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Why Cost Accounting Does Not Work – Costing Methods & Shop Rates

In this article we explain why cost accounting does not work for job shops.  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 or 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 ShopsShop Rates for Job Shops and Machine 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.

Cost Accounting Methods - Cost BasisFrom 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:

ItemQuantityCost
Plate steel20 sheets$350/sheet
Crating10 skids$150/skid
CNC Laser Time4 hours$180/hour
Press Brake Time6 hours$375/hour

 

What is the amount of direct material on the job?

ItemQuantityCostExtended
Plate steel20 sheets$350/sheet$7,000
Crating10 skids$150/skid$1,500
  
 Direct Material:$8,500

 

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:

WorkerWage RateDepartment
Worker 1$20CNC Laser
Worker 2$20CNC Laser
Worker 3$25Forming
Worker 4$35Forming
Worker 5$60Fabrication
Worker 6$45Fabrication

 

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

DepartmentWorkerTime
CNC LaserWorker 24 hours
FormingWorker 35 hours
FormingWorker 42 hours
FabricationWorker 58 hours
FabricationWorker 63 hours

 

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:

Job #4371   
WorkerTimeWage RateExtended
Worker 24 hours$20$80
Worker 35 hours$25$125
Worker 42 hours$35$70
Worker 58 hours$60$480
Worker 63 hours$45$135
Total Actual Direct Labor Cost$890

 

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).

WorkerWage RateAnnual HoursAnnual Wages
Worker 1$202,000$40,000
Worker 2$202,000$40,000
Worker 3$252,000$50,000
Worker 4$352,000$70,000
Worker 5$601,000$60,000
Worker 6$452,000$90,000
 Totals11,000$350,000

 

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.

Job #4371  
DepartmentWorkerTime
CNC LaserWorker 24 hours
FormingWorker 35 hours
FormingWorker 42 hours
FabricationWorker 58 hours
FabricationWorker 63 hours
Total Time23 hours
Cost per Hour $32.82
Total Allocated Direct Labor Cost$754.86

 

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.

WorkerWage RateAnnual HoursAnnual WagesCost per Hour
Worker 1$202,000$40,000
Worker 2$202,000$40,000
Department Total4,000$80,000$20/hour
Worker 3$252,000$50,000
Worker 4$352,000$70,000
Department Total4,000$120,000$30/hour
Worker 5$601,000$60,000
Worker 6$452,000$90,000
Department Total3,000$150,000$50/hour

 

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

DepartmentWorkerTimeCost per HourExtended
CNC LaserWorker 24 hours$20$80
FormingWorker 37 hours$30$210
FabricationWorker 511 hours$50$550
Total Departmental Labor Cost$840

 

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

MethodDirect Labor Cost
Actual Direct Labor$890.00
Allocated Direct Labor$754.86
Departmental Direct Labor$840.00

 

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:

Overhead Expense CategoryAnnual Amount
Admin salaries$200,00
Environmental$35,000
Information Technology$45,000
Insurance$50,000
Quality Personnel$225,000
Miscellaneous$30,000
Total Overhead Expenses$585,000

 

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

WorkerWage RateAnnual HoursAnnual Wages
Worker 1$202,000$40,000
Worker 2$202,000$40,000
Worker 3$252,000$50,000
Worker 4$352,000$70,000
Worker 5$601,000$60,000
Worker 6$452,000$90,000
 Totals11,000$350,000

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.

Standards that charge are no standards at all.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:

(DMAP-DMSP)*DMAQ = DMPV

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:

(DMAQ-DMSQ)*DMSP = DMQV

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 UnitLbs per partActual Cost per Unit
003-B$285.17202lbs$57,604.34
068-A$249.25105lbs$26,171.25

 

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

Job#Standard Cost per UnitActual Cost per UnitVariance
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 UnitStandard Material Price per UnitActual Quantity per UnitDirect Material Price Variance
003-B$285.17$250202lbs$7,104.34
068-A$249.25$250105lbs$(78.75)

 

Direct Material Quantity Variance:

Job#Actual Material Quantity per UnitStandard Material Quantity per UnitStandard Price per UnitDirect Material Quantity Variance
003-B202lbs100lbs$250.00$25,500.00
068-A105lbs100lbs$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:

(DLAP-DLSP)*DLAQ=DLPV

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:

(DLAQ-DLSQ)*DLSP=DLQV

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 UnitHours per partActual Cost per Unit
003-B$27.25782 hours$21,309.50
068-A$37.22467 hours$17,381.74

 

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

Job#Standard Cost per UnitActual Cost per UnitVariance
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 UnitStandard Labor Price per UnitActual Quantity per UnitDirect Labor Price Variance
003-B$27.25$35.00782 hours$(6,060.50)
068-A$37.22$35.00467 hours$1,036.74

 

Direct Material Quantity Variance:

Job#Actual Labor Hour per UnitStandard Labor Hours per UnitStandard Price per UnitDirect Labor Quantity Variance
003-B782 hours500 hours$35.00$9,870.00
068-A467 hours500 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.

… stay tuned for our next installment.

{ 3 comments… add one }
  • MICHAEL DELMEDICO April 21, 2019, 6:23 pm

    THIS WAS THE MOST ENLIGTHENING EXAMPLE OF HOW TO FIGURE HOW MUCH ITS COSTING TO KEEP THE DOORS OPEN

  • Matthew Lemke April 22, 2019, 12:55 pm

    This is excellent! The mirage we so often chase, deconstructed.

  • Steve Holcomb April 22, 2019, 4:53 pm

    Thanks Dr. Lisa and team for a great review of these principals.

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