30 words
Traditional accounting methods can often create conflict situations. Happily modern
cost management techniques, with their integrative approach, enable better
collaboration between managers, says Kellogg School of Management's Professor
Bala V Balachandran.
100 words
A major cost component in a manufacturing environment is overhead cost.
Traditional cost accounting recognizes at least three major cost components: direct
labor, direct materials, and manufacturing overhead or burden. Manufacturing
overhead is one cost pool and it is usually allocated on direct labor. This allocation
scheme divides total estimated dollars of all manufacturing overhead costs for a
current year by total estimated direct labor hours for the same year. A percentage of
overhead is then allocated to a product based on amount of direct labor dollars (or
hours) used to make the product.
Keywords: Bala V Balachandran, accounts, finance, manufacturing, overhead, labor,
cost, activity based cost, direct, fixed, direct-variable, indirect-fixed, indirectvariable, finance accounting, managerial accounting
Authors Summary
Bala V Balachandran, Professor of accounting and information system & decision
science, Kellogg School of Management
Charts exhibit 01: changes in cost classification
Exhibit 02: from conflict to collaboration
manufacturing overhead
by Bala V Balachandran
Traditional accounting methods can often create conflict situations. Happily
modern cost management techniques, with their integrative approach,
enable better collaboration between managers.
A major cost component in a manufacturing environment is overhead cost.
Traditional cost accounting recognizes at least three major cost components: direct
labor, direct materials, and manufacturing overhead or burden. Manufacturing
overhead is one cost pool and it is usually allocated on direct labor. This allocation
scheme divides total estimated dollars of all manufacturing overhead costs for a
current year by total estimated direct labor hours for the same year. A percentage of
overhead is then allocated to a product based on amount of direct labor dollars (or
hours) used to make the product.
In the past direct labor cost was the major cost incurred in producing a
product. Today with automation reducing and almost eliminating the portion of direct
labor costs in a product to less than five or ten percent, and overhead costs rising to
50-70% of product cost, labor becomes a much less meaningful, and non-causal,
basis for allocation of overhead. To put it another way, the labor tail should not wag
the overhead dog. This occurs when, due to in-accurate allocation, small swings in
labor costs produce a tremendous distortion in overhead allocation. A totally
automated production process may allocate no overhead when it is actually a
significant contributor to the over-head pool. This could also lead to games being
played where huge machine purchases might be justified because of purported
overhead and labor savings when, in fact, the justification is false due to inaccurate
accounting.
Therefore, careful research is needed to classify costs into direct, fixed,
direct-variable, indirect-fixed, and indirect-variable categories, as shown in the
comparison chart here. Activity based costing should be used and multiple cost pools
designated, the cost pools being associated with appropriate cost drivers and
activities.
With direct labor being a small percentage of the factory overhead and direct
materials and operating supplies being the only (major) direct-variable item, it is
clear that the three components of the traditional costing system should be reduced
to two in a JIT or CIM environment. These two are direct materials and all others,
which are then called conversion costs. So, cost accounting systems (software) in
the current era of modern manufacturing should apply overhead as a series of
individual burdens within the conversion costs category with each burden classified
as fixed or variable and having an appropriate and meaningful allocation method and
basis of measurement (cost drivers).
If semi-variable costs exist, one may use a simple linear regression formula to split
the two costs into a fixed component (intercept or constant term) and a variable
component (slope co-efficient). Some of the candidate allocation bases are units of
production or machine hours, velocity, material usage or costs, equipment costs,
number of setups, add investment. Further, the allocation models can be invariable
direct charging models and very few cases may need to go to complicated reciprocal
allocation type models. This is the basis for activity analysis and activity based
costing.
I believe that all classifications are largely irrelevant in the long run.
Ultimately all manufacturing costs should be assigned to products and it makes no
difference whether they are called: direct or indirect, or service, or administrative
costs. Such terms and categories refer to how the cost was determined rather than
the behavioral characteristics (fixed-variable) of the cost element. For profitability
planning and product cost analysis, identification of product costs in terms of variable
and fixed cost behavior is more important than the categorization of direct, indirect,
service, or administrative categories.
This will permit full absorption costing for financial accounting and profitability
and variable costing in managerial accounting and decision analysis. Due to the
varying nature of flexibility in product swaps, attention shifts from a product focus to
looking at the total manufacturing process including all products.