Costing as a Policy First - a Fact, Second!

Costing by its nature is as much a factory function as it is an accounting office function.  A system that depends on someone in the factory remembering to keep the office aware of everything significant that is happening in the factory, particularly where a change in procedure occurs, will not function satisfactorily.

A cost accountant, who stays in his office and waits for data from the factory to spring into action, is really a financial accountant by temperament.    An accountant who is observed leaving the office and returning with an engineering drawing and a part or component is in the appropriate job.

Costing is an art rather than a science. The total cost of a product is as much a policy as a fact.  Take the usual components of total cost:

o Direct Materials (can be identified by observation)
o Direct Labour (labour spent on converting direct materials into finished goods)
o Manufacturing Expense (total manufacturing cost minus direct materials and direct labour).

The cost of direct materials and direct labour remain fixed per unit irrespective of changes in volume of goods produced, leaving aside the concept of economies of scale (buy more; the supplier gives you a discount).   The total manufacturing expense, although largely fixed within a reasonable range of production volume, varies per unit in sympathy with changes in volume:

  Manufacturing expense      $100,000   $100,000
  Units produced                   1,000          800
  Mfg. expense per unit         $100           $125

If the Direct Materials cost $400 and the Direct Labour costs $50 per unit then this particular product has a manufacturing cost of $550 in the first case and $575 in the second case. Which cost is correct?  If facts are in dispute, will it take a policy to decide what is the true cost?

Due to the Australian Taxation Offices directive (backed by the accounting bodies) that value-added inventory (work-in-progress and finished goods) must be valued at manufactured cost, then an increase in value-added inventory results in an amount of direct labour cost and manufacturing expense being capitalised by being added to current assets in the balance sheet as opposed to being expensed in the income statement.

Some cost professionals argue that direct labour and manufacturing expense should only be attached to the inventory value either (choose one) when the goods are sold or, at least, when they reach the finished goods stage.  Otherwise, inventory may be overvalued if it exceeds an appropriate level based on sales, particularly in a fashion industry where last seasons stock will have to be discounted heavily to dispose of it. Another example is the motor vehicle industry where a change in a model leaves a heap of stock now only saleable by component manufacturers through the spare parts market.

I shall now introduce my favourite numbers, 20 and 80.  Pareto introduced these when he found that 20% of the people had 80% of the wealth in his country at that time. 

This can be extended as follows:

   20% of people  80% of wealth
   30%                 15%
   50%                  5%

This curve applies to other things, also.  The bottom 50% of your products will account for only 5% of your revenue (approximately).  This 20/80 rule should be applied in considering the design of a costing system, particularly in identifying cost drivers in an Activity Based Costing (ABC) system.  Too many cost drivers could make an ABC system unworkable.

Finally, costing has traditionally been used in building up the estimated cost of a new product.  A total cost is arrived at and a mark-up added to this to arrive at the selling price.

Target Costing proposes that a better approach is to start off with a selling price that it is considered the market will bear, deduct a reasonable profit margin and establish what the maximum cost can be.  It has been stated that 80% (one of my favourite numbers again) of a products cost is locked in at the design stage.  Therefore, it is considered that the cost should be decided on by reference to the market.  Cost is, then, not a fact but a policy. 

How do you decide on the selling price?  It all depends on whether your product will be a me-too and share a platform, or have its own unique platform.  A market survey may be called for if the stakes are high.

How do you ensure that the total cost of the product does not exceed the cost you have decided on?  Employ value engineering in subjecting each component of cost to analysis of the use it performs.  For example, something of mild cosmetic value may cost a disproportionate amount of money to produce.

Theres a lot more to costing than putting numbers down on paper or into the computer, and Id be very pleased to discuss these and your costing policies.

Dr Walter Dolan
Director Strategic Management  03 9674 7282  Walter Dolan 2011