Simple or Better? Which Costing Information Is King?

Oct 23, 2014

You have heard us argue time and again that simplicity is better than complexity in the spirit of transparency. I am not arguing against this notion, but instead, I believe sometimes there is better information available.

Recently, I was speaking with a client who I am assisting with building a costing system. They are considering establishing work centers and allocating cost based on machine hours per work center. We talked about having a cost assigned to each cost center and the president suggested compiling a grand average.

A grand average would allow you to determine if you are recovering all of your overhead in total. However, the risk is that based on the mix of products you are making and selling and the fact that you are using an average, you may not recover all of your overhead. If you are making only products that are well below your average instead of a mix that increase the average, you will most likely not recover your entire overhead. Otherwise, you may have a mix of higher recovery and believe you can reduce your prices, when in reality it is only because of the mix that may be temporary.

Digital Background

If you have a cost per work center, not only will you know if you are recovering your overhead, but you will also be able to identify where you are losing money. A grand average will also help you uncover if you are losing money, however, you will not know exactly where. It is unreasonable to believe you can tell production to stop because you are losing money. Then again, with a work center, you can pinpoint exactly how much you are losing and which work center is at fault. When you have the appropriate “where” information, it often leads to a “why” and, as a result, you can make the necessary changes to resolve a given issue.

An average is certainly a simple approach and it is by far better than nothing. Yet, in this particular instance, I consider it to be too simple. The average will not provide you with the best information possible to make smart business decisions. Knowing where and why you are making/losing money is always more beneficial and worth the extra effort.

Categories: Cost Accounting