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Cost accounting is too important to be left to the accountants
Before assuming my present role with Keller Products, I worked as a management consultant. My specialty was analysis of individual product costs and overall operating costs in changing conditions, such as investment in new facilities, introduction of a new product line, make or buy (outsource) decisions, partial shutdown, etc. In doing literally thousands of cost estimates, I found that managements did not understand their costs, and could not accurately calculate the economic effects of decisions that radically changed their operations. One pervasive cost fallacy I encountered is the idea that the ratio of overhead to direct labor is fixed for any given operation, and that increasing or decreasing direct labor automatically increases or decreases the overhead by that ratio. An extreme case of such thinking is the assumption that outsourcing an operation will eliminate the direct labor cost plus all overhead "associated with" the direct labor.
A more complex issue is the cost effect of outsourcing intermediate steps in a multistep operation. Analyzing this problem requires maintaining the distinction between fixed and variable costs throughout each step of the operation, so that the finished product cost is the sum of the prorated costs in each category for each process step. This information is not obtainable from standard accounting cost systems, but today management decisions are made from standard accounting cost data. There is a better way to evaluate costs. Let's look at how things are being done, and how they should be done.
During relatively stable periods, the time-honored rules-of-thumb for estimating shop costs are quite accurate and useful. A widely used number is the shop hourly cost; the sum of shop costs (except materials and fixtures dedicated to individual jobs) plus management/administrative costs, divided by the number of direct labor hours. The shop hourly cost is calculated by accountants based on cost data and direct labor hours for a recent time period, say the past six months or one year.
Shop managers often take this number to be a breakeven number. For example, if the calculated shop cost is $60/hr, then new jobs must be bid at $60/hr or greater in order to make money. If the shop product mix and activity...