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Do yourself a favor.

What Does Your Product cost?

The cost clerks and accountants sit hunched over their desks behind piles of adding machine tapes grinding out 'the costs". Computers do the same things faster but not much better. The best intentions and trojan efforts of your people cannot improve your costs if the basic systems and methods are not in place. Your staff needs good tools to provide you with good information.

We are talking about the "Cost of Goods Sold", the largest item on the Company's Income Statement. Simple slips, errors or omissions can create disastrous inventory losses ! While operations continue without major change, traditional rules of thumb and fudge factors can hide problem areas. Daily, you make decisions based on existing information. If the information provided by your costing system is inadequate, your ability to make good sound decisions is affected. Your decisions can be only as good as the information on which they are based. When decisions based on bad information create change, traditional relationships are destroyed. The fudge factors may no longer work. Catastrophe can result ! Can you state with confidence: "I know what is happening. I know what my costs are. My operation is under control. No improvement in profitability is possible."

As a manager, you owe it to yourself and your company to ensure that you have information available which will allow you to make good decisions. If you already have this, read no further.

Don't waste your time ! On the other hand, if evaluation of your cost information system is an opportunity, read on.

Let's start at the beginning. A good cost system will help you to:

* Price your product

* control your business

* improve productivity and quality

* measure performance

Price For Profit

Let's begin with the obvious. Your product price must cover all costs plus a reasonable return to the owners or shareholders.

Cost prices are one element in the pricing decision. If you price too high, there will be no orders or profits. Pricing too low, may eliminate profits. If costs exceed revenues, you will pay for the privilege of supplying your product to Your customer. That's not how things are supposed to work ! Pricing is a repetitive exercise. You price again, and again, and again. While pricing involves many considerations, cost is the mOst important element in the decision to ensure continuing profitability.

Cost Control

Like forest fire fighters, you too need vantage points to see clearly. Smoke is warning of a fire. Solving your problems while they are only smoke is only common sense. Raging forest fires are problems in crisis. Your problems are beyond easy control if you allow them to escalate to the level of "forest fires". You need alarms for early warning of problems.

Any quantity (eg. money, hours, pieces, feet, pounds, etc.) that measures change can be your fire alarm signal. Change and rate of change are the keys. Flows, turnovers, ratios, time related indices, relational indices, rates, levels, etc., are the means to monitor change. One thing is certain; your costs know when and by how much. You have the opportunity to act on the information immediately. Solve the little problems when the alarm first signals to avoid the big ones later.

Productivity Improvement

Cost data points the way to productivity improvement. Methods are compared and documented. Product designers are able to design products with the people and processes in mind. Procedures are controlled and formalized. Controlled and consistent processes will produce a quality product at the least known cost.

Measure Performance

Performance measures are cost control signals which double as monitors of employee performance. Actual experience is compared to an expected quantity. These monitors are the hard measures of performance in Managing by Objectives.

Manufacturing examples include measures of process efficiency, equipment utilization, material usage, scrap rates, output rates etc. Actual performance can be grouped by time, by machine, by worker, by operation, by cost center, by shift, or by location. Comparison is made to a standard, a quotation, or a sales price. The relationship of the "actual" to the "expected" is the index of performance.

At senior management levels, broad performance measures (eg. sales and profits) are used in compensation packages. Better performance through improved decisions will directly increase personal compensation.

Tailor your objectives to your specific needs. Know what you want from your cost systems.

With your objectives in mind, define the system that will fulfill them. Ask yourself a few simple questions.

1. "What kind of data collection system do I need, job or process?"

2."Should actual or standard costs be used to value Inventory and Cost of Sales?"

3. "How much overhead should be included in costs? None, some, or all?"

4. If you decided to include all overhead, there is one last decision. "Should the overhead rate be based on normal' (maximum) capacity or on 'expected' (annual?) volume?"

1. Data Collection System:

The nature and variability of the products and the processes determine the type of system.

Small quantities or unique products are costed by job order (eg. a satellite). Varying products made in consistently the same processes (eg. drug batches) are also costed by job order. The cost system is structured to send alarm signals for variations in the product "job" cost.

Mass produced quantities of identical products use a process cost system (eg. light bulbs). The process itself must be tightly controlled to ensure consistent product cost and quality. Even small variations in the process cost can represent flames of disaster.

Sometimes both systems are used within the same company. Manufactured components (eg. nuts and bolts) may be mass produced and costed in a process cost system then be assembled in a unique product (eg. a machine) which is costed in a job cost system. Obviously, the two separate systems will operate and be controlled in distinctly different ways.

2. Costing Value Basis:

The complexity of the product or process and the size of the operation will determine the best cost valuation basis.

An "actual" cost system is the simplest and most direct. Purchases of materials and labour and overheads are charged directly to the product. Single product or single process operations can use actual cost systems effectively. Small operations operated by the owner / manager are managed independently of the recordkeeping system and can also benefit from the simplicity of an actual cost system.

Simple systems provide little feedback information'. You find out what a product really costed when it is complete, not before. Substantial effort would be expended to verify costs. Usually, the effort does not yield information useful beyond the specific analysis. Pricing is usually a separate exercise unrelated but parallel to the cost system. The cost system can only deal with historical costs. Additional complications arise when there are more than one job, product or process and allocations of common costs are required.

In a standard costing system the "standard- is used as a comparison to evaluate costs as they first arise. The underlying assumption is that an item is generally purchased more than once. Material purchases are monitored by a "Purchase Price Variance" (the difference between the "standard" and the "actual" material purchase cost) on each supplier invoice. Similarly labour purchases are monitored by a "Labour Rate Variance" when the payroll is distributed. Overheads are monitored by an "Overhead Spending Variance".

As goods are produced, "Material Usage Variances- (the difference between the standard values of the "expected" and "actual" materials used), "Labour Efficiency Variances", and 'Overhead Efficiency Variances" monitor usage in the operations.

Variations are identified early in the cost cycle. Action can be taken to solve problems when the alarm signals to avoid problems of crisis proportions. Any variations that are significant and ongoing will spark immediate review of the product price. Product pricing is based on standard costs which are adjusted for known and expected future changes.

Inventories and Cost of Sales valued at standard are much more quickly and easily costed than those valued at actual. You don't have to trace costs to specific invoices, time cards etc. Using "standard" price for valuations reduces the time required to cost products and inventory while improving control information. Productivity is improved.

3. Overhead Inclusion:

The choice associated with overhead and its application is really an executive decision. You must pay for all expenses. The only question is, "How do you want to account for this overhead?" The decision will only be effective if you, as the user of the information, understand the limitations of your choice.

Direct cost includes only those material and labour costs directly attached to or identifiable with the product. It is simple and easy to see and understand what is in the cost. Don't compare to purchase cost because overheads are missing.

Variable cost is direct cost plus the allocation to the product of those costs which vary with production. Variable costing too ignores some overheads. The costs are not comparable with purchase costs. Reasonable variable costing assumes a good choice for the application base. It also assumes an accurate analysis of variable" vs "fixed" overheads. This analysis is ideally based on historical information. Difficulties will arise with some costs which are neither fully variable nor truly fixed.

Absorption costs is the direct cost plus the allocation of all other production costs to the product. Fixed overheads will always have the dubious distinction of being arbitrary allocations". Poor decisions result where allocation and application bases do not fairly represent the costs associated with the product analyzed. For example, a decision to add a product should be reviewed on the basis of incremental cost and contribution provided toward fixed overheads.

There is no "right" answer. Whatever the decision, it is not likely to encompass all system objectives. Perhaps the real question is "What overhead costs should be included in the product (and how) so that I understand the resulting costs and their shortfalls?"

Inclusion of any overhead presupposes that there is a regular "Budget" exercise to determine the overhead rates. Variable costing requires further effort to segregate overheads into the variable" and "fixed" components.

4. Overhead Concept:

The nature of your business and your purpose for including overhead in the costs will predetermine the best concept for your needs.

Normal Capacity takes the long-term view that overhead rates do not vary if an operation is properly (fully) utilized. They remain stable from year to year. To determine the rate, the expense budget would be based on capacity.

A long lapse time between quotation and delivery of your product would indicate a "normal capacity" overhead rate is best for quotation purposes. The quote is not penalized for less than capacity volume. The danger is that real overheads may not be covered by contribution even if expected volume is achieved.

Normal Capacity is really a pricing concept where there is reasonable expectation of reaching full capacity in the near future (eg. an auto parts stamping plant). The difference between actual and normal volume in the cost system is called an "Overhead Utilization" or "Idle Capacity Variance".

When most orders are taken and delivered within a 1 year period, pricing is best based on the expected annual volume". The rate is derived from the annual budget. If the budget volume is achieved, the expected overhead will be absorbed. The budget is also a direct cost control monitor of expense spending.

Now, talk with your costing person. What actually happens? How close is the real system to your defined ideal? If close enough, you will decide to do nothing.

A large gap is your first alarm. You have needs to be addressed. There is a cost, but good information tools are worth it. The improved decisions you will make will recover this cost many times over.

You can do yourself a favour. Be prepared to make the investment in your future. Commit the time and resources to help you reach your objectives. Improve your ability to make good, sound decisions. Improve your bottom line.
COPYRIGHT 1989 Canadian Institute of Management
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Title Annotation:know what you want from your cost systems
Author:Sigen, Wayne
Publication:Canadian Manager
Date:Jun 22, 1989
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