Established contract manufacturer of implant and instruments, serving the joint replacement and spinal surgery industries, seeks additional sales support in Memphis, TN and Warsaw, IN.
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To answer his question, Dynamo compared the hourly cost that would be determined by his method and accounting's method for two additional scenarios: one where a low-skilled worker would spend one-half of his time tending a large machine vs. one where a high-skilled worker would tend a small machine. The results appear as Scenarios C and D in Exhibit 3. A half hour of low-skilled labor operating a large machine would result in a $28.56 hourly rate under the current method, while that same situation would result in a $92 per hour rate under his—a 222 percent difference. A half hour of highly-skilled labor operating a small machine would result in an hourly cost of $38.08, while his method would measure that cost a $45 per hour—an 18 percent difference that seems small compared to the 222 percent difference, but one that could still mislead a decision maker.
Not one to jump to conclusions, Dynamo tried two more situations: one in which a two-man crew comprising a high-skill and a low-skill worker operate a small machine, and one where a high-skill worker operates a large machine (Scenarios E and F in Exhibit 3). The costs came out 37 percent lower and 44 percent higher, respectively, using his method. Dynamo knew he had a problem.
When he presented the results of his analysis to his Controller, Myopia responded, "Yeah, but your method is a lot more complicated and the auditors have already accepted the percentage of direct labor method." (Apparently, the finance department believes that the purpose of cost information is to make their job easy, not to help the company become more profitable.)
Bottom Line Impact
The value of accurate and relevant information has never been greater than in today's ultracompetitive, worldwide marketplace. The financial success of an organization is dependent upon the quality of the decisions made by its managers, and the quality of those decisions is dependent upon the quality of the information given to them as support. Although cost information as inaccurate as that generated by DMMD's accountants will negatively impact all sorts of decisions—from capital spending to vendor selection and from outsourcing to process improvement—I will focus here on one decision category: core business pricing.
The quotations that initially brought the issue to Dynamo's attention indicated that the manufacturing cost of the smaller product was $76.16 per hour and the larger one $152.32 per hour. Dynamo's more reasoned measures were $90 and $120. Undercosting the smaller product can lead the company into believing that it will make money at a price that doesn't, in reality, cover its costs. On the other hand, overcosting the larger product misleads the company into believing a very high price—probably one the market will not accept—is required to sell the job at a profit. Winning contracts at a price that won't cover all the company's costs while losing out on potentially profitable contracts whose costs were overstated by a dysfunctional costing model, is not a formula for financial success.
A manufacturer who fails to segregate those indirect and support costs driven by the operation of equipment* from those driven by the work of individuals will seldom arrive at product or process costs that reflect economic reality. Although it may not remedy all of a manufacturer's costing issues, accurately linking costs to both the work of production workers and the operation of equipment and then assigning those costs to jobs, products or contracts based on separate labor and machine (or equipment/cell/line) rates will eliminate one of the most damaging features of a direct labor-based costing model.
*The concept is the same with regard to cells and lines; a cost per hour for operating the cell's or line's equipment separated from the cost of individuals working in the cell or on the line.
D.T. Hicks & Co.