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Putting an End to Fuzzy Math

By AICC Staff

July 30, 2018

width=300The age-old question in the realm of cost accounting is, “How much overhead do I allocate to this job?” If you subscribe to this theory of “costing,” then each job must “absorb” some of the company’s overhead, or you will surely go out of business. Typically, in the cost accounting hierarchy we see the following “buckets” of costs that are charged to each order:

  1. Direct materials — board/paper, labels, chipboard, ink, etc.
  2. Indirect materials — glue, baling wire, tape, staples, etc.
  3. Tooling
  4. Direct labor — setup and run
  5. Other machine center variable charges — utilities, maintenance, etc.
  6. Variable factory overhead — indirect labor, employee benefits, payroll taxes, supplies, etc.
  7. Fixed overhead — rent, depreciation, equipment lease, insurance, etc.
  8. Delivery — truck costs, driver costs, mileage costs, etc.
  9. Commission
  10. Profit

Thus, every order contains a myriad of charges, some that are incremental costs to the organization, some that are allocations of costs that are directly utilized in fulfilling the order, and some that are allocations of costs that are common to all orders. The allocation methods used vary, but they are all pretty much based upon a planned level of activity and a projection of costs. Delving into the various spreadsheets and calculations used in these allocations is a daunting task, and at the end of the day there will always be a variance between the planned level of activity and the actual level of activity, and between the planned level of expenses and the actual expenses.

Typically, the calculations used to calculate even the direct costs of the orders are obscured and almost impossible to audit or review on a case-by-case basis. Most systems simply use a series of adders or system-computed charges, and at the end of the day simply post one price to the books without any way to determine how it was calculated or match up the actual costs associated with fulfilling the order. In previous articles, I have advocated “unbundling” the sale for the direct costs of the order to post a sale of freight, tooling, pallets, warehousing, etc., in addition to a sale of corrugated packaging. But even if you don’t do this in a formal way, you can at least look at the true direct costs of the order and establish a material margin and an overall contribution margin.

Costing consultants talk about the need for a rational allocation of costs to ensure that they are covered by the orders, but just because an allocation method is rational doesn’t mean that it is relevant, or that it helps you make good business decisions. In a manufacturing environment where a large number of homogenous products are made in large, time-consuming “batches,” this kind of cost-plus thinking is far more relevant. In a “custom job shop,” where most of the costs are relatively fixed over a fairly wide range of production, this kind of cost-plus thinking can make a manufacturer very uncompetitive, by making him try to charge far more than the market will bear, in an effort to cover his costs. All of this “fuzzy math” that is used to allocate these fixed and relatively fixed costs makes understanding the profitability of an order difficult at best. In a competitive market, the lowest-cost producer will have an advantage. This doesn’t mean that every order will go to the lowest-cost producer, because quality, consistency, delivery times, creativity, and other intangibles often carry the day. Companies that possess many or all of these intangibles often price themselves out of contention because of all of these allocations. The notion that you can go to market by pricing your orders based upon your direct costs, plus an allocation of your overhead, plus a provision for profit often leads to above-market pricing and missed opportunities.

If allocating costs to myriad custom jobs constitutes fuzzy math and a reduction in your ability to understand the impact of an order on your business, then firming up the various measurements of time associated with each order can be your salvation. At the end of the day, how much overhead each order must absorb is far less important than how much of your finite resources the order consumed and what the basic markup over true direct costs was. There is no general ledger account for machine hours, yet it is the most important finite resource that you have. The variable profitability of a machine hour is possibly the key factor in understanding your business, yet there is no mechanism in most accounting systems to calculate this in any formal way. Machine hours, production labor hours, and delivery hours are all very finite resources, yet most of you are not doing enough to make sure that you are measuring these resources properly and comparing them to the variable profitability of the orders that they produce.

My advice is to take the resources that you are now devoting to cost allocation and use them to build a system of formal time measurements. Put an end to the fuzzy math of cost allocations and sharpen up your measurements of machine, labor, and delivery times, and you will improve your understanding of your business and the impact of an order on your bottom line.


width=150Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or mitch@klinghernadler.com.

 

 

 

 


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