Managing costs - a focus for the future - Part 2




Overheads and ABC

In Part 1 of this series we looked at the costs and our efforts to reduce them. This week we look at "overhead costs" and some of the ways to reduce these. Perhaps Australian brothels have the best approach. They are all in single storey buildings because that way there is no overhead at all!

The traditional division of costs

Traditional costing methods allocate the overheads on the basis of production volumes, direct labour hours or machine hours to produce a "cost" for the product. The problem is that direct costs, such as direct labour, refuse to be variable and are now a small proportion of the total manufacturing costs (see Part 1). It is totally inaccurate to use them to allocate the indirect costs.

The ABC's of accurate costing

Changes in manufacturing, such as increased investment in advanced manufacturing equipment, has meant that the overheads are no longer directly related to production volumes or direct labour hours. Calculated costs are distorted in relation to the resource usage of the product and the real costs. Taken to the limit, in a totally automated factory, where direct labour does not exist, the traditional direct labour allocation method falls down entirely. Cost accounting and performance measurement should reflect our activities and the way we make the product. They should be used to manage the result rather to simply inform upper management of what happened months ago.

Activity Based Costing (ABC) has been developed to assign overhead costs (or transactions) in more accurate proportions to the products that require them. ABC says that activities drive the overhead costs and are a sounder basis for allocating costs that any of the current methods. Take supplying the automotive industry: A processor sees such work as a large volume contract and neglects the time and structure necessary to get the work. The work involves getting specifications and quotation documents, completing them and additional complex servicing procedures. This needs extra staff to cope with the work and the extra costs appear as overheads. If costs are allocated according to direct labour hours then the increased overheads drive up the price of the traditional work whilst simultaneously underpricing the automotive work (which has directly required the extra costs).

Consider the following example: A Sales Office costs 50,000 per year to run and deals with only two products, both of which have sales of 1,000,000 per year and which take exactly the same amount of materials and working hours. The only difference is in the sales ordering pattern: Product A sells in 10 equal orders of 100,000 per year to one customer and Product B sells in 1,000 equal orders per year of 1,000 to 100 different customers. Conventional methods say that the Sales Office costs are distributed equally between the products and both accept an overhead of 25,000 per year. This is not sensible because Product B uses at least 100 times as much transaction effort of the Sales Office as Product A. Conventional wisdom over-prices Product A and under-prices Product B.

ABC concentrates on the "cost drivers" for the product and says that you cannot use a global overhead figure from direct labour or machine hours to work out a product cost. You must find the "cost drivers" of the business and product. The product cost is not just related to the volume of the work but also to the overheads necessary to get and produce the particular job. ABC requires more analysis but gives clearer understanding of what a product really costs. If you are not using ABC then the "costs" used for pricing decisions probably bear little relation to those that actually incurred.

Despite the increasing relevance of the approach, too few UK processors use ABC to give accurate product costing and most rely on the "global" approach. ABC gives a clear allocation of overhead costs based on results. We can then start to concentrate on managing and reducing the transactions that drive the overheads and concentrate on results achieved - ie. on effectiveness rather than efficiency.

It is totally useless being efficient at something that you shouldn't be doing!

What are the overheads that we can manage?

ABC is not a universal panacea to costing and overhead reduction - it is a tool to focus on how overheads are generated and the value we get for money. Instead of a "shotgun" approach to overhead reduction, ABC focuses us on activities that add value and allows us to reduce or eliminate those that do not. The Pareto Principle tells us that 80% of the results in our business will be created by 20% of the activities. To improve overhead productivity, shouldn't we focus on and improve the vital 20% and cut or remove the trivial 80%?

To manage overheads managers first have to accept that these costs are under their control and that they are not simply there to be allocated away and disappear.

Manufacturing - Are your manufacturing processes adding to your overheads by building waste and complexity into the process?

Value adding and waste activities

Stocks - Money tied up as stocks and work-in-progress should be included in the "cost of production" but the accountants tend to treat them as assets.

Quality costs - The ultimate overhead that should be reduced to reduce costs and improve customer satisfaction:

Staff overheads - These are the support personnel costs of the activities that you carry out:

Energy - Energy usage is a controllable overhead and the excellent publications from the Energy Technology Support Unit (ETSU) provide a wealth of guidance on energy management:

Compressed air - ETSU also provides information on compressed air usage and the savings that can be made. Savings can be high because only about 5% of the energy used at the compressor becomes available to do work at the point of use:

There are other overheads that can and need to be managed but we must accept that overheads are part of each manager's responsibility and provide the manager with the incentive and the information to drive down the costs.

A manager should be held responsible for, and evaluated on, the costs that are under his control.

Overhead cost management

Without overhead management, any attempt at cost management is bound to be both partial and inevitably ineffective. Effective cost management depends on the measurement and improvement of overhead productivity and will be one of the keys to success in the future. Ignore it at your peril!

 A longer hit list of "Things to do Next!" to reduce materials costs is given in Easy Guide 3a.

The "Managing Costs" Series.

"Managing costs" is designed to give you direct and clear information on some ways of looking at the way we generate cost information in our companies and some ideas for managing them. The series has been written specifically for plastics processors but most of the information is equally relevant to general business. The series is:

Part 1: Introduction

Part 2 - Overhead cost management - This article

Part 3 - Materials cost management


Last edited: 16/07/12

Tangram Technology Ltd. 1998

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