Manufacturing Strategy
 - Part 9: ‘There's no accounting for manufacturing strategy’





So far in this series we have looked at various aspects of manufacturing strategy and have hopefully convinced you that it does not involve massive investment in new slick technology. Despite this, there is always a need for investment in a business so that it will stay competitive. You might say that you are 'doing all the right things' but even if you are moving in the right direction then you can still be overtaken. A hedgehog moving at 5mph in the outside lane of the motorway might be moving in the right direction but he doesn't stand much of a chance of survival. There is also a need for financial information to control the business.

On this basis you need to be able to:

The methods for these are mainly the field of the accountants but the development of JIT, OPT and your manufacturing strategy means that some traditional accounting measures need to be questioned. This article gives some ideas as to the questions you should ask.

Management accounting and financial accounting

Management accounting is concerned with providing managers with the information to aid them in decision making for planning and control. This is internal information. Financial accounting is concerned with information for people outside the company and is external information.

Financial accounting requires the matching of costs with revenues to allow the calculation of profit and traditionally management accounting has been linked to the financial accounts via the treatment of stock valuation and other conventions. If the linkage between management and financial accounts can be broken, with the help of the accountants, then we can stop thinking about out of date and irrelevant financial numbers and start thinking about the real numbers that are important to control and manage our factories.

There may then be a need for two separate accounting procedures - one to run our factories, and one to provide legally correct accounts. This should not present a problem and whoever said that you should use legally correct accounts to run your factory anyway?

  The pricing decision and overheads

One major factor that is changing in the manufacturing world is how we approach the pricing of our products and a major factor in this is the way we treat overhead allocation. Most manufacturing industry recovers the overheads by increasing the direct cost of the products by some arbitrary factor.

In the simplest form the accountants find the total overhead cost and divide this by the total number of available direct labour hours (or machine hours) to give an 'overhead rate'. The overhead rate is then multiplied by the number of direct labour hours required for the individual product to give an overhead allocation. This overhead allocation, the cost of direct labour and the cost of materials involved are all added up to give the cost of the product.

These methods grew up in the first half of this century when direct labour represented a high proportion of the costs and overheads were lower. Since then increased investment in machinery has reduced direct labour costs and simultaneously increased overhead costs. Despite this most of the accountancy systems we use have not changed to reflect these facts. We cannot really attack the accountants but must instead educate them to recognise that the model we have all grown used to is no longer valid.
In fact the problem is getting worse as automation increases, the direct labour base is shrinking further but overhead costs are increasing dramatically. This is making the old style cost accounting formulas more inaccurate. This change over time in the distribution of the costs is shown in Figure 1.

Figure 1:  Cost allocation breakdown







Direct Labour 



Direct material 




Figure 2: The costs and the efforts

The problem with the traditional method is that the costs are being recovered on the basis of an arbitrary allocation rather than on the true cost of the product. The resulting 'costs' sometimes bear little relation to the true state of affairs.

A newer technique of Activity Based Costing (ABC) has been developed to assign overhead costs in true proportion to the activities that require them. Take the example of the fabled 'contract work' for windows. Many fabricators see contract work as the saviour in these troubled times and neglect the time and structure necessary to get the work. Contract work may need extra staff to cope with the work and the extra costs appear as overheads where they are nearly forgotten.

If costs are allocated according to the traditional methods based on direct labour hours then you may well find that the increased overheads drive up the price of your traditional work whilst simultaneously underpricing for the contract work (which has required the extra costs). A dangerous situation to be in.

ABC says that you cannot use the global overhead figure from direct labour or machine hours to work out a product cost and you must instead work out the 'cost drivers' of the business and product. The cost of a product is not just related to the volume of that work but also to the infrastructure necessary to get and produce that particular job. The ABC approach gives a clearer understanding of what a product really costs. The costs that can be allocated to a particular product are allocated to that product and only what cannot be allocated remains to be split as overheads. This gives a better clarity of cost causes and can be particularly useful in the 'make or buy' decision-making.

Activity based costing allows the division of general overhead costs into controllable and non-controllable overheads. As a general rule for manufacturing industry the controllable overheads are about 30% of the total overheads and can be easily allocated to specific products or projects.

Obviously an understanding of controllable and non-controllable overheads allows a better understanding of the cost behaviour of a company and allows links to be made between performance measurements and costs.

It is strange that we have traditionally had work-study departments to measure and control direct labour yet when we look at the numbers in Table 1 we see that the direct labour cost has always been dwarfed by direct materials purchases and is now being exceeded by the overheads cost. What we need to ask in the future is that the manufacturing manager controls the controllable overheads at his disposal.

Wasted labour is visible when it is not working but how can you tell if an overhead is not working? This drive to measure and improve the productivity of overheads must be seen as one of the keys to success in the future.

Some new and old ideas

These changes in the way we run manufacturing threaten some of the basic ideas that we have regarding accounting and it is worthwhile looking at some of these in detail.

(a) There are direct costs and indirect costs. Direct costs are variable and indirect costs are fixed.

This is probably incorrect and even direct costs are not totally variable. How often do you lay off labour the moment work stops coming in? The simple answer is that you don't and that they continue to cost you money, except that they are now an indirect cost. The new idea is that this direct/indirect cost distribution is no longer valid. Both types are used in the conversion of input to output so why distinguish between them?

(b) Subtracting the product cost (the sum of the component costs} from the sales price is a good way to determine the product profitability.

In practice this is incorrect. OPT says that a business can make a profit but that a product is simply part of the mix. The real question in OPT terms is:
What is the effect of the product on the factory bottleneck machine or process in terms of contribution? The new accounting says that the profitability is determined by the rate at which the factory earns money not the contribution per product.

(c) Inventory is an asset and work in progress has an 'added value'.

In fact inventory at any stage can be defined as 'something that no-one else wants'. In terms of the three categories of inventory:

Inventory is the product of unsynchronised manufacturing and is a liability eating up the cash put into the system. This idea differs from the conventional view of inventory where there is an 'added value' as part of the inventory value. To illustrate this, the added value concept says that if you cut a 6 metre length of profile into 6 x 1 metre lengths then you add value, the reality is that you have added cost but not value. Take the receiver's eye view: Are 6 x 1 metre lengths worth more than 1 x 6 metre length? What is a finished product worth if the customer cannot or will not pay? By this definition even finished goods inventory is valued only on the basis of the price paid for the materials. This is a departure from convention but since inventory is not yet sold it is not totally logical to count the added value until it has been sold. This definition also neatly side steps the games that we play with 'added value' numbers and is also quick, simple and easily understood. The current method of 'inventory profits' whereby inventory includes value-added can act as an incentive for a manager to increase inventory even if the products cannot be sold for some time (if ever). Manufacturing managers can thus distort figures by 'making forward' even though sales have decreased. This only puts off the day of reckoning and makes the slump worse when it inevitably feeds through.

The important point to recognize is that accounting practices are not static and as we change the way we operate we also need to change the way we account for and measure our performance. If our manufacturing strategy is stressing quality, short lead times, low inventory and reliability when none of these are being addressed by our management accounts then there is obviously something wrong.

The investment decision - the cost of 'doing' versus the 'cost of not doing'

In many cases the investment required to implement your chosen manufacturing strategy must be evaluated by conventional accounting methods, if only to placate your bank manager. These methods include:

These are all 'hard' accounting procedures and an accountant will take great pleasure in explaining them to you. The only problem is that whilst they all record the cost of doing something they do not record the cost of not doing something. They are excellent for making a choice when presented with several alternatives for action but when presented as a reason to do nothing they should always be challenged.

Henry Ford once said that 'if you need a new machine and don't buy it then you will eventually find out that you paid for it anyway'. As a group of techniques these traditional investment appraisal methods tend to concentrate on increases in efficiency and reductions in manning. These measures rarely take into account the effect of reductions in working capital (via WIP and inventory reduction) and any improvement in the ability to compete more effectively. It is almost impossible to measure some of the factors, e.g.:

A management team needs to be convinced that proposals are soundly based and likely to achieve their stated objectives but there exists a case to show that investment in manufacturing strategy should not be made on the conventional IRR/ROI criteria but should be made on the strategic necessity to stay alive. This is not to say that the conventional techniques should be ignored, as it is incumbent on any manager to show that an investment is justified. It simply means that some of the intangibles need to be quantified and given numbers. These will also serve as targets for operational effectiveness improvements.

NOTE: In view of our previous discussion on OPT we know that investment in an area that is not a bottleneck will generally not improve throughput and will not be effective. Examine all such proposals with great care.


It is obvious that the current methods of accounting and performance measurement do not provide the right numbers for managing our factories and that changes must take place. The traditional management accounts need to be replaced by more relevant numbers so that operators and managers can concentrate on creative improvement and not on creative accounting. Some ideas for these numbers are given later.

"The Manufacturing Strategy" Series

"The Manufacturing Strategy" series is designed to give production managers and their staff some insights into new manufacturing methods and to prompt the industry into considering the benefits of alternative approaches to manufacturing. The series is:

Part 1: Setting the strategy

Part 2: The systems and MRP II

Part 3: Just in time (1) 

Part 4: Just in time (2) 

Part 5: Just in time (3) 

Part 6: Optimised Production Technology (OPT)

Part 7: A fundamental quality

Part 8: Quality management techniques & tools

Part 9: ‘There's no accounting for manufacturing strategy’ (This section)

Part 10: Performance measurement

Part 11: Changing roles and things to do NOW!


Last edited: 11/03/10

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