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Hi. Alan Stratton here from Cost Matters dot Com
A recent discussion in an online cost modeling forum related to “Which cost drivers can
you use to assign administration overheads to a wide product range in a manufacturing
concern.” As the discussion evolved, one response said “it is best done through the
driver of turnover of the product produced. … because the efforts of administrative
departments are in proportion to the production / sale achieved.”
Several problems scream out from this discussion. First, the cause and effect principle has
been reversed. In this person’s company it appears that administrative cost is proportional
to turnover. Why? Because turnover is how they have been allocating this cost! Of course,
it’s proportional if that’s how they’ve been allocating it. But they have confused
themselves by looking at cost first instead of taking a good look at operating reality.
Second, whenever a question is posed based on a department or departments, it’s obvious
they have not identified the activities performed by people in these departments. In each department,
people are actually doing a number of different activities. This discussion needs to center
on cause and effect relationships in each activity.
Third, how is turnover measured? According to the Merriam-Webster dictionary turnover
is “the amount of business done.” But, what is the appropriate measure of the amount
of business done? Is turnover measured in units produced, direct cost, material cost,
material weight, labor hours, labor cost, or the classic – revenue? Does selling price
influence the amount of administrative overhead? Each of these measures will produce a very
different cost picture. Unfortunately, without understanding the real work and real causes,
the “effect” is fake and potentially misleading. Cost allocation can give us a false sense
of accuracy. Even repeatedly asserting that effort is proportional does not make it so.
How should this question be resolved? First, identify the actual activities in these
departments. Take them seriously. Understand the real work performed.
Second, identify cost drivers at the activity level. Ask a lot of questions to real employees
about why they do the work and what causes them to do more or less of the activity. To
get them thinking out of the box, pose extreme what-if questions such as “What would happen
if you had ten times the number of products but the same unit volume?” “Why?” “How
would your activity be impacted if unit volume dropped to one-half but with the same product
mix?” Why? And so on. Third, use this information to select real
cost drivers and create your cost model. After you understand the real activities and their
drivers, you may decide that collecting data for these activities would cost more than
the additional insight to product cost. You now have a choice and a modeling decision
to make. But it is a decision that will be based on fact -- not assertion. Your alternatives
now deserve their own article. Watch out for broad questions like this one.
Dive down and look at the real work before making broad assertions and choices that will
adversely affect decisions management must make. The purpose of costing is to help management
make informed decisions. It is not just to distribute cost somewhere. Let’s do the
job right because cost matters.
What is one challenge you have with cost assignment?
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When Cost Matters, Profits Soar. I'm Alan Stratton from Cost Matters dot Com THANK YOU