Do You Really Know Your Costs?

Manufacturing Engineering, Feb 2005 by Hogan, Brian J

Line managers sometimes take a dim view of the accounting department. In a previous job, in which I had no budgeting responsibility, I got to know the company comptroller. A droll sort, he came across to me as a good egg. But my boss, who did have budgeting responsibility, fantasized about taking a machete into the parking lot, meeting the comptroller, and hacking him to pieces while screaming: "Die, alien mutant!"

I've been reading a book entitled Relevance Lost, The Rise and Fall of Management Accounting (from Harvard Business School Press) that might explain some of the reasons why line managers and accounting guys tend to scuffle. It's not a new book (published in 1987), but it's darn interesting, and I believe the content remains valid.

The authors, H. Thomas Johnson and Robert S. Kaplan, point out that between 1880 and 1910 engineer-managers in metalworking firms developed procedures for determining product costs of importance to management. But after 1914 those procedures vanished from manufacturing accounting practice and writing.

The authors argue that today's consolidated financial reports obscure the real cost of making products. They can produce information that conflicts with a manager's intuition concerning efficiency on the floor, and may make the manager's job more difficult. Current accounting systems, among other a things, commonly use direct labor to allocate overhead costs to products. When overhead burden rates are high, small savings in direct labor translate into large impacts on cost distributions and product costs. Quote: "Managers soon discover that any process that requires relatively large amounts of direct labor seems very expensive. In fact, it usually becomes easy to find a supplier that can produce the labor-intense component or subassembly cheaper than the cost center can fabricate it." Problem: factory overhead isn't driven by direct labor hours, so outsourcing saves only a small fraction of the component/product cost.

The book uses an outdated vocabulary to describe lean manufacturing, referring to it as just-in-time (JIT) rather than lean. But the authors see lean as a solution to some of the problems facing manufacturing managers.

They suggest establishing three types of accounting systems in US businesses: one to satisfy financial reporting requirements; one to monitor process costs; and one to follow product costs.

Reading Relevance Lost causes me to pose this question: How much of the widely publicized manufacturing cost disadvantage of high-wage countries like the US relative to low-wage countries is due to real cost differences, and how much is an accounting artifact? If US companies don't really know their production costs, then management decisions to offshore/outsource production or strive to eliminate direct labor could be serious mistakes.

Brian J. Hogan, Editor