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……..
Bob Sproull
4 comments:
Hi Bob and Bruce, I do not know if you are familiar with French, but here's my BLOG's internet addres where I translated your post Nr 248 Bob, taken from Bruce's appendix in Epiphanized:
http://faireplusavecmoins.blogspot.com/2013/10/n4-en-entreprise-comment-choisir-les.html
As agreed I believe I put all necessary mentions to the book (even links to buy it online).
Erik
Hi Erik. My French is not what it used to be, but I hope you get plenty of page views. Good luck and let Bruce and I know how it is received.
Bob
OK, now you've got me on pins and needles.
I've been a huge advocate of Goldratt's Theory of Constraints as applied to business process.
This is a great/challenging intro to cost structures and variables in the manufacturing environment.
We start almost all of our employees on piecework, testing them to see where they perform on the curve. Then, after 2-4 weeks, they move from part time/trainees to full or part time, and hourly. So far so good... but always open to a more progressive model.
Picking up your book now. Thanks for the teaser, Bob.
Hi Mark. Please feel free to contact either Bruce or I if you have any questions. And please let me know if you enjoyed Epiphanized. Thanks for your comments.
Bob
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