Looking back at the last two posts we have introduced two Key Concepts. The first was Key Concept: Throughput-margin is Additive.  The second was Key Concept: “Lost” Time.  In today’s post we’ll review the third Key Concept: “Productivity”.

In the Throughput World we have a definition of productivity that is likely very different than the definition you use for productivity.

Many shops measure productivity by tracking “labor efficiency”. The closer to 100%, the better.  After all, if your workforce is more efficient you will make more money, right? Not exactly.

This is perhaps the greatest myth in the “cost world”; the myth that if we keep everyone busy all the time, we would make all money we could. That is simply not true.

Keeping folks busy does not help you make money; only getting more jobs completed, shipped, and invoiced makes you money.

Making more money is The Goal.  Now and in the future.

Recall in the last two posts we showed you a base case in which we completed three jobs in total and the “Lost” Time example in which only two jobs were completed.

Now imagine the opposite situation.  For whatever reasons, because the company was more productive, Job 4 also was completed, shipped, and invoiced in the time period.

We call this improved “Productivity”.  Perhaps the company implemented Dr. Lisa’s solution for job shop scheduling, Velocity Scheduling System, which is designed to help job shops “get more jobs done faster”.

So, what is this very different method of defining productivity? Well, for starters we call it “Financial Productivity”. Secondly, Financial Productivity is defined for the company as a whole, not for a worker, work center, or a department.

Financial Productivity is defined as the ratio of Throughput-margin (“money-in”) over Operating Expense (“money-out”) for the time period.

Notice how there’s no mention of labor, other than the fact that it is included in Operating Expense.  Financial Productivity is concerned only with generating more Throughput-margin for a given level of Operating Expense.

So, let’s take a look at what a more Productive company would look like.

In this Productive example, Job 4 adds Throughput-margin to the total, which is now much more than Operating Expense, and the company is highly profitable for the time period.  In the example, $70,000.

But each job was not “more profitable”.  Each job has the Throughput-margin it has.  The reason the company made a lot more money was the fact that it completed, shipped, and invoiced Job 4 in the time period.

Clearly there is a lot to be said for being more productive. One of the largest sources of increasing Productivity is commonly overlooked: reducing wait times.

If you were to look at the jobs in your shop, it’s very likely you’d find that jobs are in the shop far longer than you actually work on them. (Check out Dr Lisa’s job shop scheduling webinar or Job Shop Productivity| Machine Shop Productivity article for an explanation.)

Financial Productivity

Now that we have seen the additive concept of Throughput-margin work across three examples, let’s review an example of Financial Productivity.

What is truly unique about the measure of Financial Productivity is that it relates back to the financial statements for the company as a whole.

Many times, companies utilize local efficiency metrics in isolation – which is to say there is no connection to the financial results of the company.

If you cut more parts than can be welded or machine more parts than can be inspected, you have not truly increased your Financial Productivity. You’ve simply made more parts.

Only by getting more jobs done faster can you increase your Financial Productivity.

To find how to increase your shop’s Financial Productivity (and its bottom-line), sign up for a free Strategy Session.  We’ll go deep to determine what’s possible for YOUR shop!

To find out how to increase your shops Operational Productivity, check out Velocity Scheduling System, visit www.VelocitySchedulingSystem.com. 

Key Concept #2 Lost Time / Opportunity Cost

In our last post we discussed a Key Concept: Throughput-margin is Additive.

We demonstrated that each job produces some amount of Throughput-margin and that we can simply add up all the Throughput-margin for the jobs we completed, shipped, and invoiced for a month and compare it to the total Operating Expense for the month to determine if the company made or lost money.

In this email, we’re going to take a deeper look at the additive concept of Throughput-margin and introduce a second Key Concept: “Lost” Time. Lost time is similar to opportunity cost.

A company loses money when Throughput-margin is less than Operating Expense for a time period.

Recall our example from Throughput-margin is Additive.  Our example company had completed, shipped, and invoiced three jobs (Job 1, Job 2, and Job 3).

Now imagine that for whatever reasons, the company was unable to complete, ship, and invoice Job 3 during the time period.  The reasons, while important are not where we are placing our emphasis, but rather on the bottom-line.

We refer to nonproductive time, in all its many forms, as “Lost” Time. There are numerous reasons for Lost Time, most of which are directly under your control (like set-up time).  Once the time is lost, you cannot get it back.  (But because Throughput Accounting does not allocate costs, there is no “cost” associated with Lost Time.  Rather, there is an opportunity cost for the Throughput-margin that could have been generated with the time if it was used more effectively.)

In this example, let’s just say that there was a weather event for several days.

Now as a result, the only sources of Throughput-margin are Job 1 and Job 2.  The total company Throughput-margin is less than total Operating Expense for the time period.  The company loses money.  In the example, $10,000 (loss).

In this case, both Jobs 1 and 2 still have the Throughput-margin that they do.  Neither are “less profitable”.  The reason the company lost money was that it did not ship Job 3 as originally expected.

Cost accounting would have allocated more expenses to Jobs 1 and 2, which would have meant they would have “made less” or perhaps even “lost money”.  However, that is not the case. Jobs do NOT lose money.

The jobs have the same Revenue and Totally Variable Costs (TVC) as well as the same Throughput-margin.

In this example, the loss had nothing to do with labor being inefficient or ineffective.  However, it very clearly illustrates the need for a company to generate Throughput-margin.

Operating Expense is going to be incurred each month, and in most cases regardless of the circumstances.

It’s your job as the owner to ensure your business generates enough Throughput-margin each month to cover the Operating Expense and generate the level of Net Profit you need or want.

To find out if lost time is costing you in your shop, sign up for a free Strategy Session.  We’ll go deep and dig into YOUR financials to see if Job Shop Pricing is a good fit and how much improvement is possible for YOU.

Key Concept #1:  Throughput-Margin is Additive

What if every job adds some money toward the bottom-line for the month?

What if all the jobs add up to the “money-in” for the month, and in total, you made money for the month because all of the money-in added up to more than your “money-out”?

Money-in is called Throughput-margin.  Throughput-margin is the revenue from a job less the Totally Variable Costs of the job. Totally Variable Costs, which include materials, subcontracting, and freight, are deducted from revenue to calculate Throughput-margin. Unless you are selling a job for less than its Totally Variable Costs, it is providing Throughput-margin (money-in).

Money-out is called Operating Expense.  Money tied up in the system is called Inventory.  These terms are part of the Theory of Constraints Throughput Accounting and were used in “The Goal” and the result of this new way of thinking about how to make money was the reason why such a remarkable turnaround occurred in just 3 months (that’s the story in the book).

In this context, what if there was no such thing as an unprofitable job?  And if there is no such thing as an unprofitable job, then there is no such thing as an unprofitable customer.  If this is in fact true, then its likely you would look at your decisions regarding jobs in a very different light.

Customers are the source of money-in that helps add up to the total.

If you got rid of jobs and customers that help add to the total for the month, perhaps the total of money-in would not be enough to cover all of the money-out.

Isn’t that a very different way of thinking about How Making Money Really Works?  But it is simple and straight-forward.

Dr. Eliyahu Goldratt, author of the popular and best-selling book “The Goal”, developed these concepts into what he called “Throughput Accounting”.

Throughput Accounting was developed to replace cost accounting.  Dr. Goldratt, a scientist, proved cost accounting was badly damaging those companies that used it.  The damage comes from having distorted measurements which unavoidably leads to making bad decisions.  Especially job costing measurements.

Profitable Jobs and Profitable Customers

For example, thinking of jobs as profitable and customers as profitable or unprofitable is incorrect.

Also, cost accounting incorrectly treats direct labor as a variable cost.  Yes, it varies, particularly if you pay for overtime.  But it is not totally variable.  So, using Throughput Accounting, it is part of Operating Expense (money-out) for a time period (for example, a month, quarter, or year).

And if you were to stop and think about the situation, you would realize that direct labor acts much more like a “fixed” cost. You have the same workers, working roughly the same hours each week, month, year, etc.  Sure, there’s PTO, overtime, etc., but when you think of your direct labor, we’re sure a number comes to mind of what it usually is in total each month.

You already add up all of the money-out for the time period.  That is standard practice.  You just are not used to adding up all of the money-in for the time period and then comparing money-in to money-out to determine the Net Profit for the time period.

Notice that when you think of it in this way, costs do not need to be allocated to jobs.  In fact, cost allocation is unnecessary and misleading.

The allocation process creates gross margin on a job by allocating (on an arbitrary basis) direct labor and overhead to jobs.  However, have you ever stopped to consider that if you simply got one more job completed, shipped, and invoiced in a month that gross margin dollars would increase? Probably not.

In fact, if you were asked, “How can gross margin dollars be increased?”, it’s likely you would say something about reducing your labor or overhead costs. And for all the time, effort, and energy spent on trying to reduce costs, there just is not that much to cut.

And what’s more, even if cost accounting says you decreased your labor costs somehow…how can costs go down when you have the same headcount? Did a magnanimous employee take a pay cut for the month? Not likely.

That’s why labor is classified as an Operating Expense in Throughput Accounting. Labor does not vary totally with the number of jobs you take on each period. If labor was totally variable, then you would save the expense of the labor if you did not run a particular job. But that’s just not so; you already have the workers hired and the shifts being ran.

A company makes money when Throughput-margin is greater than Operating Expense for a time period.

Recognizing that each job produces some amount of Throughput-margin, we now see that we can simply add up all the Throughput-margin for the jobs we completed, shipped, and invoiced for a month and compare it to the total Operating Expense for the month and determine if the company made or lost money.  It is just that simple.

Note in the example below, we have three jobs:  Job 1, Job 2, and Job 3.  Each job has Revenue.  Each job has Totally Variable Costs (TVC).  Each job has Throughput-margin.  But jobs do not have Operating Expense.

Only the company has Operating Expense.  Total Throughput-margin minus Operating Expense is Net Profit for the time period.  In the example, $20,000.

Notice how simple and clean an income statement presented in the Throughput Accounting format reads.  It’s very clear where the dollars are coming in from (on an individual and total basis) and how much are going out in total.

Also note, with Throughput Accounting the jobs on the income statement are not distorted (you won’t see unprofitable jobs in Throughput Accounting) nor is the income statement itself distorted by cost accounting.

Have you ever looked at your income statement and wondered, “Who’s results am I looking at?”.  You’re not alone.  Cost accounting can so distort the financials that good months look bad and bad months look good.  It would not be recommended to make decisions on such distorted results.

In summary, with Throughput Accounting we do not allocate labor or overhead, we have a totally different view of how our jobs create “money-in”, and we have a much simpler income statement that can actually demonstrate why the numbers are what they are.

In the next post we’re going to share with you how the additive aspect of Throughput-margin can impact your bottom-line.

To find if/how Throughput Accounting can help you in your shop, sign up for a free Strategy Session.  We’ll go deep and dig into YOUR financials to see if Job Shop Pricing is a good fit and how much improvement is possible for YOU.

Bonus Video:

To find if/how Throughput Accounting can help you in your shop, sign up for a free Strategy Session.  We’ll go deep and dig into YOUR financials to see if Job Shop Pricing is a good fit and how much improvement is possible for YOU.

Manufacturing overhead costs are a significant category of expenses for many manufacturers and job shops today.

Manufacturing overhead costs take on many definitions and can be allocated in several ways, thus getting a sense of what costs are in manufacturing overhead and just how much manufacturing overhead represents (for the company as a whole or its jobs, products, or services) can be a difficult challenge.

In this article we’ll define what exactly are manufacturing overhead costs, how to perform a basic allocation of those costs, and provide examples of allocating manufacturing overhead to jobs, products, and services.

Once establishing a basic understanding of manufacturing overhead and how it works, we’ll review the best way to reduce manufacturing overhead costs.

Manufacturing Overhead Defined

Manufacturing overhead is defined as the costs required to produce a job, product, or service that are not directly related and traceable to a specific job, product, or service which are apportioned to the jobs, products, or service based on some method of cost allocation.

Manufacturing overhead is also known as factory overhead, factory burden, production overhead and indirect cost.

There exist many forms of allocating manufacturing overhead (see our article on the various cost accounting methods).  One method we discuss is ABC or Activity Based Costing.

Manufacturing Overhead Costs Include

Common questions given the broad definition of manufacturing overhead are questions such as:

1. What costs go into manufacturing overhead?
2. What costs are included in manufacturing overhead?
3. What costs are excluded from manufacturing overhead?
4. What does manufacturing overhead consist of?

Examples of What Manufacturing Overhead Includes

To answer these questions, let’s review a few types of cost that are included and some costs that are excluded in the chart below:

How to Calculate Manufacturing Overhead Costs

Other questions related to manufacturing overhead deal primarily with the manner of allocation, such as:

1. When are manufacturing overhead costs allocated?
2. How to calculate manufacturing overhead costs?
3. How to allocate manufacturing overhead costs?
4. How to calculate manufacturing overhead cost per unit?
5. How to calculate manufacturing overhead cost applied to jobs?

Manufacturing Overhead Rate Formula

To answer this set of questions dealing with the method of allocation, we’ll briefly explain how the allocation process works.

For a more detailed discussion of the various allocation methods, see our article on costing methods.

Most forms of cost accounting take all the manufacturing costs and create a “cost pool.” This cost pool is then divided by the total unit number of a “cost driver.”

Typically, a cost driver would be direct labor hours, machine hours, or some other such basis for allocating costs.

Once this is done, the result is the manufacturing overhead rate. This rate is then applied to jobs, products, or services to establish the manufacturing overhead cost per unit (job, product, or service).

Manufacturing Overhead Rate Formula Example

As an example, suppose a company has $1,000,000 of manufacturing overhead annually.

Also, let us suppose it selects direct labor hours as its cost driver, which the company has 10,000 direct labor hours each year.

Thus, the $1,000,000 of manufacturing overhead divided by the 10,000 direct labor hours would yield a manufacturing overhead of $100 of manufacturing overhead per direct labor hour.

Manufacturing Overhead Examples

Now that we understand what is included and excluded from manufacturing overhead along with knowing how to do a basic allocation, let’s look at some examples of applying manufacturing overhead to jobs, products, and services.

After gaining an understanding from these examples we’ll take a step back and think about what these calculations are actually telling us as opposed to what we think they are telling us.

How to calculate Manufacturing Overhead for Jobs Example

To calculate manufacturing overhead for jobs, the first step would be to calculate the manufacturing overhead rate, as we did previously. For purposes of this and other examples we’ll utilize the $100 per direct labor hour we previously calculated.

Suppose Job #911 has 17.5 of direct labor hours reported on it. The formula to calculate the manufacturing overhead on the job would be:

This is how manufacturing overhead is calculated for jobs.

How to calculate Manufacturing Overhead for Products Example

Calculating manufacturing overhead for products can be done the same way as for jobs. The total hours of the cost driver (direct labor in our examples) is multiplied by the manufacturing overhead rate to determine the manufacturing overhead on the job.

Alternatively, manufacturing overhead cost per product can be calculated for a production lot or batch of products.

Suppose Lot #626 yielded 3,400 units of product LZ4. It took 435 direct labor hours to produce Lot #626.

The formula to calculate the manufacturing overhead on the job would be:

This is how manufacturing overhead is calculated for jobs.

How to Calculate Manufacturing Overhead for Services Example

Services would not typically be thought of as having manufacturing overhead associated with them.

However, for toll manufacturers this is their primary business, providing their manufacturing capabilities as a service to their customers.

Suppose Service Job #787 has 406.4 of direct labor hours reported on it. The formula to calculate the manufacturing overhead on the service job would be:

This is an example of how manufacturing overhead can be allocated to services.

The Ultimate Way to Reduce Manufacturing Overhead Costs

(scroll up to read from the top of this article)

Now that we know what manufacturing costs are defined as, how to calculate them and have seen examples demonstrating how the manufacturing overhead allocation process works, let’s dive into the ultimate way to reduce manufacturing overhead costs.

The ultimate way to reduce manufacturing overhead costs is to simply make more.

More products.  More jobs.  More services.  It’s just that simple.

When the level of production goes up the unit costs of jobs, products, and services go down.  They must decrease.  There is no mathematical alternative.

Recall the formula for manufacturing overhead per unit is:

Manufacturing Overhead Costs / Units Produced = Manufacturing Overhead Cost per Unit

Thus, if the denominator goes up, the quotient must go down.  It’s a mathematical law that applies to manufacturing overhead costs as it does any other math equation.

Let’s now examine the magnitude of simply producing more to better understand its true impact.

For instance, suppose manufacturing overhead is $1,000,000 annually and our company produces 1,000 jobs.  Each job would have an overhead cost of $1,000 (assuming a simple, flat allocation of manufacturing overhead costs over the number of completed jobs).

Suppose we completed 2,000 jobs.  The manufacturing overhead per job drops to just $500.  That’s cutting manufacturing overhead costs in half!

Now perhaps it seems a bit extreme to double the number of jobs completed and cut your manufacturing overhead costs in half. What if we have a 20% increase, that seems much more believable doesn’t it?

The same effect occurs. With a 20% increase in the number of jobs completed we would have the $1,000,000 of manufacturing overhead divided by 1,200 jobs, for a manufacturing overhead cost per job of $833.33.

This is why we’re so focused on creating flow. You have lower costs and earn more margin, both of which add up to making more money with the same people and resources.

In fact, Velocity Scheduling System has been designed to help job shops get more done with the same people and resources by managing the flow of jobs through you shop.

Nothing else can reduce manufacturing overhead costs to the extent that simply producing more can, both in terms of its magnitude of impact and in terms of the confidence we can have in the fact that costs will go down.

Furthermore, the results are the same, no matter the method of accounting you use.

If you use traditional cost accounting, the answer is very simple: more jobs, products, and services produced result in a smaller cost per job, product, or service.

If you utilize activity-based costing, it’s a very safe assumption that in order to produce more jobs, products, or services you will need more activities, across all levels of the organization.

More activities mean lower activity costs.  Lower activity costs mean lower unit costs, for jobs, products, and services.

Simply producing more is indeed a surprising silver bullet to the problem of how to reduce manufacturing overhead costs.

Extending the case for making more (jobs, products, or services) would be examining what happens to jobs, products, and services as more is produced.

For instance, on jobs, as the manufacturing overhead cost per job decreases, the gross margin on the job increases.

Thus, as we produce more, our jobs become more profitable.

Not only that, as we produce more, we’re able to earn more gross profit in total using the same resources.

We have the same labor, same overhead, same building, same machines, etc.

So simply by producing more with the same resources we have created a virtuous cycle consisting of earning more profit per job as well as earning more gross margin in total by completing more job.

A true win-win.

Now there is one assumption underlying the solution of making more: we sell what we make!

It obviously would not be beneficial to simply park our efforts into inventory and watch as we pour more and more money into inventories each month.

Yes, the per unit costs are decreasing, but this does not actually generate more sales or total margin for us.

Problems Associated with Reducing Manufacturing Overhead

Now, it would not be unreasonable to assume that if cost accounting reports more gross margin per job and in total along with lower manufacturing overhead costs per job cost accounting would also encourage actions that lead to such results.

Unfortunately, nothing could be further from the truth.

How can this be?

It seems that I’m suggesting the same system can encourage different (and even contradictory!) actions.

It’s true.  Dr.  Goldratt would famously say, “A building cannot have two heights!”

So how then is it that cost accounting systems can lead us to increase production (make more) and at the same time lead us to decrease production (make less)?

I’m glad you asked.

We have laid out the case for making more: more margin in total, more margin per job, less overhead cost per job.

The case for making less emerges as we begin to take the actions at the local level that could lead to producing more.

What if you bought a more expensive raw material to use in your production process? Suppose this more expensive material allowed you to run your machines at a faster rate and complete more jobs.

What would cost accounting say?

It would say more material cost means less gross margin.  Less gross margin is a negative result (i.e.  DON’T BUY THE EXPENSIVE MATERIAL!)

Further, most folks would agree, if you put more workers on a job the job would get done faster and more jobs in total would be produced.

What would cost accounting say?

Cost accounting (no matter the method) would say it took “more labor cost” to complete the jobs, therefore, each job had a lower gross margin than if we were to simply put less workers on the jobs.

And what about reducing overheads? Well cost accounting would suggest increasing batch sizes.  Now at first glance, this appears to be in the correct direction (make more).

However, what happens when batch size increases? It takes longer to process each batch.

What happens when it takes longer to process each batch? It takes longer to get a complete set of parts to a welding or assembly operation.

What happens when it takes longer to get all the necessary parts to a welding or assembly operation? We get less jobs finished.

Less, not more, is done.

You see, this is a problem that strikes to the heart of the problem with cost accounting, across all its various methods.  The actions needed at a global level (make more) are not the actions needed at a local level (make less).

The same system gives different answers! And what do we intuitively know? The actions needed for the company as a whole should be the same actions needed at the shop floor level.

They are literally the same place! So why would the same place need different actions to produce the same result?!

That’s like saying you need to eat healthy and increase your daily intake of doughnuts to lose weight.  It just doesn’t add up.

As mentioned earlier, let’s now stop, take a step back and truly think about what manufacturing overhead is really telling us.

Each job, product, or service has overhead assigned to it from the examples. We performed the calculation correctly, yet the result is wrong.

Why is the result wrong? Well, think about what the result is actually telling us.

By placing overhead on the job, product, and service listed above, the result is saying that we have incurred these costs to provide the job, product, and service. But is that true? NO!

Think back to where we listed the examples of the costs which are included in overhead. Would any of these costs be saved by not producing the job, product, or service in the examples? NO!

So how then is it that cost accounting says manufacturing overhead is incurred for the job, product, or service yet we cannot save these same costs by not working on the job, product or service?

If doing the work causes the cost to be incurred, then surely NOT doing the would work would be we would NOT incur the cost?

Unfortunately, the story we get from allocating manufacturing overhead is not what happens in reality.

Manufacturing overhead creates confusion, distorted decisions, and conflict in many organizations and it’s easy to see why.

Think about the last time you quoted a job.

Was it quoted the same way as the the previous RFQ your responded to?

If this was a repeat job or part, was it quoted the same way as it was before (not likely, despite have the previous estimate!)?

It’s likely some costs were included that were previously excluded, or vice versa. It’s also likely each time you try to engage your estimators in a discussion to understand just how they arrived at their conclusions, they become defensive and provide an exhaustive justification of their “costing.”

You then walk away from the conversation worn out and you’re no closer to understanding their estimates than when you began.

The reason there are shifting definitions, methods, conclusions, and approaches to manufacturing overhead is that is not being managed in a consistent and logically correct manner (the same is true of direct labor in fact. See our course, “How Cost Accounting Distorts Decisions” for more information).

The Best Way to Reduce Manufacturing Overhead Costs

This now brings us to the best way to reduce manufacturing overhead costs. The best way to not have manufacturing overhead costs is simply to get rid of the entire concept of manufacturing overhead in the first place.

This is exactly what Throughput Accounting does and why it provides such a powerful foundation for Job Shop Pricing.

You see, Throughput Accounting does not define manufacturing overhead as a category of expense at all. Throughput Accounting has two types of expenses: Totally Variable Costs and Operating Expenses.

Totally Variable Costs (TVC) are those costs which are incurred to produce a job, product, or service and alternatively are saved if we do not produce a particular job, product, or service (unlike manufacturing overhead!).

Operating Expenses (OE) are all other costs that are not a TVC.

Pretty simple, right? It’s almost too simple at first glance.

However, Throughput Accounting with these simple definitions provide a tremendous amount of clarity and removes the barriers from seeing how actions and decisions will truly impact a company.

That’s why you’ll hear me say oftentimes, “It’s not the math, it’s the logic!”

What I mean by this is the math of cost accounting is built on bad logic, thus there is no way to get the right result – even if you do the calculations correctly. Alternatively, in Throughput Accounting the math simple, yet built on sound logic, thus it is easy to develop the correct answer – unlike with cost accounting methods.

So, there you have it, the best way to get rid of manufacturing overhead is simply to not have it and use it to make decisions with, but rather utilize Throughput Accounting for your decision-making needs.

To learn more about Throughput Accounting, check out our course, “The Fundamentals of Throughput Accounting.”

If you’re ready to really understand your costs and see what might be possible in YOUR shop, watch the webinar, then sign up for a free strategy session.

In this article we explain why cost accounting including activity based costing, does not work.  We discuss job shop costing methods and shop rates using traditional Cost Accounting. We cover the actual and allocated direct labor methods, department rate method, cost basis, cost rates, standard costing, direct material and overhead as typically used in custom job shops, machine shops and for manufacturing.

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Cost Accounting is widely accepted, promulgated, and viewed as the de facto standard for making financial decisions.

However, despite the ubiquity of cost accounting, there exists a growing contingent of business owners who view it with a healthy dose of skepticism, and rightly so.

Many business owners are realizing that cost accounting just does not work – and in fact oftentimes leads to decisions which are directly counter to their goal!

To better understand why this is the case, we’re going to review a few methods of cost accounting to understand how they work, understand their practical application to an individual job/product and with that understanding we’re going to examine the undesirable effects of using them – specifically in the case of job shops and custom manufacturers.

And let’s never lose sight of THE GOAL.  We want to make money now as well as in the future.

Our accounting systems are the basis of our measurement systems.  And it’s our measurement systems which drive behavior – which drive results.  So, it’s important to get this RIGHT!

How Job Shops Determine Job Shop Cost Rates and Shop Rates

Before we jump into understanding the vast array of accounting methods, we need to first understand the context that guides their application in a job shop or custom manufacturing environment (we’ll be using job shop to represent both job shops and custom manufacturers throughout this article).

Job shops use cost accounting methods in one of two primary ways.

Cost Rates for Job Shops

The first is to compute a “cost rate”.  This cost rate can be computed in a variety of ways.

For instance, there can be a cost rate for each machine, employee, or a single cost rate for an entire shop.  How the cost rate is sliced and diced depends on each specific business and how the managers of the business have decided to compute the cost rate(s) they use.

Shop Rates for Job Shops

Secondly, job shops use cost accounting to create what is known as a “shop rate”.

The shop rate is the rate at which a job can charge to both cover costs and earn a profit.

Unlike a “cost rate”, the “shop rate” is one universal rate for the entire shop that covers all costs and has profit built in.

Most business only utilize one “shop rate”, unless they have multiple locations.  In that case, one could find “shop rates” for each of the separate locations, but it is still more likely to see a shop rate for the company as a whole.

Costing Methods – Cost Accounting Methodologies for Job Shops

The key to understanding these costing methods and rates is to understand their formation.

The shop rate is simply an extension of the cost rate, applied to the shop as a whole, with a built-in profitability level.

The level of profitability is dependent upon the owner or manager’s target profit level.

Thus, understanding the “cost rate” will allow us to see how both the “cost rate” and “shop rate” function in the real world.

As mentioned earlier, the “cost rate” can be based on several items, such as total labor or machine hours, departmental labor or machine hours, batch-level activities, job-level activities, and so on.

To help understand the many ways cost accounting can be applied, I’ve developed the chart below.

From the chart, you can see that there’s a myriad of ways to go about applying cost accounting to any particular business.

Using either traditional or standard costing allows a shop owner to set labor rates, machine rates, department rates, or shop rates.

All are possible and the decision boils down to preference on the part of owners, managers, and the accountants as to which seems the most appropriate.

Traditional Cost Accounting

How Traditional Cost Accounting Works

Traditional cost accounting is the basic method of cost accounting taught to most business students in colleges today.

Although no one singular history  exists, its origins can be traced back into the 1800s when railroads and cotton mills were trying to reconcile high capital and fixed costs into a high volume of small revenue generating jobs or products.

Traditional cost accounting suggests that a job or product is comprised of three basic components: direct material, direct labor, and overhead.

Direct Material

Direct material’s definition is apparent from its name.  It is simply the materials that which can be directly traced into a job or product.

These materials would include raw materials used in production acquired from vendors as well as sub-assemblies purchased from vendors.

For instance, suppose a car manufacturer purchased engines from an engine manufacturer.  The engine would be considered direct material to the automobile manufacturer.

Also included in direct material would be the expenses related to scrapped materials as well as the material expense of having to rework an item.

For example, suppose a steel fabricator realized during manufacturing one component was made of the wrong material type and needed to be replaced.  The materials that were scrapped as well as the new material consumed to produce the correct component would both be included in the end product’s direct material cost.

Direct Material Example

Suppose the following represents relevant facts of a job that is being quoted:

What is the amount of direct material on the job?

The total direct material is $8,500, which is made up on the expense of buying the plate steel and the crating for the job.

Direct Labor

The second component, direct labor, also lends itself to an easy understanding based on its name, but a quick look below the name reveals much more complexity than direct materials.

Direct labor is generally viewed as the labor cost required to actually produce the job or product on the shop floor.

This is determined by the actual touch time or processing time of the job or product being multiplied against a direct labor cost per hour.

The direct labor cost per hour can be determined by one of a few methods: direct labor cost by employee, allocated direct labor cost or, direct labor cost by department.

The actual direct labor cost is based on the specific expense of each employee working on the job or service.

For example, suppose an experienced, certified welder was working on a job with a new welder.  The experienced welder may make upwards of $50/hour including benefits.  The new welder may only be paid $30/hour including benefits.

Thus, the theory is that by using actual hours you get a more accurate reporting of labor expense on a job.

Allocated direct labor cost entails adding up all the labor expenses for a period of time (generally a year) and dividing those by the total labor capacity (expressed in hours).  This would provide the direct labor cost rate, which would then be applied to the hours on a job or product.

Obviously, in allocating labor the detail of who performed items on a job at what specific cost are lost, but it may not be important if most workers are paid fairly similar wages.

The third method is a hybrid of the two previous methods.

Direct labor cost by department is calculated by pooling together all employees of a department (workers and supervisors) and then creating a cost per hour taking into account only the direct labor hours of workers, not supervisors.  In this manner, where the workers’ hours are reported on jobs or products also allocates the supervisor’s salaries proportionately based on the work performed.

Although the allocation direct labor cost method could be viewed as not as “accurate” as actual direct labor cost it has several benefits.

First it is easier to administer as it requires much less shop floor detail.

Only total job or product hours are needed, with no breakout by worker required.

Secondly, in shops where workers switch between many jobs or products during the day, having a system  to support actual labor costing can be cost prohibitive and overly burdensome on shop floor employees.

Thus, it is often cheaper and easier to us the allocation method in many shops.

Direct Labor Example

There are 6 workers at a job shop who are paid the following wage rates (including benefits) and are in the departments indicated:

Job #4371 has just been completed and utilized the workers’ time as follows (note, worker 1 did not work on this job):

Calculate the labor cost using the actual direct labor method, the allocated direct labor cost method, and by using department rates.

Actual Direct Labor Method

The actual direct labor method is simple and straightforward, provide the data collection on the shop floor is done correctly and at the appropriate level of detail.  The labor cost using the actual direct labor method is as follows:

Allocated Direct Labor Method

The allocated direct labor method requires a bit more work on the front end but is easier to apply to a specific job.

First, we must determine the direct labor rate, which requires allocating all labor costs over total labor hours (note: Worker 5 only works 1,000 hours as the worker’s other time worked is spent as a quality inspector and trainer for new workers and it is part of overhead).

Allocated direct labor cost per hour = $350,000 / 11,000 =$32.82

Now that we have the labor rate, we can compute the job’s allocated direct labor cost.

Department Rate Method

To determine the department rates, we’ll perform the same calculation as we did for the allocated direct labor rate, except we’ll perform the calculation at the department-level.

We’ll add up the annual hours of each worker and their associated wages, then we can divide the annual wages by the annual hours for each hour to determine the departmental direct labor cost per hour rate.

Now that we have the departmental rates, we can apply them to the time on the job, as follows:

Before we move on to understanding overheads, let’s summarize all three methods:

So, which is it? Actual, allocated, or departmental? All three are “valid”, allowed, and used by many businesses.

It’s pretty easy to see why cost account creates confusion and produces bad information.  And this is just for direct labor, one of three parts of a job’s cost!

And not only that, think about this, we have three different “labor costs” on this job, just simply based on which method we used, but did labor in total change?

Nope.  Not by $1.

We had the same workers, working the same shifts, same hours.  Nothing changed, but that’s not what cost accounting suggest.

Cost accounting would not only lead us to believe that there’s significance in the way we assign labor to jobs, but also that these jobs “caused” this labor cost for the company.

No matter which method you select, they each suggest this job has direct labor cost between $750-$900.

However, let me ask this question: What if we didn’t have this job?

Well, if we did not have the job, cost accounting would imply that we would not have these costs.  Everyone knows that’s just not true.

Can you fire any of these workers for a few hours at a time? Not likely.

In fact, once you hire a worker you’ve got to keep their hours up to prevent them from looking for a new job.  Sure, you have SOME flexibility with scheduling, but let’s not kid ourselves.

Let’s continue on to overhead.

Overhead

Overhead, also known as manufacturing overhead, takes its name from all the costs that occur “over the heads” of workers on the shop floor.  Items like the shop building’s rent or lease expense, electric, water, and other utilities expenses, manufacturing supervisors, environmental, quality, and all the other expenses related to manufacturing that are not direct materials or direct labor.

These overhead expenses are pooled together and then allocated to jobs or products.  In practical terms, this means the overhead expenses are added up (the overhead “pool” if you will) and then are divided (allocated) over a base of direct labor hours, direct labor cost, or machine hours or machine cost.

Overhead includes both fixed costs and cost that are variable, just not directly traceable to a job or product.  For instance, electricity is used by the machines to produce jobs or products; however, it simply is not practical to determine each job or product’s share of the total electrical bill, thus the electrical expense is allocated to the jobs or products based on some reasonable basis (called a cost driver).

Overhead Example

Let’s look at an example of how to compute overhead rates.

We’ll examine how to compute overhead rates based on direct labor hours and direct labor cost, which would be same steps to calculate the overhead rates had we used machine hours and machine cost.

Using the information below, let’s compute the overhead rate for the job shop:

Using the same labor information from the previous examples, we can see the overhead rates:

Overhead per direct labor hour: $585,000/11,000 = $53.18 per direct labor hour

Overhead per direct labor dollar: $585,000/$350,000 = $1.67 per direct labor dollar.

Again, the same critiques made against direct labor can be leveled against overhead.  In fact, it’s an even worse situation as far as overheads are concerned.

For instance, the $1.67 of overhead per direct labor dollar would imply that overhead increases as more labor cost is added to a job.  But is that true?

Do you expense to pay more insurance expense? No? Why then would we have higher overhead costs on a job if overhead costs in total are not changing?

Do you expect to spend more on I.T.  just because you took on a new job? Again, no.  So why is the accounting system suggest that there will be more I.T.  cost if there are more direct labor hours on a job?

Do you see the problem? Cost accounting is associating “costs” with jobs, although the underlying expenses 1) don’t change and 2) are not in any way related to a specific job.

Now, once the direct material, direct labor, and overhead costs have been calculated, they are summed up to form what is known as “job cost” or “product cost.”

If two of the three components of “job cost” are fundamentally flawed, how effective do you think using “job cost” is for making decisions?

If you care about the bottom-line it’s easy to see cost accounting is taking you in the WRONG direction!

This is why Job Shop Pricing does not use traditional cost accounting to base its decisions upon, but a new and much superior method of accounting.

But before we get into that, let’s address Dr. Goldratt’s long-time nemesis: Standard Costing.

Standard Costing

How Standard Cost Accounting Works

Dr. Goldratt was NOT a fan of standard costing.

In fact, at the 1983 National Association of Accountants annual meeting (now the Institute of Management Accountants, or IMA), he delivered his speech entitled, “Cost Accounting: The Number One Enemy of Productivity.”

I agree with most of what Dr. Goldratt said. I would have not put the words “of Productivity” in there as cost accounting works against much more than productivity.

So, let’s continue on and learn more about standard costing and what caused it to provoke such a strong reaction from Dr. Goldratt.

Standard costing is very similar to traditional cost accounting; however, standards of cost are developed to further facilitate analysis of an operation.

Imagine knowing EXACLTLY what a job or product should cost and being able to identify the exact areas that are creating too much cost for the job or product? Sounds great right?

With these standards in place, efficiencies can be evaluated by both the consumption of material and capacity along with analyzing how effective management utilized its high cost resources.

It’s like having the perfect set of lenses through which to view your organization…only they do not work as promised.

But before we get into that, let’s find out how standard costing REALLY works.

Direct Material

As in traditional cost accounting, direct material represents the expense of raw materials, purchased parts and subassemblies, and the waste and scrap used to produce a job or product.

However, in standard costing, a standard amount of material will be developed.  This standard is based on two components: price and quantity.

The price component of the standard represents the standardized price per unit paid for a given quantity of material (cost per lbs., sheet, cube, MSI, MMLF, etc.).

In setting the price standard component of the standard direct material cost, the cost accountant must consider past purchase history along with expected trends in cost.

Thus, setting the standard price is a process subject to judgement.

If the standard price were set too high, it would create an incorrect positive price variance and show encouraging results when there were none.

Setting the standard price too low would create the opposite effect; that is showing negative effects when reality may have been positive or at worst, at standard.

A very tricky process indeed (perhaps this is why the cost accountants use so many decimal points in their calculations).

Input from key stakeholders, such as production planners, procurement staff, and others may be necessary to create the standard price.

Once the price standard has been established a quantity standard will be established.

The quantity standard represents the ideal amount of direct material utilized to complete a job or product.

Again, establishing the quantity standard is a subjective process subject to judgment.

Engineering and operations may need to be consulted to establish the quantity standard.

Factors such as worker experience, frequency of production, tolerance requirements, defect rate, and other such items need to be considered in setting the quantity standard.

With the price standard and the quantity standards set, the standard direct material cost can be established.  It is simply the price standard multiplied by the quantity standard.  The product of this calculation represents the standard direct material cost of the job or product in question.

Direct Material Cost Variance Analysis

To perform the variance analysis on direct material, the standard direct material cost is compared to the actual direct material cost.

The difference between the standard cost and actual cost is the direct material cost variance.

As the standard cost was comprised of two elements, so too is the cost variance.  The cost variance is comprised of a price variance and a quantity variance.

Direct Material Price Variance

The direct material price variance is determined using the following formula:

(DM_AP-DM_SP)*DM_AQ = DM_PV

The formula reads as follows: The difference between direct material actual price less direct material standard price multiplied by the direct material actual quantity equals the direct material price variance.

Direct Material Quantity Variance

The direct material quantity variance is determined using the following formula:

(DM_AQ-DM_SQ)*DM_SP = DM_QV

The formula reads as follows: The difference between direct material actual quantity less direct material standard quantity multiplied by the direct material standard price equals the direct material quantity variance.

Direct Material Cost Variance Analysis Example

For our example, let’s suppose the following facts:

A composite aircraft part has a direct material standard of $25,000 per part. This is comprised of a price standard of $250 per lbs. and a quantity standard of 100lbs per part.

The manufacturer has recently begun production of the part and has selected two jobs to evaluate against the standards. Here is a summary of the jobs:

Job#	Material Price per Unit	Lbs per part	Actual Cost per Unit
003-B	$285.17	202lbs	$57,604.34
068-A	$249.25	105lbs	$26,171.25

 

Let’s now compute the direct material standard cost variance for each job:

Job#	Standard Cost per Unit	Actual Cost per Unit	Variance
003-B	$25,000.00	$57,604.34	$32,604.34
068-A	$25,000.00	$26,171.25	$1,171.25

 

As we can see, neither part was produced to standard cost. However, the second part, made with Job 068-A, was significantly less “expensive” than the first part.

Obviously, we’d expect a learning curve in making a sophisticated part for the aerospace industry, so to better understand the causes of variation, let’s now compute the price and quantity variances for the two jobs.

Direct Material Price Variance:

Job#	Actual Material Price per Unit	Standard Material Price per Unit	Actual Quantity per Unit	Direct Material Price Variance
003-B	$285.17	$250	202lbs	$7,104.34
068-A	$249.25	$250	105lbs	$(78.75)

 

Direct Material Quantity Variance:

Job#	Actual Material Quantity per Unit	Standard Material Quantity per Unit	Standard Price per Unit	Direct Material Quantity Variance
003-B	202lbs	100lbs	$250.00	$25,500.00
068-A	105lbs	100lbs	$250.00	$1,250.00

 

As we see from the direct material price variance, the first job had a much higher cost variance than the second job.

This could be attributable to the fact that the company was purchasing smaller, yet more expensive quantities of material in the beginning at production ramped up or the purchasing department finding a less expensive vendor.

We see the same trend occur with regard to the direct material quantity variance.

The first job used considerably more material than the standard, over double the standard quantity. Most likely attributable to having a defective part produced, having to scrap it, and reproduce the part.

As can be seen from the example, the analysis can provide many insights to managers.

Direct Labor

In standard costing, actual direct labor is calculated in the same ways as it is in traditional cost accounting.  Direct labor can be accounted for on an actual basis, allocated basis, or on a departmental basis.

In standard costing, direct labor standards are established which then allow for variance analysis to be performed, just as is done with direct material.

Direct Labor Price Variance

The direct labor price variance is determined using the following formula:

(DL_AP-DL_SP)*DL_AQ=DL_PV

The formula reads as follows: The difference between direct labor actual price less direct labor standard price multiplied by the direct labor actual quantity equals the direct labor price variance.

The price variance arises when higher cost labor is utilized to produce an item.

For instance, perhaps higher-skilled workers are utilized, or overtime was used, which increased the actual hourly rate (price) paid to workers.

Direct Labor Quantity Variance

The direct labor quantity variance is determined using the following formula:

(DL_AQ-DL_SQ)*DL_SP=DL_QV

The formula reads as follows: The difference between direct labor actual quantity (hours) less direct labor standard quantity (hours) multiplied by the direct labor standard price equals the direct labor quantity variance.

Several causes can lead to the direct labor variance being either higher or lower than the standard.

When there are quality problems, process problems, worker problems, or any interruptions to flow, the actual quantity of direct labor will increase, which means there will be a positive variance (which is to say more cost was incurred than anticipated in the standard).

Alternatively, as workers become proficient and experienced in their jobs, there may be direct labor variances that reflect this improved efficiency.  The direct labor variance in these situations would be negative (which is to say it took less labor expense than was anticipated in the standard).

Due to these factors, it may be necessary to revisit standards periodically and update them so that they reflect the tasks being performed and the workers doing them.

Direct Labor Cost Variance Analysis Example

For our example, let’s suppose the following facts:

A composite aircraft part has a direct labor standard of $17,500 per part. This is comprised of a price standard of $35 per hour and a quantity standard of 500 hours per part.

The manufacturer has recently begun production of the part and has selected two jobs to evaluate against the standards. Here is a summary of the jobs:

Job#	Labor Price per Unit	Hours per part	Actual Cost per Unit
003-B	$27.25	782 hours	$21,309.50
068-A	$37.22	467 hours	$17,381.74

 

Let’s now compute the direct material standard cost variance for each job:

Job#	Standard Cost per Unit	Actual Cost per Unit	Variance
003-B	$17,500.00	$21,309.50	$3,809.50
068-A	$17,500.00	$17,381.74	$(118.26)

 

Here we have the same jobs from the previous example.

In the case of direct labor, we see that the first job did not perform to the standard direct labor cost.

The second job came in slightly below the standard direct labor cost. Most likely this is attributable to workers getting up the learning curve and being more familiar with producing the part.

Let’s now compute the price and quantity variances for the two jobs.

Direct Labor Price Variance:

Job#	Actual Labor Price per Unit	Standard Labor Price per Unit	Actual Quantity per Unit	Direct Labor Price Variance
003-B	$27.25	$35.00	782 hours	$(6,060.50)
068-A	$37.22	$35.00	467 hours	$1,036.74

 

Direct Material Quantity Variance:

Job#	Actual Labor Hour per Unit	Standard Labor Hours per Unit	Standard Price per Unit	Direct Labor Quantity Variance
003-B	782 hours	500 hours	$35.00	$9,870.00
068-A	467 hours	500 hours	$35.00	$(1,155.00)

 

Unlike the direct material cost variance analysis, this example contains a mixed set of outcomes.

Certainly, Job 068-A outperformed Job 003-B, but Job 003-B had a favorable price variance, while Job 068-A had a favorable quantity variance.

The cost accountant would say that Job 068-A was preferred as its overall cost variance was favorable while Job 003-B was unfavorable.

The reason the overall cost variance was better on Job 068-A could be attributable to the fact that more experienced and most expensive workers were on Job 068-A.

This would be why the price variance was unfavorable (expensive workers) but the overall job was favorable as the workers cut significant hours out of the process (creating a larger, favorable quantity variance).

Before we move into overheads, let’s stop to consider the ramifications of such a system applied to direct labor.

In these environments, it seems that standard costing could be applied to control and manage direct labor, but is this necessarily true?

Look at the examples above. Did the company really have a higher direct labor expense?

Notice I said direct labor expense not cost. Of course, you’d say it cost more to produce. Buy what would you say about the level of expense?

We both know the level of expense did not change. The company did not hire nor fire anyone just for one of these jobs, so how could it?

So, if the direct labor expense did not change, how did the direct labor cost change? You see, yet another distortion caused by cost accounting.

This is why the Job Shop Pricing system does not rely upon “cost.” Cost is a very deceptive word, which leads many astray.

Overhead

Overhead in standard costing follows the same practices as found in traditional cost accounting to determine the actual overhead amount on a job or product.

Overhead can be calculated as a standalone rate, much like the direct labor rate and applied based on a cost driver, such as direct labor hours or machine hours.

Alternatively, overhead can be expressed as a rate of absorption.  This is commonly performed by dividing the total overhead dollar pool by the total of direct labor dollars.  This results in an overhead rate expressed in terms of direct labor dollars, such as, “overhead is 150% of direct labor dollars, or 1.5 times direct labor dollars.”

Problems with Standard Costing in a Job Shop

We’ve addressed a few of the problems of standard costing along the way, but let’s take a deeper look at the issues caused with a standard costing system.

Ultimately, standard costing is a measurement system, and measurement systems are designed for one thing: to drive behavior.

As Dr. Goldratt famously said,

“Tell me how you measure me, and I’ll tell you how I behave.”

In the mind of managers who implement standard costing systems they are satisfying objectives believing this will lead to profitability for their companies.

Those objectives would be:

1. Discourage waste of money, material, and time
2. Monitor and control waste of money, material, and time

If no one wasted time or material that would mean the company would use only the material, labor, and overhead necessary and not more. This prevent the company from incurring additional material, labor, or overhead expense other than what was required.

For example, if the company’s purchasing department is pulling its weight, it will ensure the company pays the lowest cost for raw material, thereby reducing costs and increasing profits.

Not only that, but if the laborers do not waste their time and are not overpaid, then the company will also have the best utilization of its workforce given the amount spent.

And if laborers don’t waste time (theirs or machine time), and overhead is tied to labor (or machine) time, then we won’t incur any more overhead than necessary.

A perfect system to eliminate all waste and ensure productive use of all resources, or so it would seem.

Unfortunately for adherents to standard costing this just is not the case.

For starters, as was the case with traditional cost accounting, the allocations of direct labor and overhead do not represent actual “costs” of the job. Placing them next to a standard and claiming that costs are above a standard does not change this fact.

Suppose a job takes more time than the standard to produce. The claim would be that this job cost too much and had an unfavorable variance.

The reality is that direct labor did not change in total for the period; so how then could a job “cost” more when the expense does not change?

Not only that, what would the Theory of Constraints say about an unfavorable labor variance at a non-constraint?

If you say the “Did you know?” regarding the International Prototype Kilogram, compare its resiliency to change to a standard that is set in standard costing. If a standard utilized in standard cost accounting lasts more than a quarter, it should be considered a stunning achievement by the accounting department!

A standard that changes is no standard at all.

Continuing on, standard costing is akin to applying transfer prices at the shop floor level: the results will not be pretty.

How easy do you think it is to come to any form of agreement on these “standards”? Not only that, but in a job shop environment, what is the source of the standards?

Even if a part is being reproduced, using the previous job as a standard would not be ideal. Different workers, machines, materials could be employed thus leading to wild differences in the standard cost variance analysis.

What information does this provide other than the fact that job was ran under different conditions at a different time? So what?

Further, we’ve already established that the many of the supposed “costs” of a job are not costs at all, but rather mathematical phantoms.

Alternatively, as a manager, you could jump right into the heart of the age-old battle between the estimators and workers on the shop floor. I’m sure you’ll come out unscathed.

I’ve never met an estimator who got an estimate wrong – it was always the idiots on the floor who didn’t process the job correctly. Nor have I met a worker on the shop floor that would claim they were given enough time by the estimator to perform a job (they claim the estimator does not have the first idea of how things really are on the floor).

So, in a job shop, how can you possibly set these standards? And even if you can get a standard set – how can you possibly trust what it is telling you?

Oh, and let’s not forget Heisenberg’s Uncertainty Principle (sounds complicated – but it’s simple), which basically states that once you begin measuring a system, you’re also simultaneously affecting the system which distorts your ability to measure it.

What this mean in practical terms is this: People will behave to make the measure look good – not the reality.

Suppose you put a standard time on a job of 10 hours. How many jobs do you think will finish below 9 hours? If you find such an instance, please report the miracle that has taken place.

The reason you’ll be hard pressed to find a job that finishes well below the standard is the workers know how to play the game – better than the best of the accountants.

Suppose a worker finished a job in 6 hours. What do you think would happen? Praise from management? Sure…for that job.

But what about the next job? Do you think the accountants will allow the time standards to remain so high causing the company to incur so much “cost”? Not hardly.

So instead of fighting a never-ending battle, the worker will simply ensure that the “standard is met”.

In Job Shop Pricing our standard is simple: moving towards THE GOAL is good, moving away from the goal is bad. It’s obvious that standard costing does not meet this standard.

Activity-Based Costing (ABC)

Activity-based costing (ABC), was born out of the recognition that traditional and standard costing methods were simply inadequate and ineffective.

In the book Relevance Lost, Harvard professors Johnson and Kaplan describe in detail just how flawed the existing methods of cost accounting were at that time.

From their analysis of the many deficiencies of existing cost accounting methods they developed and promoted what was to be the method needed to set the records straight: activity-based costing.

How Activity-Based Costing Works

ABC works similarly to traditional and standard costing methods with regard to direct material and direct labor costs.  Where it differs is in its treatment of how overheads are allocated.

With ABC, the approach to allocating overheads is as follows:

1. Identify the costs to be allocated.
2. Create cost pools according to activity level.
3. Assign activity drivers and accumulate activity driver information.
4. Allocate costs to cost objects.

We’ll now dive into each of the four steps and take a detailed look, specifically at how ABC allocates costs to jobs or products.

Identify the costs to be allocated.

The first step of identifying the costs to be allocated is critical to ABC.

In a job shop environment, this would include what we typically think of as overhead costs, but would also include other costs, which may not have necessarily been considered in the past, such as engineering or distribution costs.

These costs are included as ABC takes a broader view of product costs and is seeking to account for all the costs associated with a product, from development to production to distribution.

Once the costs have been identified, the next steps begin the process of allocating these costs to cost objects.

Cost objects are the items whose cost is being determined by the analysis.

With ABC, many cost objects are available for costing, such as jobs, products, services, departments, distribution channels, customers, etc.  For purpose of this article the focus will be on jobs and products, which are costed in a like manner.

Create cost pools according to activity level.

Now that the costs which are to be allocated have been identified, the costs are then categorized into various cost pools according to their activity level.

There are four primary activity levels:

1. Job/Product Level Activities
2. Batch Level Activities
3. Product-Line Level Activities
4. Support Level Activities

Let’s now review each in detail.

Job/Product Level Activities

The job/product level activity cost pool (also called unit level cost pool) would include items that occur only at the individual job/product level.

Examples of job/product level activities would include direct materials, direct labor, utility consumption (traceable to the job/product), use of consumables, and so on.

As mentioned previously, direct material and direct labor are treated in ABC similarly to how they are treated in other forms of cost accounting.

Batch Level Activities

Batch level activities occur only when a new batch is ran.When producing a job, there may be one or more batch level activities that take place.

For instance, if an order quantity of 100 units was spilt into two batches of 50 units that were both part of the same job, there would be two batch level activities that took place (therefore incurring twice the amount of batch level cost)

Examples of batch level activities would include setups, changeovers, monitoring of machines in progress, costs of cleaning for a new batch, and waste from beginning or ending a batch.

These costs are accumulated together into the batch level activity cost pool, based on the activities that occur at that level.  (Note: for any activity level pool there may be multiple drivers for the various activities that occur at that level).

Product-line Level Activities

Product-line level activities are those activities which support the production of a distinct product-line or service offering.

In the job shop or custom manufacturing world, many times certain types of work require dedicated resourcing to enable that type of work.

For instance, your company may have a program manager for NAVSEA or other such type of military program work.  Other examples would include hiring a new quality manager to support an AS9100 effort to move into the aerospace market or obtaining and maintaining the AAR qualification for railroad work.

Additionally, you may have you sales team split based on the type of jobs or products sold.  You may have a military division, or it’s possible to have divisions within industry segments.

These would represent separate cost pools in the product-line line.

As an example, you could have R&D sales, repair sales, and new part manufacturing all within one particular industry segment.  This would represent having three different product-lines, each with a unique cost pool.

Support Level Activities

Support level activities are those activities which are not identifiable as job/product level, batch level, or product-line level costs.

Examples of support level activities would be facilities, security, material handling and so forth.

Generally speaking, support level activities are not allocated, which is a departure from traditional and standard cost accounting.

ABC at least recognizes the fact that there is no sufficient linkage between these expenses and the jobs/products being produced.

Multiple Level Classification of Certain Costs

Some costs, such as building costs, can be considered either a support level or a product-line level cost.  For instance, suppose a company had two buildings, one dedicated to military production, and the other dedicated to all other production.

The company in this case could consider its military building a type of product-line cost and allocate the cost of that building to its military product line while not allocating the costs of its other building, which could be considered a support level activity cost.

Accumulate activity driver information.

Once the costs have been accumulated into activity levels, it is now time to accumulate the activity driver information.

For job/product level activities, the driver would be the number of jobs or products produced.  For example, each time a product is made, the amount of direct material and direct labor consumed is known.

For batch level activities, the number of batches or setups would be the driver of those costs.  Each new batch or setup causes the company to incur batch level costs, such as setup (labor time, consumables, etc.), cleaning (chemicals, labor time, etc.) and so on.

Product-line costs could have number of product types or the number of jobs/products produced (on an annual basis) within a product-line as potential cost drivers.

Allocate costs to cost objects.

Once the costs have been segregated into their associated activity-level pools with cost drivers assigned, the process of allocating costs to cost objects can begin.

As mentioned earlier, this article focuses only on jobs/products as cost objects; however, the process is the same even if the cost object is different.

All the costs in a pool are divided by the units of its cost driver (e.g.  number of setups, units produced) to determine a cost per activity.

As jobs/products are produced, they cause these activities to be performed and thus incur the costs of each activity required for their production.

Activity-Based Costing Example

Now that the general process of how an ABC costing has been outlined, let’s look at an example.

Suppose the company, Cost-A-Lot, has the following details assembled for its ABC analysis:

With this information available, the company can analyze two jobs, Job 202-A and 207-C.

Now that the analysis has been done, let’s compare the two jobs and expose how ABC maintains the inherent flaws of previous generation cost accounting methods.

Recalling from the analysis of traditional and standard costing, the source of the distortions those methods produced was the allocation of direct labor and overhead.  ABC is no exception.

ABC merely masks the allocation process across the activity-levels that it claims are necessary to perform a costing.  This is nothing more than a sophisticated form of obfuscation.

What all costing systems are after is the ability to produce information.  Information is the answer to the question asked (Goldratt, The Haystack Syndrome).  Information is an OUTPUT of the decision-making process, which is incorporated into the systems we use.

Data goes into our accounting information systems, which have embedded in them our decision-making processes.  Once the data goes through the system, decisions are made, we are then given information – or so we believe.

The problem is that any form of accounting which utilizes cost allocation takes the data and passes it through a distorted information system, which yields incorrect information.

Thus, cost allocation-based systems take good data and render it useless.

In the case of our “simple” example provided there are several items which contribute to distorting the data used by an ABC system.  Let’s review using ABC’s activity level categories.

Job/Product (Unit) Level

Direct Materials

Direct materials are truly an expense of performing a job.  If you were to not take on the job, there would be no need to purchase the material.  In case of material it is correct then to associate its expense with the expense of a job/product.

Direct Labor

As with traditional and standard costing, direct labor is in fact an allocation that merely provides the illusion of accuracy.

Yes, the hours of labor has been accumulated on the jobs, but were these jobs the cause of the labor? It’s likely the labor was hired and scheduled to work before the orders for these jobs were even received.

How then can any method of accounting claim that the direct labor reported was caused by the jobs themselves?

Batch Level

The cleaning of a machine does indeed occur at the batch level.  However, the real question is not what level does an expense occur at, but what was its cause?

We know from determining the cost pool for machine cleaning that it includes both direct labor and cleaning consumables.  The direct labor in the machine cleaning cost pool is no different than the direct labor that produces the products.  It is incorrect to state any job caused this direct labor to be incurred.

However, it is true that in the absence of this job the company would not incur the expense of the cleaning consumables.  It would be appropriate to assign these expenses to the job.

However, what has ABC done? ABC has added direct labor expenses to the expenses of the cleaning consumables.

Not only can the true expense not be seen, but it’s comingled with an expense that should not be assigned to the job!

Product-line Level

The batch level expenses of product marketing and laboratory certification also are expenses which, yes are caused by the requirements of the product-line; however, there is no linkage between the individual products and the expenses themselves.

Thus, ABC is incorrectly attributing these expenses to the individual units.

We can also examine the issue in this way: Suppose the total number of units the cost pool was allocated over was doubled.  The math would say the cost per unit was cut in half for product level expenses.  But is this actually true?

It’s just a mathematical phantom, not a real change in costs.

Also, what would happen if the total number of units the cost pool was allocated over were not produced? Say demand fell off for a particular product towards the end of the year and production was curtailed.

Does this mean that the units produced earlier were somehow more expensive than reported? Not at all.

In fact, there should be no allocation of these expenses to the units in the first place.

Activity Based Costing as a Measurement System

We must not view an ABC system in isolation of the broader organization in which it is deployed.  Instead we need to give full consideration to the impact that an ABC has on the behavior of people within the organization.

Not only does ABC calculate the measures of performance, but rather the rules of the system itself create a measure.

Costs are viewed as detractors from the goal of making money in most organizations.  Thus, most workers would agree that actions which reduce cost should be taken.

However, this is an incomplete view of the decision to be made.  The complete decision would also consider if the increase in costs would increase benefits to the organization by more than the amount of the cost.  If so, then the action could be of benefit to the organization.

However, there are no such allowances made in the analyses provided by ABC.  And it is this one-side thinking and decision-making in isolation which causes ABC to create so many problems within organizations.

For instance, let us examine a rather simple issue.  One of the primary activity levels of cost in an ABC system is batch level costs.  These are the costs that occur each time a new batch activity is undertaken, such as a setup.

Let us also suppose that a job’s routing causes it to pass through five resources.  As the parts in the job pass from resource to resource, the cost of a setup is incurred.  This could mean that the products are burdened with the costs of five setups.

How does such a system impact behavior? How do you think the production manager responsible for these five resources would respond?

Most likely, the production manager would take actions to avoid the setups, thereby avoiding incurring setup costs.

However, this is yet another detrimental, one-sided decision made in isolation of the system as a whole.

What happens when setups are avoided? Generally products remain in WIP, stymied at their current stage in production until like products arrive at the resource in sufficient quantity to lower the cost per unit (after allocation of the setup cost to the batch) to acceptable levels.

This fact, when combined with the fact that the demand for products is uneven and not in synch with the optimal batch sizes a company may run means that products sit in WIP, waiting many times.

The resources remain busy, working on work that does not require a setup.

As the WIP grows, it creates confusion of the priorities on the shop floor.  Imagine a worker that is told to work on the jobs/products that do not require a setup despite the fact that products that do require a setup will become late if he does not process them today.  A sticky situation indeed.

We know form Little’s Law that as inventory increases flow decreases.  This means the organization is funding more material, more labor, more overhead all the while there is less margin being generated.

All because of the costing system.  Why do we allow and use costing systems which are so detrimental to our organizations?

Conclusions on Activity Based Costing

Despite the genesis of ABC being the desire to see improved costing methods, it too has fallen to the same ills that Johnson and Kaplan railed against in their book, Relevance Lost.

The fact that ABC is built on the same house of cards (cost allocation) as the other methods has ultimately resulted in its being a more sophisticated, elaborate, and costly scheme to achieve the same useless results.

As I have stated before, and will continue to do so,

COMPLEXITY DOES NOT EQUATE TO CORRECT.  Many times, in fact it equates to the exact opposite.

The Undesirable Effects of Cost Accounting

“UnDesirable Effect (UDE) – A negative aspect of current reality, defined in relation to the organization‘s or system’s goal or its necessary conditions; a visible symptom of an underlying root cause, core problem, or core conflict.”   TOCICO Dictionary

The theory behind all forms of cost accounting holds that with knowing your job or product cost, a proper assessment of many business decisions and scenarios is possible.  How you arrive at this “cost” may vary, but once you have this information many things are possible.

The main assumption in this theory is that simply by covering “cost” a company can adequately manage profitability.  After all, if prices are above costs, there must be profit, correct?

Well, if that were true, how then are there unprofitable shops with only profitable jobs?

The reason is that cost accounting is founded on a flawed set of principles.

Right from the outset, the notion that jobs or products create “costs” such as direct labor and overhead on a job is a false notion.  The entire theory behind cost allocation is flawed, and by extension any method that allocates costs is likewise flawed.

We’ve seen as we’ve looked at the various methods of cost accounting a few examples of these flaws causing serious organizational problems.

Now we’re going to turn our attention fully to these undesirable effects so we can understand the true impact they have on our organizations, and it’s a much larger “cost” than you’re thinking.

The Undesirable Effects of Using Cost Accounting for Jobs and Products

Ultimately, all the undesirable effects of cost accounting can be grouped into one of two categories: ineffectiveness or unreliability.

Unreliability is not doing what should have been done.  Ineffectiveness is doing what should not have been done.  And ineffectiveness is the greatest source of unreliability.

Very simple concepts, yet very profound when we examine how cost accounting causes these two broad categories of effects.

From the perspective of a job shop or custom manufacturer, there’s two primary things that must be accomplished: win jobs and make jobs.

However, from these two simple tasks come a variety of questions and issues, such as:

• What jobs?
• At what price?
• What market(s)?
• What job/product mix is preferred?
• How best to run the jobs?
• What actions are needed to improve both the jobs coming into the business and how they’re being fulfilled?

Unfortunately cost accounting creates four undesirable effects that prevent owners from finding effective answers to these questions.  Those undesirable effects are:

1. Jobs that should not be taken on are taken on (ineffectiveness).
2. Jobs that should be taken on are not taken on (unreliability).
3. Actions that do not benefit the company are done (ineffectiveness).
4. Actions that do benefit the company are not done (unreliability).

Let’s go through these four undesirable effects and really understand the damage to the bottom line they are creating.

Most folks would all agree that some jobs are more profitable than others.  They would also agree that some jobs are easier to produce than others.

And certainly, most would believe and agree that taking on profitable jobs that are easy to make would be the ideal situation.

However, cost accounting does not lead business owners in this direction.  Reason being, as we’ve discussed, two of the three components of job cost are not in fact “costs” of a job.

So, what have been called “costs” (direct labor and overhead) have actually been some type of margin all along.

So not only do business owners not know the total margin on our jobs, we’ve been calling margin, cost!

Cost accounting has made everyone who uses it totally blind to how much margin jobs are actually contributing our company!

Because cost accounting has so distorted our view of the world, we know the first two undesirable effects MUST be happening simply because we have no way to recognize or stop them from occurring.

So, this means we’re taking on jobs that are not as profitable as we’d like while at the same time not taking on jobs that are at our desired level of profitability.

Now that we know we’re likely to be taking on the wrong jobs and not accepting the right jobs this means our job or product mixes are way off the mark.

Getting product mix right can make a HUGE difference in profitability.  With the same number of jobs, customers, and hours in day you can make significantly more just by adjusting your product mix to a more profitable mix of jobs.

Unfortunately, cost accounting methods do no allow you to find the ideal product mix.

Not only does cost accounting affect our preference of the type of jobs quoted and sought after, but cost accounting also affects the ways in which we run the jobs on the shop floor.

Would you like to guess the predicted impact cost accounting has on shop floor actions? I can assure it’s not positive.

Once again, cost accounting causes two main types of problems on the shop floor: ineffectiveness and unreliability.

In the ineffectiveness group, cost accounting would lead to taking actions such as: reducing total number of batches to produce a job, reducing total time on jobs, and outsourcing jobs when their external cost is lower than their internal job “cost.”

Many times, these actions run directly counter to THE GOAL.

For instance, we know that if you reduce the number of batches that batch size goes up.  When batch size goes up, it can ultimately reach a size that exceeds the current order quantity.  When this occurs, the company is simply creating inventory, not additional margin from sales.

Would a cost accountant ever tell you that your inventory is a measure of how ineffective your operations are? Never!

They’ll be sold…eventually.  That’s the line managers feed to bankers, auditors, and themselves to feel better about the high levels of inventory (Heaven forbid you wipe your hand over any of this inventory – you’ll find more dust than value!).

And cost accounting does much more than just have folks take ineffective actions.

It also actively discourages and blocks beneficial actions – leading to unreliability in operations.

As an example, suppose if you doubled up the number of employees working on jobs.  Instead of 10 workers on 10 jobs, what if you had 2 workers on 5 jobs.  Suppose at the end of the month by doubling up labor we had 5 completed jobs instead of 10 jobs halfway completed.

Sure, the jobs would finish faster, no doubt.  However, if you view the world through the lenses cost accounting provides, you would be inclined to say, yes, we got the jobs done, but we incurred much more direct labor than we had to, so we made less money.

However, why don’t we ask the income statement what it would think of such actions?

We know we would have the margin of the 5 complete jobs versus no margin for the partially completed work.  That’s a plus.  But what about all this extra labor “cost.”

Well yet again, cost accounting is distorting reality.  Did you hire anyone extra? No.  Did your workers work overtime? No.

So where exactly does the extra labor expense come from then? This is one of the mathematical phantoms I’ve been telling you about! There is no increase in labor expense!

So, let’s paint a complete picture of how cost accounting is hurting your bottom line.

For starters, you may be accepting jobs of lower value than higher value jobs.  Not only that, but you take actions, due to cost accounting, which are in direct contradiction to the actions you should be taking to get the jobs complete.

Further, you might could overcome accepting poor quality jobs if you took the right actions in operations –  but cost accounting has cut you off at the pass and blocks you from taking such actions.

It’s a wonder any business using cost accounting survives at all!

Knowing what we now know about cost accounting, it’s not a stretch to say that the profitability of your company is left to chance, pure luck, rather than being controlled and actively managed.

Well, like Dr.  Goldratt’s book, It’s Not Luck, we do not use luck in Job Shop Pricing.  We use a new form of accounting, Throughput Accounting, to guide and inform our decisions. 

Decisions are made with complete clarity and confidence.

Throughput Accounting stops you from both ineffective and unreliable actions and instead points you to effective and highly reliable actions.

It’s everything you’ve been looking for in an accounting system.

I remember when I was a controller, our CEO was in a meeting and asked me to develop a simple, clear, concise accounting system which did not require a Ph.D.  to understand.

Unfortunately, he was too steeped in the cost-world mentality.

He began to describe how this system would work.  About an hour later he finished…speaking that is.  He was nowhere close to being finished with describing his form of a “simple” accounting system.

In fact, he had methodically walked me through how to do activity-based costing (ABC) at our company! Ugh!

ABC is THE most complicated, unnecessarily sophisticated form of COST ACCOUNTING that there is!

You do all this work and guess what? YOU STILL HAVE THE SAME UNDESIRABLE EFFECTS!

Throughput Accounting is the exact opposite.  It is simple and effective.  And by the way, that’s all it needs to be.

Complicated or sophisticated does not mean better.  It means more complexity, not better.

Many times, complexity gives way to chaos, not better results.

So, in your search for a better method of accounting do not overlook Throughput Accounting because it is not as complicated as you think it should be.

In the words of Chris Voss, former FBI Negotiator,

“Do not be so committed to what you want that you wouldn’t accept something better.”

Argent International of Plymouth, Michigan, and Mexico City participated in the Job Shop Pricing program to great results. The Job Shop Pricing program is for custom manufacturers — specifically custom job shops.  Custom job shops often find cost accounting problematic due to mix and volume changes.

The mix and volume changes that are common in job shops and machine shops makes it difficult to have a consistent pricing strategy.  A lot of time is spent trying to “accurately” calculate prices and costs.

Job Shop Pricing Strategy

Check out their case study and story: Argent-Job-Shop-Pricing-Story

Chris Autterson of Argent International was interviewed by Mike Touzeau, an independent writer.

Chris explained how their old pricing system and cost accounting practice lead them astray and the benefits they achieved the Job Shop Pricing System.