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.
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.
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.
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.
Similarly, Fixed Overhead also has two types of variances that can occur.
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, who co-leads FGMK's Management Consulting Practice.
|Michael A. Fenske Managing Director 312.638.2941 MFenske@fgmk.com|
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