Are Your Costs Really Variable?

Sep 25, 2015

1Recently I met with the CFO from a large manufacturing company and we were discussing some of the costing issues related to his company. In his case, the company was about to make a major shift in their accounting systems to a new ERP system and they were also thinking about changing their costing method to standard cost. That led to a whole variety of subjects related to standard costing and the opportunities and problems that he was likely to encounter on the conversion. This company had foreign owners so he was somewhat limited in his ability to make changes in the direction senior management wanted to take the company, but he was clearly focused on changing the cost drivers from those they were currently using.

In his case his company was a very capital intense company that had very expensive equipment. Most of the manufacturing processes were machine controlled which meant that labor was becoming a smaller and smaller part of his total manufacturing cost as more and more automation replaced the labor costs.

In fact what he found is that the vast majority of his cost were now fixed in nature with smaller and smaller components every year being variable.

He was convinced that the cost driver for allocating fixed overhead is crucial to the reliable results or lack thereof of the entire costing system. I believe his main frustration had to do with the fact that this costing system has been in operation for years and was originally set up so that the cost driver would be direct labor, which, very likely, was a good choice many years ago.

However, as more and more automation has crept into their manufacturing process, labor has become more and more indirect in nature. The percent of labor in each part is now down under 5%. In many cases “direct” labor is simply an indirect cost of maintaining the machinery that is primarily responsible for production speeds, quality and productivity in the plant.

I totally agree with his conclusions that in a manufacturing environment where the vast majority of the costs that you are trying to recover are fixed in nature, how you choose your cost drivers and the method that you choose to allocate costs to your production processes is crucial to having a reliable cost system.

Bad choices in cost drivers lead to inaccurate costing systems with the underlying issue being so fundamentally in error that more effort to properly apply the wrong driver will not result in significantly better results. Essentially the wrong driver gives you erroneous and worthless results.

Categories: Cost Accounting