Cost accounting can be a real drag. You don’t see immediate results, and the effort to get it right can seem Herculean at times, but good cost accounting systems are worth their weight in gold. The results of inaccurate cost accounting systems can be pursuing product lines or customers that are either marginally profitable, or worse yet, are actually unprofitable.
Many manufacturers have developed overhead rates that are being used long after their “best if used by” dates. The reasons for this include the thought that inflation isn’t all that significant, so how much different can the rate be from last year, and besides it’s so much work to update the rate. After a while, you find the rate hasn’t been updated in a few years and then your costing system has slid into ineffectiveness. Also, cost drivers tend to not be examined that often. Some manufacturers have always used labor hours as cost drivers, so they do not even consider that the significant capital expenditures they have made in the business make the more plausible cost driver machine hours. In standard costing systems, standards are sometimes not updated as often as they should be for some of the same reasons.
Do you have underutilized capacity in your plant? If yes, has this been captured in your overhead rate and your standards? If not, then you may have a significant problem. Have overhead rates and standards not been updated as often as they should be because of constraints within your accounting and management personnel? Are you having issues determining which product lines and customers are most profitable?
Here is a brief refresher on the basics of cost accounting, and some of the pitfalls to try to avoid.
The components of product costs are direct materials, direct labor, and manufacturing overhead.
Cost accounting systems can be broken down into essentially two types, job and standard. Job costing systems attempt to apply actual direct material and direct labor costs to a manufactured product. Manufacturing overhead is applied based on a rate per cost driver. Standard costing systems apply direct materials, direct labor, and manufacturing overhead to the cost of a manufactured product based on standards calculated by management.
Direct materials are the raw materials a manufacturer uses to produce a product. In a job costing system, there is an attempt to assign the actual cost of the direct materials to the product being produced. In a standard costing system, a standard is developed and the cost to produce the manufactured product is assigned to the product at standard. The standard material cost is determined based on past experience as to how much material is used to produce the product, including an allowance for scrap, multiplied by the price that the manufacturer is paying for the material. In a standard costing system, if there are physical issues with materials or new production methods that are causing unexpected scrap issues, the standard may need to be reassessed more often than is normal. The same goes for significant price changes for direct materials.
Direct labor costs relate to the employees who manufacture your products. These costs include not only wages, but also payroll taxes and fringe benefits. In a job costing system, there is an attempt to assign the actual cost of the direct labor to the product being produced. The standard labor cost is determined based on past experience as to how much time is used to produce the product multiplied by the wage that the manufacturer is paying for the labor. In a standard costing system, if there are new production methods or personnel that are causing unexpected scrap issues, the standard may need to be reassessed more often than is normal.
Manufacturing overhead consists of those costs that are required in order to produce a product, but are not traceable to the product directly. These costs include utilities, rent, property taxes, indirect materials, and indirect labor. In a job costing system there is an attempt to assign the actual cost of the manufacturing overhead, possibly based on budgeted amounts, to the product being produced via a standard rate multiplied by a cost driver, with total cost driver units possibly based on a budget. The standard manufacturing overhead cost is determined based on budgeted manufacturing costs divided by budgeted production quantities. The determination of overhead rates can be complicated in either costing system.
A qualified CPA team can analyze your current system and assist in expanding your costing systems’ capabilities and accuracy to allow you to make better management decisions and maximize profits.
Jon Herdlein is a principal based out of our Buffalo, NY office.