8. Product Decisions & Cost

Transcription

1 Objectives 8. Product Decisions & Cost As we ve learned in previous modules, standard costs are not an effective way to represent unit product costs in a lean organization. With this said, once a standard costing system is no longer being used questions might arise on how to evaluate unit cost and compare alternatives when making decisions about pricing, product mix, special orders, make- or- buy, and more. So, in this module we ll show you ways to make these decisions once standard costs are no longer being used. Specifically, by the end of this module you ll understand the advantages of using throughput to calculate conversion costs instead of using standard costs; we ll explain how features and characteristic costing can help with pricing decisions, and we ll show a better way to evaluate product mix, special orders, and make vs. buy decisions. Importance of Throughput OK, to get started, we d like to stress the importance of throughput. Specifically, the impact of throughput on conversion costs is a key concept for product related decisions in a lean environment. In the following example, we ll show how standard unit costs based on total process time in a cell leads to inaccurate product costs, which in turn, as we ll show throughout this module, leads to decisions based on poor information. In this example, we ll compare 4 products that are each run through the same 5- station cell. We d also like to point out that when using standard unit costing, cost is positively correlated with total time; in other words, when we total the time from each station in a cell, as total time increases the unit cost also increases. Page 1

2 Finally, in this example, we ll show two methods for calculating the overhead contribution for unit cost: labor time and machine time. OK, as you can see below, Product A and Product B each have a total processing time of 18 minutes, but note that Product B doesn t use station B. Product C s total time is 23 minutes and Product D s is 25 minutes. Now, in this example, method 1 uses labor to allocate overhead while method 2 uses machine time to allocate overhead, where overhead rates vary by machine and are applied using the time on a specific machine. As you can already see, these two methods result in different costs for each product, yet the actual product cost doesn t change. Page 2

3 For example, product B s cost using labor to allocate overhead results in 21 dollars while method 2, which uses machine time to allocate overhead, results in a cost of 20 dollars and 62 cents. Also, this example makes a few assumptions, such as the direct labor rate being $12/hr. This number doesn t include employee benefits, such as healthcare, retirement contributions, and tax contributions. If these were included the hourly rate would be much higher. OK, so, at a high level, that s how a traditional approach to costing is done now, we d like to transition to what we feel is a far superior method the throughput costing method. 4 Steps to Throughput Costing Specifically, we d like to present a 4- step process to throughout costing. The first step is to identify the bottleneck process. In other words, we need to identify the process with the highest cycle time since that process will, in fact, constrain the entire system. So, in this example, we see that process C is the bottleneck since its cycle time is 6 minutes. The next closest cycle time is process A at 4 minutes. The second step to throughput costing is to determine the maximum throughput based on the bottleneck process. So, in our example, since the bottleneck process is 6 minutes we d only be able to produce a maximum of 10 units per hour since 60 minutes in an hour divided by 6 minutes is 10. The third step to throughput costing is to calculate the conversion costs per unit. In this example, the team calculated the conversion cost per hour to be $200. For a review on how this is done feel free to review the inventory module. The team then divides this conversion cost by the maximum throughput value which, as we just learned, is 10 units per hour. So, when we divide 200 dollar by 10 units we arrive at conversion cost per unit of 20 dollars. And, lastly, the 4 th step to calculating throughput costs is to add in material costs. So, in our example, we know the conversion cost per hour for this process is $20 and the team also determined the total material costs to produce one unit was 9 dollars. So, by adding 20 dollars to 9 dollars we arrive at a total throughput cost of 29 dollars. Page 3

4 Now then, let s have a look at Products A through D again only this time let s look through a throughput costing lens. Product A and B both share the same bottleneck process which is C with a 6 minute cycle time. As such, the maximum throughput for both is 10 units per hour. Product C s bottleneck is 5 minutes and occurs at stations A, C, and D making the maximum throughput 12 units per hour and, finally, product D s bottleneck is station C since its cycle time is 7.5 minutes making its maximum throughput 8 units per hour. We then calculate the conversion cost per unit for each product for example, Product D s conversion cost is calculated by dividing the overall conversion cost per hour of $200 by the maximum output of 8 units this works out to be $25 per unit. We then add in the material costs as shown here and then calculate the total throughput costs as shown here. OK, here s a graph that compares the three different cost calculations. The blue bars represent the costs calculated using method 1, which focused on machine time. The red bars represent costs calculated using labor, and the yellow bars represent the throughput costs we just got done calculating. If you compare the three methods of calculating costs you ll notice a few Page 4

5 things. First, the throughput unit cost is higher for all 4 products, but this should be expected since the conversion costs were calculated using the bottleneck process. If you re wondering why think about the last time you were part of a meeting in a conference room Would it make sense to count each person s time in the meeting based on the time they spent talking while all other time wasn t counted? And what about the temperature control and lighting costs for the room? Would you divide these costs by the amount of time each attendee talked? Of course not but that s essentially what s being done with a standard costing approach. Another observation we d like to point out is that product C s costs are higher than product A and product B for the two standard unit cost examples, but lower than A and B for the throughput method. An organization using standard costs would have failed to recognize that product C is a more profitable product because the organization can produce it more quickly; instead, organizations that are using standard costs might choose to never develop product C or discontinue it if it s already in production. As such, it s extremely important to realize how much business decisions can be impacted as a result of how you cost products. For example, organizations often attempt to understand which products are most profitable. Unfortunately, when standard costing is used, instead of throughput costing, the results may not be misleading. In fact, standard costing often leads organizations down the wrong path altogether when it comes to things such as product pricing, product mix decisions, special orders, and make vs buy decisions. Put another way, standard costing is bad and throughput costing is good. OK, and that wraps up this module on product costs and decisions. In our next module we re going to talk about target costing so, we ll speak to you soon. Page 5