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This is the second article of a series that will explain how to best maximize cash flow and profits in your business through “modes of operations” using Theory of Constraints and Lean Manufacturing principles. The underlying theme in this series is: “What to Change,” “What to Change To” and “How to Cause the Change.” In the previous article we focused on the financial measurements we use to evaluate these modes of operations.
(See Wood Digest, October 2008 for more information.)
Many businesses feel the undesirable effects of tight cash flow, long lead times and competition based upon price. Over time many organizations have taken countless actions to rid themselves of these problems, yet the implications continue to exist.
HOW COST ACCOUNTING NEGATIVELY AFFECTS THE WAY WE OPERATE
This article focuses on perceptions of profitability, traditional batch and queue processing and the effect on the organization as a whole.
There are two ways of making money in business: increase your sales and/or decrease your costs. Net profit is calculated as revenue minus expenses over a given period of time. The predominant measure of traditional cost accounting is “cost per unit.” This calculation is performed by taking the total cost of materials and resources (i.e., labor and overhead) over a period of time, and dividing it by the total output (i.e., units produced) to get cost per unit (or product cost).
In most companies, not all products are manufactured through the same processes. As a result, in an attempt to be more accurate, organizations apply labor and overhead costs to products as they go through individual work centers. The product’s total labor and overhead costs are the summation of the applied labor and overhead cost from each work center, that the product passes through for manufacturing.
Assume the following:
| Example | Applied Labor & Overhead Costs (Per Hour) |
Production Rate (Units Per Hour) | Calculated Labor & Overhead Cost Per Unit |
| Work Center (A) | $250 | 25 units | $10/unit |
| Work Center (B) | $50 | 10 units | $5/unit |
| Work Center (C) | $120 | 15 units | $8/unit |
| Total Labor & Overhead Costs | $23/unit | ||
A product goes through work centers (A), (B) and (C).
What would happen if instead of producing 25 units per hour, work center
(A) produced only 10 units per hour?
The calculated cost for work center (A) would go from $10 per unit to $25 per unit ($250 ÷ 10 units = $25/unit);
Whereas, the total labor and overhead cost would go from $23/unit to $38/unit ($25 + $5 + $8).
Initially the above increase in the total product cost per unit appears very bad. But in reality, you have to ask the question: “Did the total cost change according to the company’s profit and loss statement or even the company’s checkbook?” The answer is not really.
Typically, the total cost of labor and/or overhead expenses do not change significantly as production output increases or decreases. Expenses — such as rent, depreciation, insurances, etc, — are repetitive payments or expenses made on a routine basis which are based on something other than production volume. This reality may appear more obvious for overhead expenses, but what about the cost of labor?
