Doubling Production Should Cut Costs in Half, Right?
Sep 24, 2014
While it seems logical to think if you are able to double production that your costs would be cut in half. However, in most cases this assumption is wrong! I was talking to a client the other day who had this exact scenario. He allocates his overhead based on machine hours. He has one machine and one product that he is able to produce two at once. All of his other machines and products are produced normally. He was concerned that in his quoting his costs would be cut in half since he doubled his production.
I explained to him that since his overhead is allocated based on machine hours and he was not changing the number of machine hours then his costs were not changing. I also clarified that if he cut his machine hours in half since he was doubling his production, he would in actuality be increasing the cost he would need to recover per machine hour. This was frustrating to him as it seemed quite counterintuitive. The more we discussed the theory, the more he understood.
I explained to him if his ability to increase the production was continuous, then we may need to review our overhead allocation base. Perhaps allocating on machine hours would eventually not make sense, but for now since the large majority of his manufacturing remained the same, then his allocation base should also remain the same.
It is important any time you are experiencing changes and/or doing quoting, that you think about how different production methods will effect your status. What may seem logical at first glance, may not seem so productive once you invest the time to think about its effects. Luckily the production manager did not agree with my client and that pushed him to call me. Otherwise, he may have made a notable mistake in his quoting!
Categories: Cost Accounting