To accommodate new trends in manufacturing, many companies are re-examining their costing models to better support strategy and performance.
By Pat Garrehy, CEO of Rootstock Software
With today’s latest trends in manufacturing – including personalization of products, multiple modes of manufacturing, increased outsourcing, rising costs of employee benefits and additional factors – companies need greater flexibility in how they track, analyze and control costs.
These market shifts have caused manufacturers to re-examine, and in some cases, reconfigure their costing methods. Two common models – standard and average costing – are prevalent, and there are situations when it’s best to use one over the other, as well as additional considerations to ensure companies can handle all of their costing complexities.
Traditional vs modern manufacturing
In the 1970s and 1980s, manufacturers produced a large volume of the same products with little to no variation. Back then, only a few cost factors—such as material, labor and overhead—needed to be tracked. These firms had the infrastructure to set standard costs, and they had the cost accountants to monitor variances, which made the use of this model effective.
Today, most companies don’t have deterministic production runs with little deviation. This is especially true since manufacturing has become more personalized. Many companies engage in engineer-to-order (ETO), manufacture-to-order (MTO), assemble-to-order (ATO) and configure-to-order (CTO) modes of operation.
In addition, there are simply more cost elements to track. Beyond the basics of direct material, direct labor, and labor overhead, there may also be freight, other landed costs, outside service, assembly by vendor (e.g. subcontracting costs), and various overheads – which could be further delineated by material burden and machine overhead. In addition, direct labor overhead is based on the employee’s payroll rate and can also include fringe costs.
When is it best to use each model?
Most “to order” (ETO, MTO, ATO, CTO) and “build to project” businesses find standard costing impractical because there are few or no standards from order to order. For example, in an ETO manufacturing firm, the non-recurring cost of engineering doesn’t have a standard that relates to a unit of product. In this case, it may be best to use a moving average cost.
In general, average costing may be a better model when:
- The process of establishing standard costs on the various cost elements may be too time consuming and prone to error.
- The organization does not have the internal experts familiar with standard cost accounting, or it doesn’t have the manpower to set and monitor standards.
- Each item’s cost varies to such an extent that there is no standard bill of materials or no standard routing for the item.
- Product costs are attributed to rapidly changing commodities or other variables.
With this model, the cost of an item is calculated by adding all the costs of the goods and services used, then averaging the cost across the total quantity and over a given period of time.
On the other hand, manufacturers that continue to build standard products or use standard processes may find average costing has its limitations, which won’t support their needs. For example, average costing can create a “time lag” in seeing what costs used to be versus actual cost variances occurring in real-time on the manufacturing floor. Differences between standard costs and actual costs show up in variance reports, and these variances then become the basis to improve operations and profitability.
Manufacturers must also ensure that their costing model and system can handle added factors that help improve financial accuracy and controls:
- Multiple Plants. Various sites add to costing complexities. In some instances, a company might want to run standard costing in one division and average costing in another. This is especially true in those cases where one division is ‘build to order’ and another is ‘build to stock’. The company should be able to consolidate its divisions into a single chart of accounts and support AR, AP and general ledger at an enterprise level—even though the divisions use different costing methods.
- Change in manufacturing modes. Businesses typically change over time. A “to order” business could change to a “to stock” business—and vice versa. The operational system must be flexible enough to support adjustments that could lead to changes in the costing model that’s used.
- Going against the grain. Most often, a “to order” business is using average costing on an item-project basis, and a ‘”to stock” business will use standard costing calculated on an item level. In unusual circumstances, a ‘to order’ business may want to run standard costing, which means the cost is contained at the item level (rather than the item-project level). Here, the operational system that facilitates costing must be flexible enough to accommodate such departures from the norm.
- Determining profitability. No matter the costing model, a company must have the KPIs to measure performance. For example, in a “to order” environment, many more KPI’s are required to measure “profit cost” progress, so the organization does not have to wait until the completion of a job to determine profitability. A company will also want to know if costs – such as material, labor, overhead, outside service, machining, etc. – are running within the estimated budget.
Flexibility is what’s needed in 2020
In manufacturing, one costing method doesn’t fit all. A company must understand the costing data it needs to run effectively. There are times when standard costing should be undertaken, but an organization might not fully grasp the model. In such situations, a company might start with average costing, and as it grows to understand and support standard costing with deeper expertise, it can make the move.
Another important factor is breadth in tracking. The systems that manage manufacturing data should be able to monitor and report on at least 10 costing elements, whereas in the past, they only needed to track three or four basic elements. Finally, since change is inevitable, handling costing via the cloud has provided the flexibility to easily transition between models – or even hybridize models. In this way, companies have the infrastructure to reinvent and hone their strategy, while also ensuring performance is on track for growth and success.
Pat Garrehy is founder and CEO of Rootstock Software (www.rootstock.com). He has extensive experience in cost accounting and a background as a software architect and engineer. With over 30 years of management and technical experience, Garrehy possesses a unique blend of analytic and business savvy. He can be reached at firstname.lastname@example.org.