Wrong Cost Drivers

May 14, 2015

A few weeks ago I was having lunch with the CFO friend of mine, we are talking about the kinds of cost issues that both of us had seen in our careers and it was remarkable how similar our experiences have been event though we worked in completely different industries. Many of the problems that were reoccurring had nothing to do with the industry and far more to do with human nature.

One of the things he mentioned was the reoccurring problem of cost managers choosing the wrong cost drivers for purposes of allocating overhead to production. We were somewhat divided as to whether the real problem was managers not understanding the basic concepts associated with choosing the correct drivers. Or, was it more related to cost drivers that were chosen years earlier. These earlier cost drivers may have been appropriate at the time, but as production methods have changed and technology has advanced, no one thought it might be necessary to re-evaluate how cost drivers were being utilized.

Since direct labor represented the most stable and highly correlated method of allocating cost to production many years ago, the most common mistake is continuing to use direct labor. As times have changed, automation and productivity have become the standards for virtually all manufacturing operations. Direct labor has become less and less of a control point in a manufacturing process and more directly related to the overhead associated with running the machine. This means direct labor is not the driver of  machine speeds any longer, but rather one of the costs associated with keeping the machine operational.

There are some manufacturing operations that are still in transition which means that some parts of their operation have become highly automated, and others are completely dependent on manual operations to complete the manufacturing process. In those cases, I have seen dual cost drivers be used with apportioning the overhead into the general buckets required to keep the manual operations going as well as the automated operations, and then differing rates for each of the manufacturing processes. In one case for the manual operations based on direct labor hours and in the other case, in the highly automated operations, based on machine hours.

I have seen other manufacturing operations where square feet was used as the cost driver or in some cases, direct material for allocating overheads. In many cases, those allocations were correct and resulted in the best identification and assignment of overhead cost to production.

The main rule to keep in mind is that each operation is different and requires some analysis to determine the most accurate cost drivers. There are statistical techniques available to help make those decisions and cost managers should take the time to identify the best drivers by operation to produce the most accurate, useful product cost. This is especially true in times of transitions where operations are upgrading to faster more efficient processes that could result in a significant change in the cost drivers used to allocate overhead.

Categories: Cost Accounting