For those of you who haven’t read Bruce Nelson and my book, Epiphanized, I thought you might enjoy reading one of the writings in our book’s appendix that Bruce wrote. It’s all about the dangers of using traditional cost accounting to make routine decisions. This subject will be delivered in two different posting, but I think you will enjoy it. Bruce and I have received quite a few positive comments on our appendix and this subject has been very well received.
The Sock Maker
In the early 1900s Cost Accounting (CA) was in its early stages and beginning to be widely accepted and used. For a business owner there were many things to consider in the day-to-day operation of the business. One of the most important functions of the business owner was tending to the daily needs of the business financial situation. Keeping the books, calculating cost for raw materials, calculating labor cost and making sales were all important issues to be dealt with on a daily basis.
It was understood by business owners that in order to stay in business and make money the cost they paid for the products or service rendered had to be less than the selling price of their products or services. If it wasn’t, then they would quickly go out of business. Then and now, the needs of business haven’t changed much, but others things have changed.
The ideas and concepts about what was important to measure and how to measure it were starting to form and were being passed from one generation to the next. This was considered important information that you needed to know in order to be successful. Without this understanding, it was assumed that you would fail. Back then, the business structure and methods were different than they are today. The labor force was not nearly as reliable, and most workers did not work 40 hours a week. When they did work, they were not paid an hourly wage, but instead were paid using the piece-rate pay system.
As an example, suppose you owned a knitting business, and the product you made and sold was socks. The employees in your business would knit socks as their job. With the piece-rate pay system, you paid the employees based on the number of socks they knitted in a day, or a week, or whatever unit of measure you used. If an employee knitted ten pairs of sock in a day, and you paid a piece rate of $1.00 for each pair knitted, then you owed that employee $10.00. However, if the employee didn’t show up for work and did not knit any socks, then you owed nothing. In this type of work environment, labor was truly a variable cost and deserved to be allocated as a cost to the product. It just made sense in a piece-rate pay system. The more socks the employees knitted, the more money they could make. Also, as the business owner your labor costs were very precisely controlled. If employees didn’t make any socks, then you didn’t have to pay.
In time, metrics for calculating labor costs changed and the labor rates changed as well. Many employees were now paid a daily rate instead of a piece rate. Labor costs had now shifted from a truly variable cost per unit to a fixed cost per day. In other words, the employees got that same amount of money per day no matter how many pairs of socks they knitted or didn’t knit. As time went by, the employee labor rates shifted again. This time labor rates shifted from a daily rate to an hourly rate. With the new hourly rate came the more standardized work week of forty hours, or eight hours a day, five days a week. With the hourly rate the labor costs now become fixed.
With these changes, it became apparent to the sock-knitting business owner that in order to get the biggest bang for the labor buck, the owner needed to produce as many pairs of socks as he could in a day in order to offset the rising labor costs. The most obvious way to do that was to keep all of your sock knitters busy all of the time making socks. In other words, efficiency was a key ingredient and needed to be increased. If the owner could make more pairs of socks in the same amount of time, then his labor cost per pair of socks would go down. This was the solution the business owner was looking for—reducing his costs. If everyone was busy making more and more socks, and they could make a lot of socks in a day, then his new labor cost per pair of socks could be reduced! This had to be the answer— look how cheap he could make socks now! Or so he thought.
To be continued……..