Self Fulfilling Prophecy

May 08, 2014

I was reading an article recently concerning how companies set standards based on budget, and that when coordinating the budgeting process with the standard cost revision, proper technique would require that companies not plan variances in relationship to setting standards for both direct costs and overhead.

If your company goes through an annual budgeting process and coordinates that with an annual review of costs and makes appropriate changes in standards related to the upcoming year’s activities and costs, then I believe this concept would apply to you.

In times of stability or growth, the method of coordinating standards to the annual plan particularly in the area of overhead recovery seems to work pretty well. In times of stability in cost, as well as stability in volume with relatively modest increases in volume or even slight decreases, the application rates and the development of standards is a reasonably comparable process from one year to the other and does not result in radical changes across the board. It is still possible to have significant changes in one product or product line as the standards that were used to cost the product originally or in times of revised processes warrant major changes in that products cost structure. However, there are many different scenarios where across the board cost changes would result if a company attempted to tie their standard cost revision processes to their annual plan.

The example that I think of most frequently relates to a company that has dramatically decreasing volumes because of temporary changes in their industry or the overall economy is significantly reduced which makes anticipated volumes for the next year significantly lower than in earlier years.

The question that arises is: Do I modify my overhead application rates to reflect this temporary change in volume? Companies that do modify their overhead rates could be looking at substantial increases in product costs simply because volumes have been reduced. Accordingly, that may affect selling price and force even greater reductions in volume as selling prices go up, customers resistance in searching for lower-priced alternatives drives down the volume of the companies products. Sort of the self fulfilling prophecy in the fact that the company anticipated lower volumes and then arranged their costing so as to ensure volumes were reduced.

This calls in to question the possibility of planning for a volume variance. This means not making radical changes in your product costing to avoid even further reductions in volume. It would also include planning for reduced volumes but not adjusting the costing downward to reflect this change in activity. The companies that I work with who are dealing with such issues generally try to maintain strict controls over costs so as to reduce overhead cost as much as possible in relationship to planned lower volumes. The end result is for those able to accomplish this would be significantly negative volume variances offset by significantly positive spending variances. The end result is that the planned change in overhead did not materialize thereby making our original application rates correct for this companies current year in which lower volumes were experienced.

Categories: Cost Accounting