower unit costs and improve margins is to spread your factory overhead cost over more units of production.  Therefore, it is often to your benefit to take on certain jobs and to keep certain items in your product line that lose money on paper, but help absorb your factory overhead cost. 

A single shop rate for overhead is best

As with labor, a single hourly shop rate for overhead is the best way to evenly allocate overhead across all your products without unduly penalizing or rewarding one process over another. 

Mike Hart is the co-founder and President of DBA Software Inc., a leading provider of manufacturing software for small businesses.

Comments

[wms]

I absolutely agree. Keeping high utilization (to reduce cost) can hurt service level to customers. I think activity based costing can be alternative to traditional costing.