There are various cost accounting techniques used to measure the cost of a product. The three most common methods are job costing, process costing, and activity-based costing.
- Job Costing is most commonly used when costs can be attributed to specific units or groups of units, as is often the case for manufacturing environments producing a wide range of custom products.
- Process Costing is typically used when production runs are very lengthy, involving products that are indistinguishable from each other, such as would be the case for a refinery.
- Activity-based Costing (“ABC”) assigns manufacturing overhead costs based on the activities that actually contribute to the overhead costs.
While ABC is the most accurate form of managerial accounting, why has it not been adopted broadly by manufacturers? Likely, because there are several significant barriers to using ABC.
- ABC is not accepted as a costing methodology under GAAP, therefore requiring a second costing system to be used in addition to the costing system calculating cost of goods sold (“COGS”) for the Income Statement.
- It can be time-consuming to interview staff to understand how they spend their time in relation to overhead activities.
- Employees often overstate actual work times, excluding non-value idle time so that they look more productive than they may actually be.
- Depending on the number of employees and products, the amount of data require can be prohibitive.
- The benefits of ABC may take months or years to materialize, even in the best environments.
This raises the question: In lieu of an ABC environment, how can midsized companies better understand and trust that cost estimates are accurate?
First, recognize that there are four types of costs associated with manufacturing a product.
- Raw Material Costs Also called Direct Materials, these are products that a manufacturer buys from other companies to use in the production of its own products.
- Direct Labor Costs (Machine Operator) The employees who work directly on the production line.
- Variable Overhead Costs (Utilities, Production Supplies, etc.) These consist of indirect production costs that increase or decrease as the quantity produced increases or decreases.
- Fixed Overhead Costs (Equipment Depreciation, Admin, etc.) These are indirect production costs that do not increase or decrease as the quantity produced increases or decreases.
It is very common to define standard costs for each of the above cost elements and apply them to each product manufactured. Ideally, these standards are reviewed on a periodic basis to ensure they accurately reflect what is happening on the shop floor. However, since manufacturing processes are not always consistent, even for the same job, understanding the impact of these variances on individual jobs or products is essential to understanding product profitability.
Although many companies have a good understanding of material costs, allocating labor costs and overhead costs can be a bit more confusing. Since overhead is typically allocated to the production cost based on a cost driver such as machine hours, direct labor hours, or total units produced, allocations can vary widely, depending on which cost driver is chosen, and what is happening on the shop floor. Consequently, understanding the variances associated with Variable Overhead and Fixed Overhead is critically important.
Regardless of which cost driver is used, there are two types of variances related to Variable Overhead: Spending Variance and Efficiency Variance.
- Spending Variance occurs when there is a difference between the standard variable overhead rate and the actual overhead rate (i.e. total variable overhead is greater than or less than the standard overhead rate multiplied by the number of units produced).
- Efficiency Variance occurs when there is a difference between the standard hours and actual hours required to produce a product (i.e. actual variable overhead hours are greater than or less than the standard variable overhead hours multiplied by the number of units produced).
Similarly, Fixed Overhead also has two types of variances that can occur.
- Spending Variance occurs when there is a difference between what is actually spent versus the annual budget.
- Volume Variance occurs when there is a difference between the standard quantity multiplied by the fixed overhead rate compared to the annual budget.
Evaluating variances related to both Fixed and Variable Overhead is an essential tool for management in helping them understand product profitability. Completing this analysis not only answers the questions as to why expected profitability does not match actual profitability, but also provides a basis for reviewing and revising the accuracy of the cost driver used to allocate these costs, and what alternatives may prove to be more representative of the true costs to manufacture a product.
In summary, understanding how overhead costs are allocated and diagnosing the causes of overhead variances are important tools to ensure product profitability is accurately reflecting the costs of the business. If you are questioning the accuracy of your product profitability, it may be time to review your costing methodology used to drive those calculations.
If you have additional inquiries about this article, please contact FGMK.
Michael Fenske is a Managing Director at FGMK in Chicago, who co-leads FGMK’s Management Consulting Practice.
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