Are You Sure Average Rate Is Best?

Oct 28, 2013

Our most recent cost assignment involved a manufacturer that has been in business for many years and has a diverse series of processes all located in one operation. This business has simple operations with simple machines, loading, unloading, and material handling processes, all the way up to the most complex types of equipment with extensive supplies needed. These extensive operations can require a lot of highly trained support for set-up and maintenance. This business for years has operated under the assumption that a fully loaded average rate is satisfactory for purposes of quoting and determining overall job profitability. That’s exactly what we have done for years. We have computed average labor and overhead rates that would apply to every machine in the operation with little regard as to complexity and/or resources actually used in the completion of those various manufacturing processes.

The company has always been profitable and for many years this method was fine. However, more and more demand has been placed on this business’ costing system, and now the owner realizes he needs to take a more in-depth look at the costing system. He needs to determine how machine rates are adjusted for known differentials in costs that are readily identifiable. Accordingly, we recomputed the rates after a joint meeting with the quality manager, production manager, the owner, the in-house accountant and a member of the sales team.

A more specific machine rate requires more in-depth information about how processes run, what resources they use, and what level of activity they can expect. And although the information was previously not necessary, we were able to accumulate much of the basic data within a few days. This led us to uncover some issues that we had previously not known about: how accounts were being charged, as well as how labor was being assigned both to equipment and within the general ledger accounts. None of this would have been uncovered had we continued to use the same method.

We then agreed to compute the machine rates for each of these operations and discovered huge differences in individual machines as compared to the average rate they were using for all machines. In fact, the range of difference from the lowest to the highest is in excess of 150%.

As a result, the owner now has a totally different view of what jobs are profitable and what jobs are not compared to when all machines were assumed to have the same average rate. This information will be invaluable in negotiations that are soon to begin with one of his major customers as to their willingness to give back profits in the form of rebates. This additional information will give added credibility to the owners negotiating points as to protection on some costs that are outside of his control; such as outside services or raw materials.

I believe the information that we have developed will be valuable on a go forward basis and with the kinds of tweaking of information and assumptions that is inherent in all good costing systems our machine rates will get more and more precise each year as we modify our calculations based on our experience and changes in business operations.

Categories: Cost Accounting