Costing Systems

In my opinion, product costing in a manufacturing environment is important for a few reasons:

  • It allows the company to properly price its products
  • It helps a company understand what products drive profits (up or down)
  • It allows for benchmarking of production goals and the resulting variance analysis

And probably a bunch of other things, but I’m getting bored with listing them. I think a lot of people who don’t work in manufacturing probably don’t realize the importance of manufacturing variances and the analysis thereof. Manufacturing variances do two important things, to my mind: they allow for the accurate reflection of gross profitability, and they point to the effectiveness and efficiency of operations.

From an “Accounting 101” viewpoint, that’s probably all you need to know. What I struggle with, though, is that in the real world it’s all about information. What do we know, what don’t we know. The specific costs of a product are typically divided up into “buckets” depending on the specific costing system used. In a standard costing system you would have raw materials, labour, and overheads. In an activity based costing system you would have raw materials, and then labour and overheads would be combined and separated into a bunch of activity centre costs specific to the operation.

And that’s where the problems tend to start. If you have a simple manufacturing operation where you only make one thing, it’s easy to attribute costs to it. But as manufacturing operations become more complex, tracing costs to specific products becomes quite difficult. Consider an assembly line with 10 workers on it. On this line, three products are made simultaneously from the same materials. Each worker at any given time can be making any or all of the three products, but one product is very exacting and takes a long time, one product is somewhat difficult, and the other product is quick and easy. So at the end of the day you have 80 hours worked, let’s say at $20/hr so that’s $1,600 in labour costs. Now, how are you going to divide that cost among the three products? It would be easy to say you could come up with some sort of pro-ration, but what if the total amount produced in limited by the customer order size, so you can’t work backwards from total production?

I guess the real answer is that you’d do some testing to decide how long it should take to do the work and cost the product accordingly, and the variance would be the difference between actual and budgeted labour cost. So then you end up with the variance problem. At the end of the week, let’s say you spend $9k instead of the budgeted $8k. So that’s an unfavourable $1k labour variance; easy to calculate, but how do you explain it? What portion of that variance is due to which of the three products? Maybe the workers are generally inefficient and the variance results equally from all the products… or maybe one of those products is being made a lot slower than budget for some reason.

Activity based costing tends to assume that costs can be allocated to work centres on a fairly consistent basis. For example, the labour and overhead needed to run a machine is, say, $150 per hour. So to cost the product you determine how long it spends on that machine. If it spends 15 minutes, you have a cost of $37.50. It sounds simple enough, but when you have many different products moving through that work centre, what is the mechanism to assign variance to those products? Maybe there isn’t one. I’ll need to do some research on this.

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