Thursday, September 26, 2013

Focus and Leverage Part 252

This posting is the last in our series comparing Cost Accounting and Throughput Accounting written by Bruce Nelson in our book Epiphanized and I hope you have enjoyed it.  So many companies that I consult for to help improve their profitability are still suffering from the stranglehold of Cost Accounting and I hope this series has proved beneficial to better understand the stark difference that exist between these two distinctly different accounting methods.

The decision-making process becomes much easier when these factors (i.e. T, I and OE) are considered.  The movement either up or down, of these three measures should provide sufficient information for good strategy and good decisions.  Any good decision should be based on global impacts to the company and not just a single unit or process in isolation.  If your thinking is limited to the lowest level of the organization, and you are focused on the wrong area, then the positive impact will never be seen or felt by the entire organization.

Figure 1.Common Practive vs. Common sense

If we compare these two concepts at the highest level, then CA is all about the actions you take to try and save money, while TA is about the actions you take to make money.  Once you’ve made the cost reductions and you still need more, what do you do next?  Where else can you reduce costs?   On the other hand, making money, at least in theory, is infinite.  What is the limit on how much money your company can make now?  Figure 1 compares the top level priorities of these two accounting approaches. With these differences in priorities it is easy to see why CA is focused on saving money and TA is focused on making money.  So consider the real goal of your company before you decide which path to take.

You can pick up the newspaper almost any day of the week and see the effects of these priorities. You can read about company XYZ that is going to lay off 500 employees in order to reduce costs and become more efficient and align themselves to be more vertical with the customer and . . . blah, blah, blah!  What these companies are really saying is they have forgotten how to make money.  They are so focused on saving money that they have forgotten what the real goal of the company is.

So, how did all of this come about?  Why are things happening the way there are?  If all of this CA and saving money is so good, then how come so many companies seem to be in trouble or worse yet—bankrupt!  There are many reasons and some could be debated for weeks, if not months or years.  But however many reasons there may be, all of them are not equal.  Some reasons are bigger players than others, and as such have had a far greater impact.  Let’s look at the cost model associated with both the CA and TA concepts.  It provides an interesting history about why things are the way they are.   Figure 2 defines the cost model concept for both CA and TA.

The product depicted in Figure 2 is exactly the same for both models. It indicates the same selling price, same manufacturing process, same everything.  In the CA model you notice the layers of allocated cost that are applied to each product as some percentage of the cost, or allocated rate. The sum total of all of these costs, whatever it may be, equal what CA considers to be the cost to manufacture.  Let’s look at each layer.
Figure 2. Cost Model Comparisons

Raw Materials—This is the total cost of all the raw materials used in the product you make.  An average raw material cost for most companies might be around 40%, but some can, and do, go much higher.

Labor Costs—This is the allocated labor cost per parts.  It is usually calculated based on some type of total parts per hour, or day, or production batch, or order, or some other value. Then the total labor cost is divided by the number of parts produced to arive at the percent of labor to be allocated to each part.

Overhead Costs—This is the allocated percentage per part to pay for all of the overhead costs.  These are items like the management staff, administrative jobs, training and so on.  Usually these types of overhead  assignments  cover many type of parts, but also no part in particular.  Human Resources or even Finance are examples of organizations that fit in the overhead category.  You need to have some place to charge and collect your overhead costs.

Corporate General and Administrative—This is the allocated cost that pays for all of the corporate staff and everything they provide.

Profit—This is the location where you add the percentage of profit you want to receive for your product.

Selling Price (SP)—This is the selling price for your product once you’ve gone through and added together all of the manufacturing cost categories and the percentage of profit.

There very well could be more layers in your company, but in the end the hope is that when you add up all of the costs and sell to the market, or consumer, or the next guy in the supply chain, your selling price is always greater than your manufacturing costs.  If it is, then you have made a profit.

But in reality the selling price is not determined by the manufacturer, but rather by the consumer.  If the price is too high they won’t buy your product and will look elsewhere. So if that happens, what are your choices?  Somehow you have to lower your cost and selling price in order to make your product more attractive to the consumer.  So how do you do that?  You could cut your profit margins, but most organizations do not like to do that.  If you can’t do that, then what else do you look for?  How about overhead cost? You can slow down or stop doing some of the things associated with overhead, for example, training.  You could cut your raw materials expense.  Perhaps find a different a vendor, or maybe buy cheaper parts.  If you do that, then what about the quality risk?  How about cutting labor costs?  If you could just get more efficient, then your labor costs would go down.  If labor costs go down, then we can make more profit – correct?  I think by now you understand the cycle of chaos that takes place when you focus on efficiency—disaster usually follows in short order.  Such is life in the cost model cycle.

In your company if you do not pay your employees using the piece-rate pay system, then the assumption of using allocated labor costs, or any costs, is invalid!  Why is the stigma of allocated costs so strong in CA?  The assumption that higher efficiency reduces the cost per part is also invalid.  In today’s reality of the per hour rate the cost remains the same.

The TA cost model contains only Total Variable Cost (TVC) and Throughput (T).  The calculation is simple: T = SP-TVC.  Throughput, in essence, equals the dollars remaining from selling the product after you have subtracted the TVC cost.  Nothing is allocated, nothing is assumed, it’s just a simple cash calculation from the sale.

Bob Sproull

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