Sunday, July 6, 2008

Cost is Cost, Right?

At a recent National Summit of Chief Executive Boards International, our member Chuck Gilmore gave an excellent presentation on Theory of Constraints as a manufacturing strategy. You may remember a book from years ago -- "The Goal" by Eliyahu Goldratt. If you haven't read it lately, it's worth picking up again.

This fable teaches us that every process (in this case, manufacturing) has a point of constraint that gates its throughput. And that focusing on only that constraint is the way to improve the performance of the entire process.

What has evolved from that idea is a costing concept called "Throughput Accounting." Throughput Accounting is based on the theory of constraints, stating that "If a resource is not constrained, it can be eliminated from consideration as far as management decision-making is concerned." It focuses on maximizing the throughput dollars from the constrained resource -- everything else takes care of itself.

Then there's Marginal Cost Accounting. Marginal Cost Accounting asks: "What is the cost of producing just ONE more of an item?", in contrast to conventional standard cost accounting. The question is: "What are the actual variable costs of producing just one more? What is the contribution margin of producing 1 more? The machines were there, the people were there, the lights were on. Is there much more than the cost of material to produce one more part?

Using only standard cost accounting to analyze management decisions can distort the unit cost figures in ways that can lead managers to make decisions that do not reduce costs or maximize profits. In fact, they can do just the reverse.

I recently heard of a company that had installed a new production tracking system, that included a cost analysis module. To their surprise, they were not only over-burdening their standard costs, but they were also double-counting some components of burden. As a result, their costs were overstated and they were turning away business that would, in fact, have been profitable. They were convinced that their competitors were pricing below their costs. It turned out they were the ones confused about their costs. After only 6 months of making decisions based on the new costing data, the business turned from a net loss to a net profit, and has steadily increased net cash flow since.

There are some important lessons in here. First, any system (the costing system included) deserves to be reviewed regularly, to make sure the assumptions are still valid. Secondly, the assumptions themselves deserve to be challenged. If you're using standard cost accounting, you're likely being misled in certain situations. Throughput cost accounting might give you a more credible view of your constrained resources, and marginal cost might be the better consideration where incremental business is concerned.

In general:
  • Standard Cost Accounting works best for budgeting and long-term resource planning
  • Throughput Accounting works best when there are specific constrained resources (until those constraints are eliminated, or move)
  • Marginal Cost Accounting works best for day-to-day operational decision-making

What costing methods do you rely on? Are they perhaps getting in your way, or maybe even misleading you? Would it be worthwhile to brush up on costing methodologies?
If you take a look at your costing and find some interesting things, would you click "Comments" below and let us know what you found?

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Terry Weaver

Chief Executive Boards International

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Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it

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