December 2009 Vol. 143 No. 6

Do You Know Your Costs?

Does accounting information mislead manufacturing engineers?

Douglas T. Hicks, CPA, CMC President D.T. Hicks & Co. Farmington Hills, MI E-mail: Web site: www.dthicksco.com

Prior to the 1930s, "cost finding" was the domain of engineers and economists, a strange pair of bedfellows if ever there was one. But one characteristic common to both disciplines is their quest for the truth—the desire to understand and measure the reality of how the world actually works. It was this quest for truth that helped cost finding advance steadily during the late 19th and early 20th centuries.

Then, in the early 1930s, came the Securities and Exchange Acts, a set of laws that had the effect of moving responsibility for developing cost information away from "truth-oriented" engineers and economists and into the laps of "regulation-oriented" accountants. Cost finding became cost accounting. This change led to a dark age in costing that lasted for a half-century.

Beginning in the mid-1980s, academics, consultants, and practitioners began to recognize the dysfunctional nature of the traditional costing practices espoused by accountants, and developed a variety of solutions, many of which have proven to be powerful, effective management tools. Unfortunately, accountants have remained the gatekeepers when it comes to costing practices, and they have proven to be very resistant to change. As a consequence, the cost-measurement systems in effect at a vast majority of 21st-Century manufacturing firms continue to provide management, including manufacturing engineers, with information that is inaccurate, misleading, and dangerous.

As manufacturing engineers, your companies rely on you to plan, direct, and coordinate elements of design, materials, and manufacturing processes in their production facilities. In performing these duties, you need access to economically sound cost information. Unfortunately, a substantial majority of you cannot rely on the cost information provided by your accountants.

Cost-accounting systems at most manufacturers ignore many economic realities, forcing manufacturing engineers to work while viewing the economics of manufacturing through distorted glass. Some of the realities most often overlooked relate to costs incurred in supporting raw materials and components, outside manufacturing services, offshore purchases, manufacturing processes, and inprocess movement and storage.

Varying degrees of effort and investment are required to support different categories of raw materials and purchased components. Consider the different purchasing, receiving, quality, storage, obsolescence, and carrying costs related to these categories:

• Bulk materials vs. packaged materials,
• Standard components vs. custom components,
• Purchased items vs. consigned items,
• Items invoiced monthly vs. items invoiced individually, and
• Just-in-time purchases or vendor-managed purchases vs. those requiring an investment in inventory.

At most, traditional costing methods establish one material-overhead category that isolates a portion of the cost related to the acquisition, receipt, handling, and storage of raw materials and purchased components, and then simply applies that cost as a percentage of material or component cost. Although better than completely ignoring the linkage of these costs to materials and components, the application of the costs fails to recognize the substantial differences that can exist among the various categories of materials and components. Without properly matching support costs with items purchased, it is impossible to measure the true cost of these items—only the price paid for them is known.

Consider the case of resins used at an injection-molding facility. Resins used in high volumes are often purchased in bulk, stored in silos, billed and paid for on a single monthly invoice, and delivered to the press using an automated system. The inventory of these resins usually turns quickly. On the other hand, low-volume resins are purchased often and in small quantities, and are shipped, received, and stored in gaylords that require a significant amount of handling. They must be manually moved to and from the press, as well as manually introduced into the molding process. The inventory of these resins usually turns slowly. Accounting would have you believe that there is no difference in the cost related to the two categories of resin. A pound of high-volume resin and a pound of low-volume resin having the same price per pound would be treated as having the same cost per pound, when in reality cost would be substantially higher for the low-volume resin.

One area where failure to appropriately measure component cost significantly obstructs a manufacturing engineer is in mass-customization and build-to-order initiatives. For example, if a multiuse component with a price of $2.25 could substitute for each of five different components priced at $2.00, traditional costing would make it seem absurd to substitute the $2.25 multiuse component for each of the $2.00 components. In reality, economies of scale—like those described earlier for high-volume resins—could make the total cost of the multiuse component significantly less than the total cost of the single-use components, despite its $0.25 higher price. Traditional costing practices would make this potential cost reduction invisible.

Outsourcing manufacturing activities requires a significant amount of oversight and internal support such as: double and triple handling of products; transportation costs; material-control efforts; engineering and quality oversight; scheduling problems; inventory losses; payables disputes; extended lead times; and inventory-carrying costs. Traditional costing methods seldom add any of these costs to the direct cost of the outside manufacturing service. Instead, these "out-house" support costs are categorized as manufacturing overhead, and included in manufacturing overhead rates. In effect, costs attributable to processes performed outside of the company are assigned to processes performed inside the company. Failure to link these costs with the related outside manufacturing services can result in inappropriate outsourcing decisions.

More companies than ever are purchasing raw materials, components, and other manufacturing services from offshore suppliers. The reason is obvious; the prices charged by these offshore suppliers are considerably less than those charged by domestic suppliers. But is the cost of an item purchased from an offshore vendor actually less than the cost of purchasing it domestically, or manufacturing it yourself?

There are, of course, some obvious costs that relate to offshore purchases that are much higher than for domestic purchases. Inbound freight costs are probably the most visible, but there are many others. Purchasing, engineering, and quality costs often increase, because the additional work required to deal with distant suppliers in different time zones with different primary languages leads to an increase in headcount, and to higher travel and communications costs. Internal handling costs are often impacted by offshore purchases. Items received from offshore vendors have usually been ordered in large quantities well in advance of the date they are required, to allow for transportation problems. In addition, products produced overseas are often floorloaded—meaning that they are containerized as-produced with boxes of various products mixed in each shipping container. This arrangement leads to increased costs for sorting and organizing upon receipt, as well as movement-to and retrieval-from intermediate storage locations.

Carrying costs are almost always increased by offshore purchases. Additional storage space must be procured for the higher safety stocks resulting from less-controllable deliveries, and insurance and tax costs increase. Payment terms for these purchases usually require that funds be spent much sooner than they would under the terms of standard domestic purchase arrangements. Even more important is the increased cost of capital resulting from these higher inventories.

Obsolescence costs are usually overlooked in costing offshore purchases. Because the lead time for ordering from an offshore vendor is generally much longer than from a domestic vendor, the quantities ordered must be based on longer-term forecasts that are less likely to match future realities. Further complicating the matter is the fact that "unexpediting" an offshore order is usually next to impossible. As a result, items are often received that are not currently needed and, in some cases, may never be needed.

Remanufacturing and rework costs are sometimes incurred to "make right" parts that don't quite meet specifications. When a part is needed and the vendor is overseas, there is often not enough time to return the items and/or get replacements. In such cases, rework is often performed to save the parts and enable them to meet the immediate need.

Traditional costing's failure to measure these costs, and link them to the price of items purchased offshore, often results in higher, not lower, costs for the manufacturer.

As for manufacturing processes, 50 years ago direct labor may have been a major element of cost at a manufacturing firm, but as we begin the second decade of the 21st Century, direct labor no longer dominates most manufacturing firms' cost structure. For manufacturers during the past half-century, the general trend in costs has been toward a significant increase in nondirect costs, because of changes in the diversity and complexity of products, services, and customers, higher levels of quality, and accelerating rates of change.

Manufacturing costs are more often driven by the ownership, maintenance, and operation of equipment than by the employment of workers. The fixed costs of ownership, capital, and occupancy, as well as the variable costs of maintenance, perishable tool usage, and utility consumption, have nothing to do with workers working. They are driven by owning and operating the equipment itself. Yet traditional costing methods frequently tie these costs to the activities of direct-labor personnel, instead of linking them to the use of the equipment. This faulty linking of costs to causes results in significant distortions in cost savings generated by improvements in operating processes.

Nowhere is this more apparent than in the creation of workcells. Workcells are not the sum of the individual processes that make up the cell; they are new, unique systems that require costing measures that reflect the economics of the individual cell. Reducing crew size required to operate a cell from four workers to three does not reduce the cost of its operation by 25%, as would be suggested by direct-labor-based cost-accounting calculations. Not only will the cell's fixed costs remain the same, but all variable costs driven by operating the equipment will remain the same. Only labor-driven costs will be eliminated.

A workcell is a single-purpose mini-factory within the production facility with the basic economics of any manufacturing business; money is invested, materials, components, and manufacturing services are purchased, and operating costs are incurred to generate throughput. The goal is to minimize per-unit costs by moving toward the optimum balance of capital costs (for both fixed and working capital), outside purchase costs (not prices—costs), operating costs, and throughput rate. Costing rates for individual steps within the cell are irrelevant, only their effect on the overall cost of operating the workcell is important. Direct labor-based costing practices totally distort the actual economics of the cell.

A great deal of in-process movement and storage takes place between value-adding, manufacturing activities. Unless all manufacturing processes are organized in a continuous flow, there will be both product movement and inprocess inventory investment and storage required wherever the flow is interrupted. The cost of these direct, but nonvalue-adding, activities is almost always buried in manufacturing overhead rates. In-process movement and storage also add to the amount of scheduling and inventory control work required to get a product out the door. Failure to isolate these costs not only distorts final product cost, it hides opportunities for applying lean principles that will ultimately lead to lower cost, higher-quality products.

These are just some of the areas in which accounting information misleads manufacturing engineers.there are many others. The fact remains, however, that most manufacturing engineers are forced to drive improvement at their firms despite the cost information provided by their company's cost-accounting system. Cost accounting does not serve as an aide to their efforts; instead, it acts as a hindrance by distorting economic reality.

Perhaps the time has come for engineers to retake control of the cost information they need to be effective. This may take some doing, because it's unlikely that accountants will let go of their control over cost information without a fight, but it's a task well worth the effort. Leave the "regulation compliance" cost information to the accountants. But if they are to be successful, manufacturing engineers need to create and use actionable cost information that represents the truth.

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