Outdated Cost System Impacting Profitability

Feb 11, 2016

A few weeks ago, I met with a potential new client regarding a costing matter related to their manufacturing company. The company had been in business for number of years and was profitable, but not nearly to the extent the owner perceived possible. He believed the costing system being used was providing inaccurate information and could be significantly improved upon for both costing information and overall control of the shop.

As we went over his costing system, an Excel-based model, it became clear in order to determine product cost, management was making a series of “best guesses”.

ProfitabilityThe company had a dozen cost centers each doing a different type of operation and each requiring different support both in labor and other expenses; such as, utilities, indirect labor, and quality. The actual usage of those resources were incurred disproportionately among the various cost centers. The owner realized the best method of operation was the development of rates per hour of production for each of the cost centers. This would then be applied to each of the parts based on the speed at which they crossed a given cost center.

The owner used his industry knowledge, past experience, and best guess to set the machine rates based on estimates without any specific identification or knowledge of what his operation may actually be incurring. Each of the dozen costing centers had costing rates assigned, but all without any regard to a method of allocating costs and actually computing rates.

The other component the owner had estimated was the speed at which the parts were being produced. Again, based on his industry knowledge and his relative understanding of how the parts were processed, he developed estimated rates of production which were applied against the estimated hourly cost to produce product cost. These product costs were then used to determine profitability of jobs, set selling prices, or be used for overall profitability of customer, process, part or sales person. Needless to say, the results were unpredictable at best, and in many cases, absolutely misleading related to the actual costs being incurred on the floor.

The owner recognized the inaccuracies and was anxious to get started on a new system where the costs incurred by each process could be specifically identified. This would allow for the various rates of production by each of the parts to be more carefully recorded and compared to early results. This comparison would ensure the costs would be as accurate as historical records and the actual cost per hour of each the cost centers would accurately and fully recover the cost associated with that center.

The owner envisioned a variety of sales and marketing tools resulting from knowing accurate product cost and how that could be used to help position the company with potential customers as a preferred supplier. His concern with the existing method was that some products were being costed far above what they actually cost and others were being costed far below. The end result, some jobs were awarded which would never result in profitable operations and in the other case, jobs were not even given consideration due to competitive quotes at far lower price.. We ended our conversation with an agreement to begin the process of identifying cost centers and production rates, so that we could begin the process of building a new, more efficient cost model. One that would also supply a variance analysis, which would help improve the efficiency of the entire manufacturing operation.

Categories: Cost Accounting