You drop a product when it loses money. Simple. But, as with most “simple” things, it’s always a good idea to apply a little extra thought. Going back to your cost accounting course in college, you were taught to continue selling a product as long as it covers variable costs. In technical terms, the product has a positive contribution margin and contributes to pay for fixed costs. A sound theory, but let’s examine how this theory becomes messy in both practice and execution. Accounting rules contribute to this “messiness,” but keep in mind that the issues discussed also apply to evaluating product profitability.
Let’s start with the typical components of a product’s cost.
First, direct material—what could be simpler? But, does your direct material include continuous adjustments for process improvements that reduce scrap, warehousing/handling/movement costs, procurement staff costs, inspection costs, etc.? Some of these may be in other direct costs or overhead; evaluate if they are applied to product cost to reflect cause-and-effect resources and process relationships. Some of these may even be factored into administrative costs and not into product cost at all.
Second, let’s examine direct labor. Is direct labor assigned by position, or cost center, rather than actual time recording? If so, idle labor time is increasing product cost. This means they may not recognize efficiency improvements until you can reduce staff or absorb a major production volume increase. Many aspects of direct labor are fixed costs—such as benefits and vacation time—but are often applied as variable. Administrative support from human resources and finance for direct labor normally isn’t included in the direct labor rate.
Third is other direct costs, which is a very broad area. Examine these costs to ensure they don’t confuse fixed and variable costs. Does the assignment to product clearly reflect operational resource and process causal relationships? Is excess, idle time, or capacity hidden in the assignment of other direct costs? For example, is all depreciation assigned to the product even though the equipment is only used eight hours per day? Depreciation alone is a highly problematic and distorting issue, since accounting rules assign it based on the earth orbiting the sun, even though most equipment deteriorates with actual use; and it often continues to operate even after accounting rules say it is fully depreciated.
Overhead is famously full of decision distorting quagmires. The first issue is the size of the overhead pool or pools. Large pools lump together costs with very different causal factors. The second issue is overhead cost assigned with a driver that has a strong causal relationship to the resources that generate the cost, or just allocated generally? Third, is the meaning of fixed and variable clear? Electricity is a completely variable input; but as it is consumed, it can become a fixed cost in relationship to a product. Consider a product where raw material, manufacturing, work in progress and final inventory storage, and delivery require refrigerated temperatures.
The final factor is costs beyond manufacturing. Sales commissions are an obvious example of a cost not normally factored into product cost. Many sales and marketing costs have clear causal relationships to products. Ongoing customer service and warranty support also need to be considered.
Most manufacturing accounting systems miss many of the causal relationships between organizational resources, their costs, and products. Accounting product cost is a very limited calculation, and often a highly distorting one, for economic decision-making purposes. The solution is to use managerial cost system that is designed purely for internal decision-making and is useful to manufacturers and other operational decision-makers throughout the organization. Most traditional product cost accounting information isn’t useful to anyone (even industry analysts) beyond its presentation in financial statements, and perhaps calculating executive bonuses that may drive short-term behavior.
>>Larry White, CMA, CFM, CPA, CGFM, email@example.com, is executive director of the Resource Consumption Accounting Institute (www.rcainstitute.org) which trains and advocates for improved cost information connecting operations to business performance.