What Are Your Production Costs?
Cost accounting is too important to be left to the accountants
By Richard Strauss
Keller Products Inc.
Before assuming my present role with Keller Products, I worked as a management consultant. My specialty was analysis of individual product costs and overall operating costs in changing conditions, such as investment in new facilities, introduction of a new product line, make or buy (outsource) decisions, partial shutdown, etc. In doing literally thousands of cost estimates, I found that managements did not understand their costs, and could not accurately calculate the economic effects of decisions that radically changed their operations. One pervasive cost fallacy I encountered is the idea that the ratio of overhead to direct labor is fixed for any given operation, and that increasing or decreasing direct labor automatically increases or decreases the overhead by that ratio. An extreme case of such thinking is the assumption that outsourcing an operation will eliminate the direct labor cost plus all overhead "associated with" the direct labor.
A more complex issue is the cost effect of outsourcing intermediate steps in a multistep operation. Analyzing this problem requires maintaining the distinction between fixed and variable costs throughout each step of the operation, so that the finished product cost is the sum of the prorated costs in each category for each process step. This information is not obtainable from standard accounting cost systems, but today management decisions are made from standard accounting cost data. There is a better way to evaluate costs. Let's look at how things are being done, and how they should be done.
During relatively stable periods, the time-honored rules-of-thumb for estimating shop costs are quite accurate and useful. A widely used number is the shop hourly cost; the sum of shop costs (except materials and fixtures dedicated to individual jobs) plus management/administrative costs, divided by the number of direct labor hours. The shop hourly cost is calculated by accountants based on cost data and direct labor hours for a recent time period, say the past six months or one year.
Shop managers often take this number to be a breakeven number. For example, if the calculated shop cost is $60/hr, then new jobs must be bid at $60/hr or greater in order to make money. If the shop product mix and activity level remain approximately the same as for the period in which the shop rate was calculated, using the shop rate for estimating purposes is relatively safe. If shop business conditions change significantly, then continuing to use the calculated shop rate as a guideline for quoting or other decision making can be misleading or actually dangerous to the financial health of the shop.
The problem of estimating costs in changing conditions can be illustrated by taking as an example the basic unit in the metalworking industry, a small job shop. The methodology and general conclusions derived for the small shop can also be applied to any manufacturing operation, large or small. Let's say that our example shop is a well-established precision job shop with three major long-time customers who supply the aerospace and automotive industries. Because of its record of excellent quality and on-time delivery, the shop has been able to secure all the business it needs, quoting at premium rates for its technically demanding jobs. On occasion, the shop has been asked by its existing major customers and others to quote on relatively routine jobs for which it had no particular technical advantage, and for which it would have to quote based on lower shop rates. So long as the shop's floor was occupied with premium jobs it declined to quote on these fill-in jobs.
In Case A (see table), we construct a complete cost picture for the shop. The cost numbers are representative; you can substitute numbers appropriate to your own operation. Costs are calculated on an annual basis. It's important that all cost items are included, and that each cost item is specifically identified and can be used as the standard cost to be compared to the actual monthly or quarterly cost reported by the accountant. Note that there are no mystery entries, such as Indirect Overhead or Corporate Burden.
Our shop has eight machine operators and a foreman, resulting in shop direct-labor costs of $352,000/year. Shop overhead items are broken out into categories that can be individually monitored. The only shop overhead cost estimated as a multiplier of labor is personnel costs at 20% of labor. Similarly, office and administrative costs are broken out by salaries and by specific overhead accounts. Depreciation, a non-cash charge, is not included in this analysis. However, lease charges, if any, would be included.
Total annual cash cost for the operation under standard conditions is $910,900. If we assume that each of the eight operators is working productively on saleable product 90% of the time—a rather generous assumption—then there are 14,400 billable operating hours per year, and the cost per operating hour is $63.26. This is the shop rate, which often is interpreted as the breakeven cost when calculating quotes. Because our shop has established its position as a favored supplier of critical components to its three major customers, it has been able to charge the premium rate of $75/hr and keep the shop full. Total annual enterprise revenue is $1,080,000, and the cash profit before taxes is $169,100.
Assume that conditions change. The shop continues at the comfortable level of business cited above until one of its three major customers goes out of business, a victim of predatory purchasing practices by its major automotive customer. The shop manager must now decide how to deal with this potentially dangerous situation. To illustrate the workings of the cost-calculation system, we limit the possible courses of action available to the shop manager to the following two:
- Layoff three of the eight operators, prune overhead expenses as much as possible, and continue to specialize in the premium work which had been the historic basis for the success of the shop, or
- Maintain the existing labor force and aggressively seek out the non-premium business which had not been of interest in the past, even though it means quoting jobs at less than the $63.26 shop rate.
Case B in the table shows the cost and profit resulting from the first possible course of action—layoffs and belt-tightening. Three of the eight operators are laid off. Because the shop owner intends to remain in business indefinitely, and to continue to specialize in premium work, he will definitely retain his skilled and experienced foreman. With the reduced shop activity, various shop overhead accounts can be cut somewhat, resulting in a saving of about $41,000. Similarly, one person might be cut from the already lean office staff, the most likely candidate being the person responsible for sales, who obviously was not an exceptional performer. Some savings can be made by tightening travel expenses, but the rest of the overhead expenses remain essentially fixed. The projected total expenses are now $689,750, a 24% reduction from the $910,900 expenses in the base case.
But billable operating hours are reduced by 37.5% as a result of the layoffs, so that even if we continue to bill at $75/hr, total revenue will be $675,000, producing an operating loss of $14,750. It's interesting to note that the new calculated shop rate is $76.64 per hour. While—technically—this is the new breakeven rate, the information is of no use to the manager, because it would hardly be advisable to raise billing rates to existing customers at a time of decreased sales.
What about the other possible course of action, retaining the existing work force and aggressively seeking to replace the lost premium business with new competitive business at a lower billing rate? By returning to the potential customers who had previously asked him to quote on this type of business, the manager determines that he can fill his shop again by quoting the replacement business at $55 per hour, well below the calculated "breakeven" rate of $63.26 per hour. The result of this approach is analyzed in Case C.
This table illustrates the impact of staff reductions on shop profitability, and the alternative impact of accepting work at a lower billing rate, while retaining staff.
Because there have been no changes in employment or in shop activity, all expense items remain the same as in the base case. The total revenue must now be calculated at $75 per hour for 9000 hours of premium business, plus $55 per hour for 5400 hours of new business. The result is total cash revenue of $972,000, and profit before taxes is $61,100. Thus, replacing lost premium business with business priced at less than the "breakeven price" results in a profit advantage of $75,850, compared to scaling back and maintaining only the premium business.
The shop manager may still decide—for commercial or strategic reasons—that cutting back is the best course, but he will be able to make that decision knowing the true financial consequences. In contrast, the calculated shop hourly rate is useless for decision making when shop conditions change significantly.
Cost estimating in changing conditions requires rethinking conventional accounting approaches. While in the above example cost calculations are based on a small shop, the general conclusions from this exercise apply also to large operations. Consider that:
- When shop conditions change significantly, ratio numbers, such as cost per operating hour or overhead to labor ratio, are not reliable for estimating purposes.
- With the exception of personnel costs for direct labor, all overhead costs vary independently of direct labor. It should not be assumed that if a fraction of direct labor is eliminated, the overhead "associated with" or "attributed to" the direct labor will also be eliminated. To reiterate: both direct labor and overhead should be estimated independently, and it's clear that they can also vary independently. Overhead costs are in addition to direct labor costs, not some simple multiple of direct labor costs.
- A large proportion of annual overhead costs remain constant if the shop activity level varies by up to +/- 30%, and those overhead costs that change will change at a lower rate than the change in activity rate. In our example, a reduction in activity of 37.5% resulted in a reduction in overhead cash costs of 16%. Based on data from hundreds of cost estimates for large and small manufacturing operations in many industries, it's prudent to assume that any overhead cost will remain constant when activity level changes until proven to change via item-by-item analysis.
- In a multiproduct operation, if a product or a processing step is to be eliminated—for example, by outsourcing—simply subtracting the cost of the operation as reported by the accounting system will not give a true picture of the possible cost saving. The accounting system will show overheads spread-to or attributed-to the product or process. The annual cost of most of those overheads will remain unchanged or be minimally reduced when the outsourced activity disappears. The accounting system will then spread the unabsorbed overheads to the remaining activities, and increase their reported costs accordingly. Rather perversely, it is most difficult to extract data on costs after conditions change from those cost systems in which the accountants have made the maximum effort to ensure that the current costs are fairly attributed to each operation and to each product.
- The only accurate method for evaluating the cost effects of a significant change in operations is to construct the cost picture of the entire operation item by item before the change, and to repeat the calculation after the assumed change. While the accounting standard cost system may not readily supply these answers, shop management can obtain from the standard cost system all the data needed to make the calculations.
All overhead costs are plant-wide costs, and are not associated with any specific product. When calculating individual product costs, we allocate overhead costs to each product. But this is strictly an arithmetical procedure, and doesn't necessarily reflect the actual cost situation. The only practical way to monitor overhead costs is by comparing monthly shop-wide actual costs with the standard monthly costs. There is no value for shop/plant control purposes in comparing reported overhead cost/unit of product with the standard overhead cost/unit of product. Finally, the ratio of overhead to direct labor is an interesting calculation, but should be used with caution.
What all this means is that shop management should take the initiative to organize cost reporting into a format that permits practical calculation of the cost effects of proposed significant changes in shop operations, and permits convenient comparison of monthly actual costs to standard costs for each account. Cost accounting is too important to be left to the accountants.
This article was first published in the December 2005 edition of Manufacturing Engineering magazine.