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The Dangers of Direct Labor-Based Costing at Orthopaedic Device Manufacturers

As we begin the second decade of the 21st Century – over a quarter-century into the “cost measurement and management revolution” – most U. S. manufacturers, including those who precision manufacture orthopaedic devices, continue to base not only their day-to-day cost accounting systems, but also the cost information they use to support critical management decisions, on cost models driven primarily by direct labor. These cost models, developed at a time when product and process variety were minimal and direct labor was a major cost of manufacturing, are simple, easy to use and explain, compatible with most enterprise resource planning (ERP) and other manufacturing software and, in a vast majority of cases, totally inappropriate.

The introduction of high-tech and computer-controlled manufacturing processes, the ever-increasing demand for complexity and variety in manufactured products, the adoption of lean manufacturing philosophies and the expansion of pre- and post-manufacturing services – including distribution and fulfillment – have pushed the realities of 21st Century manufacturing far beyond the capabilities of “simple and easy to use.” As costing pioneer Alexander Hamilton Church stated over 100 years ago, “No facts that are in themselves complex can be represented in fewer elements than they naturally possess…there is a minimum of possible simplicity that cannot be further reduced without destroying the value of the whole fabric.”

In the 21st Century, direct labor-based costing has fallen far below the “minimum of possible simplicity.” It no longer provides a valid model of the economics that underlie a modern orthopaedic device manufacturing organization and, as a consequence, should no longer be relied upon as a method of measuring a manufacturer’s product, process or customer costs – especially when these costs are used to support critical management decisions.

What’s Wrong With Direct Labor-Based Cost Models?

In its simplest form, a manufacturer will use a single, plant-wide overhead rate – expressed as either a percentage of direct labor cost or an overhead cost per direct labor hour – to be added to direct labor’s hourly cost. All non-manufacturing costs will then be assigned to cost objectives (products, customers, etc.) as an add-on percentage (known commonly as an SG&A rate). The irrationality of such a cost model should be apparent to anyone who gives it a second thought.

Is the cost of an individual manually assembling or visually inspecting a part the same as one who operates a high-tech machine center that devours power and expensive perishable tooling? If a worker can operate two machines at the same time, does each machine only cost one-half as much as when a worker can only operate one machine at a time? Is the cost of heat treating or plating determined by the amount of time it takes for workers to load and unload parts? A direct labor-based cost model with a single, plant-wide overhead rate suggests that the answer to each of these questions is “YES” - an answer that totally defies logic.

4 COMMENTS

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Denny Zimmer

06/06/2012 12:50 AM
It may be more the application of the tool than the tool itself. As well known economist once told me, "a good economist never uses the word always and always avoids the use of the never." So too should we view the use of the comment "Direct Labor" systems should not be used in device manufacturing processes as a cautionary approach rather than a blatant statement. Direct Labor systems have their place in every manufacturing environment. It is the application of a single burden rate for the entire operating environment that creates problem of inaccurate cost presentation.
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Bill Pratt

05/16/2012 06:46 PM
That's a great article and I've personally grappled with these issues for years. Fortunately I'm at a small company and have the latitude to cost products as he suggests - not because accounting wants to, but because I can personally ferret out all the nooks and crannies of cost and arrive at a semi-real model. We're more cost competitive and profitable because of it - but traditional ERP doesn't support it. Unfortunately this turns costing into an engineering task - accounting can't grasp the manufacturing complexity of each product. I've seen terrible business decisions made on the basis of blind accounting - but it certainly opens an competitive opportunity for the quick and nimble.
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