Harry F. Landsburg - July 27, 2018

Full standard cost accounting systems with numerous variances have been around since the mid 1900’s. Historically, inventory and production management personnel would take the whole month of December to calculate next year’s standard cost for all raw material and finished goods. All variations in finished products for materials and labor would be totaled for the month, and 15 days after month end, financial and production managers would sit around to analyze the variances. Following numerous comments on what happened, they would look at the next month’s variances.

Sometimes variances were accepted as the new norm and standards would be updated to minimize variances (or the extended discussions about them). Adjustments to standards became more frequent to the point where standards were adjusted to avoid negative commentary.

This level of standard costing differs from standards that are applied to operations on a routing where anticipated times are used to compare to actual labor effort. This use of “standards” is essential to managing variation in actual performance that can be analyzed to derive continuous improvement opportunities rather than values that differ from the “standard.”

Proponents of standard costing systems also spend a great deal of time focusing on the under-absorption or over-absorption of overhead costs. Under-absorption of overhead costs really means that not enough product was produced/sold to fully absorb the allocated overhead costs. Over-absorbed overhead costs means that more sales than was expected resulted in excess absorption of allocated overhead, generally a winning outcome.

One way to offset under-absorbed overhead is to produce more (build more inventory), which is a terrible way to put company cash on the warehouse shelf but have better cost accounting results and less management whining. Over-absorbed overhead is a total victory that nobody wants to fix with any type of follow-up activity except “keep doing that.” One can question the value of this absorption information if it is not used in support of continuous improvement activities that better the operations of the business.

Why not keep everything simple?

  • Use December to establish new blanket purchase orders for the ensuing year, stabilizing the cost of your unit purchases whether you buy 1,000 or 100 of an item.
  • Value inventory at weighted average or average cost.
  • Spend your valuable time analyzing closed work orders to determine individual or patterns of difference between anticipated costs and the actual costs. Use these difference “signals” to initiate continuous improvement activities on the factory floor or in the conference room using value stream mapping techniques to identify non-value added activities.

All the effort supporting and analyzing the information from a full standard costing system does not improve on-time delivery or quality. It’s better to spend your valuable time implementing process improvements that add value to your products and get them to your customers on time. Do that and you will over-absorb overhead every month, further diminishing the value of your grandfather’s standard cost accounting system.

DVIRC’s Harry Landsburg has worked with well over 100 area manufacturers to analyze their costing methods to suggest best practice approaches to costing/quoting/pricing jobs and products.

Calculating optimal product/service prices requires striking a delicate balance. Miscalculate, and your prices could be too low to cover the associated costs, or too high to remain in the running with target customers. Costing for Competitiveness is an instructive, hands-on opportunity to learn strategies for determining costs, understanding the true value of your offerings, and apply that knowledge to maximize profit margins.