Activity-based costing really works for custom molders.
Knowledge of product cost is critical for any organization that hopes to maintain or improve its competitive position. A proven way to gain that knowledge is through activity-based costing. "ABC," as it's often called, can be used by molding companies of all sizes, not only to better determine the cost of making their products, but to better understand why they cost what they do. With the knowledge gained from ABC, a molder can acquire a more profitable mix of products, identify activities that need to be improved, make better use of limited capital funds, and generally make better business decisions. Without accurate and relevant cost information, managers are "flying blind."
Recently, D.T. Hicks & Co. partnered with the Michigan Manufacturing Technology Center in Ann Arbor on an "Agile Manufacturing" project sponsored by the Department of Defense's Advanced Research Project Agency (ARPA). As part of the project, we helped three small to mid-sized injection molders implement activity-based costing systems. These firms' have annual sales from $5 million to $15 million and employ 50 to 100 workers each. None of the firms had the resources needed to implement a comprehensive ABC system, but all believed they would benefit from the type of information ABC provides. This article will discuss the significant hidden costs these three molders identified with ABC methods.
HOW ABC WORKS
The idea behind activity-based costing is surprisingly simple: It holds that costs are incurred as a result of the activities an organization performs, and that all those activities are performed for the purpose of making and selling products. ABC assigns costs to the activities that incurred them and then attributes accumulated activity costs to the part or product that made the activities necessary.
For injection molding businesses, ABC does not concern itself with outside costs that are directly attributed to a specific product. Examples of these items would include the cost of materials and of purchased components and services. Instead, ABC includes the cost of all activities performed by the molder to turn these "direct" items into products and ultimately into cash in the bank. According to the logic of ABC. activity costs "follow" material and outside processing services to the jobs or products that consumed those materials and services.
Before implementing ABC, the injection molders in our project handled their costs like most manufacturers do by dividing their activity costs into just two categories: Costs related to manufacturing were assigned to jobs or products on the basis of direct labor or machine hours. Costs from administration and sales were assigned as a general percentage add-on - either as an add-on cost or as part of the add-on margin.
The false implication of this type of cost structure is that all costs are either caused by the activities involved in manufacturing or are simply the general cost of being in business. In looking at our three injection molders through the "lens" of ABC, we found that a substantial amount of the cost included in manufacturing costs was neither directly nor indirectly attributable to manufacturing and that most of the costs classified as administrative and sales were far from being "general."
FIND HIDDEN MATERIALS COSTS
Investigation of cost accounting at the molders participating in our project uncovered many significant costing issues related to materials and other outside costs. In fact, 9-12% of each molder's activity costs were related to the acquisition, storage, and handling of materials and outside processing services. Here's a look at how the activities related to direct costs can add up.
Materials: The cost involved in acquiring, handling, and storing each company's standard, high-volume plastic compounds was relatively low. Although these high-volume compounds accounted for 70-90% of direct material cost, the activities relating to them amounted to only 32-34% of their material-related activities costs. The balance of the material activities costs were attributable to a wide variety of low-volume or special types of material, to outside processing services, and to excessive material movement.
Low-volume or special items included precolored material, abrasive compounds, and purchased or consigned components. At the one participant where precolored material was in use, the material-activity cost/lb for pre-colored material was almost triple that for white or black material. The two major factors that caused this difference were the low volumes in which precolored materials were purchased and the extra quality effort expended to ensure proper coloring.
We also noted than abrasive compound caused accelerated deterioration of molds and higher mold-maintenance costs at two of our sites. These should rightly follow the abrasive compounds to the jobs or products in which they are used.
One company received and stored compounds at a site located a mile from the manufacturing facility and incurred close to $150,000 annually in excess material-handling costs, adding 3 [cents] to the cost of every pound of plastic.
Outsourced secondary operations: All three locations contracted with outside processors to perform some manufacturing activities. One molder spent over $1,000,000 annually, while the other two spent about $100,000/yr. When the cost of activities existing to support these outsourced processes were attached to the prices charged by the vendors, they added 3% to the cost for the site making extensive use of outside processors and 2040% to the cost at those sites using outside processors less frequently.
Purchased components: These components generally required even more purchasing and quality effort per dollar of direct cost than did specialty materials. At one site, the storage and handling of customer-considered components cost the molder close to $30,000 per year.
KNOW YOUR MARKETING COSTS
Two of the molders in our study either sold their products in more than one marketplace or to more than one type of customer. One sold to both automotive and non-automotive customers while the other sold primarily to the automotive industry but had one major customer whose buying habits varied considerably from all of the molder's other customers. In both instances, activity-based costing revealed factors that raised the cost of jobs or products for certain customers.
The company selling to both automotive and non-automotive accounts found that costs related to operating in the auto industry added less than 8% to the activity costs of producing and selling automotive components, while 11% was added to the cost of producing and selling parts to non-automotive customers. Much of this difference was due to having fewer automotive customers that placed larger orders. While individual sales or service calls made in each market cost about the same, those made in the auto industry related to higher volumes of business. As a result 80% of the molder's market-related costs were spread over 85% of its business. The remaining 20% of its marketing costs related to only 15% of its business.
The impact was even more noticeable for the company with the one customer that differed from all the firm's other customers in its buying habits. The behavior of this customer, which accounted for 20% of the company's sales, caused it to incur over $50,000 in extraordinary support costs. The remaining 80% of the molder's business required only about $30,000 in such extraordinary support costs. The attribution of these extra support costs to the one customer substantially reduced the profitability of making its products.
An additional customer-related cost issue was uncovered at one of the sites investigated. At this molder, all new jobs required the submission of an Advance Quality Plan. In addition, a new Advance Quality Plan had to be submitted after each engineering change was made. Preparing each one of these plans cost the molder approximately $2800. Those customers that have a history of making numerous engineering changes during a job's life cost the molder considerably more to service than those who did not. Attaching the cost of the Advance Quality Plans to the customers making excessive engineering changes also substantially reduced the profitability of those customer's products.
WHAT MOLDS REALLY COST
One participating firm produced a wider variety of parts in much shorter production runs than the others. As a result, it found that costs related to the procurement, maintenance, and use of molds were a significant cost issue.
This company had inherited a group of low-quality molds when it took over a line of business from another firm. The increased difficulty in setting up and using these molds added over $7 per press hour to the cost of molding when they were in use. In comparison, higher-quality molds added less than $1.40 per press hour when they were in use.
The higher number of molds purchased also made it important for this short-run molder to know the activity costs that are related to the acquisition of each mold. The various activities required by that activity cost the company approximately $2700 per mold. As a result, the company could not consider only the mold purchase price when measuring the up-front investment in a new part. It also had to consider the additional $2700 of activity cost.
NEW LOOK AT MOLDING COSTS
Similar ABC structures for injection molding operations were developed at all three sites. Press hours, not direct-labor hours or dollars, were established as the primary driver of injection molding costs. All three molders agreed that press operators, who had always been considered direct labor, were actually one of the indirect costs required to make the presses run.
Presses were broken down into only a few size-related categories. All sites agreed that calculating a separate rate for each press would generate precise, but probably inaccurate and misleading cost information. On the other hand, using a single rate for all presses would not take into account the different amounts of investment in the various presses, nor would it account for the different variable operating costs and internal support costs of the presses. So, all three sites arrived at four press categories. Although given different titles at each facility, they could generically be described as small, medium, large, and extra-large presses.
Costs included in the four "press rates" that resulted included depreciation or lease cost, utilities, and other manufacturing supplies. Also included were distributions that reflected the presses' normal use of support activities such as maintenance, building and grounds, engineering, quality control, inspection, and plant supervision.
The cost of the press operator, although considered indirect, was not included in the basic press-hour rate. Instead, press operators were considered a separate, variable component of the press-hour rates. It was found that for a number of parts, the press cycle time was considerably longer than the time required for the operator to perform his or her duties during the cycle. In many such cases, the operator performed assembly, marking, or other operations on either the part being molded or on other parts to use the extra time productively. In these cases, only a fraction of a press operator hour is required to support a press hour.
In other instances, the size or configuration of the part being molded made it impossible for a single press operator to keep up with the press cycle time. In these cases, the press cycle had to be slowed down to match the operator's slower cycle time, or additional personnel were added to help the operator keep up with the press. To accommodate this variability, a separate hourly rate was determined for press operators and added to the press rate on a part-by-part basis, depending on the "crew size" required for each hour the press operates. This press-operator rate included the operator's wages and fringes as well as distributions that reflected the operator's requirement for support activities, such as human resources and payroll processing.
TABLE 1 - PRODUCT COSTING Cost per Part Difference Traditional ABC $ % Part A $1.4930 $1.3360 -0.1570 -10.5% Part B $0.3650 $0.4886 +0.1236 +33.9% Part C $0.1985 $0.2198 +0.0213 +10.7% Part D $7.4600 $7.9287 +0.4687 +6.3% TABLE 2 - EFFECT OF SUBTRACTING NON-ACTIVITY COSTS[a] Activity Cost per Part Difference Traditional ABC $ % Part A $0.6318 $0.4748 -0.1570 -24.8% Part B $0.1050 $0.2286 +0.1236 +117.7% Part C $0.0482 $0.0695 +0.0213 +44.2% Part D $2.0435 $2.5122 +0.4687 +22.9% a Non-activity costs are direct costs of purchased materials, components, or outside services. These are the same under both accounting methods.
Set-ups were not included in overhead, but were treated as separate activities. Although the means of charging set-ups to jobs varied, all facilities agreed that inclusion of set-ups in overhead rates made jobs with short production runs appear to be more profitable than they actually were at the expense of jobs with longer production runs, which were actually more profitable than they appeared.
IMPACT ON PRODUCT COSTS
At the end of the day, ABC shows its worth in finding "true" product costs. Indeed, for all three molders, the difference between product costs calculated using activity-based costing methods and those using traditional methods proved to be dramatic. (The impact on four parts tested at one of the molding facilities is summarized in Table 1).
Even more dramatic results can be seen when the cost of direct materials, purchased components, and outside processing are subtracted from the totals. These are the "non-activity" costs, or direct costs, that are the same under either method of cost accounting (Table 2).
Product costs determined using overgeneralized, traditional costing methods can differ considerably from ABC costs that take into account the cost behavior that actually takes place within the facility.
Douglas T. Hicks, a certified public accountant, offers management consulting for manufacturing businesses through his firm, D.T. Hicks & Co., in Farmington Hills, Mich.
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|Author:||Hicks, Douglas T.|
|Date:||Jul 1, 1997|
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