Nature Of Manufacturing Expenses
The indirect manufacturing expenses or overhead costs of a manufacturing operation have increased significantly as business has become more complex, and the utilization of more sophisticated machinery and equipment is more prevalent. As the investment in computer controlled machinery has increased, improving productivity and reducing direct labor hours, the control of depreciation expense, power costs, machinery repairs and maintenance, and similar items has received a greater emphasis by management.
Manufacturing
overhead has several distinguishing characteristics as compared with the direct
manufacturing costs of material and labor. It includes a wide variety of expenses,
such as depreciation, property taxes, insurance, fringe benefit costs, indirect
labor, supplies, power and other utilities, clerical costs, maintenance and
repairs, and other costs that cannot be directly identified to a product,
process, or job. These types of costs behave differently from direct costs, as
the volume of production varies. Some will fluctuate proportionately as
production increases or decreases, and some will remain constant or fixed and
will not be sensitive to the change in the number of units produced. Some costs
are semi variable and for a particular volume level are fixed; however, they
may vary with volume but less proportionately and probably can be segregated
into their fixed and variable components.
The control of overhead costs rests with many individuals involved in the manufacturing process. Certain costs such as repairs and maintenance are controlled by the head of the maintenance department. Manufacturing supplies may be controlled by each department head who uses the supplies in carrying out his function. Other costs may be decided by management and assigned to a particular manager for control for example, depreciation, taxes, insurance. Accounting planning and control of manufacturing indirect expenses is diverse and a challenging opportunity for the controller.
Responsibility For Planning And Control Of Manufaturing Expenses
Responsibility for the planning and control of manufacturing expenses is clearly that of the manufacturing or production executive. However, this executive will be working through a financial information system largely designed by the chief accounting official or his staff although there should be full participation by the production staff on many aspects of the system development
In
formulating the expense account structure under which expenses will be planned
and actual expenses matched against the budget or other standards, the
controller should heed these common sense suggestions to make the reports more
useful to the manufacturing executive :
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The budget (or other standard) should be based on technical data that are sound from a manufacturing viewpoint Among other things, this will call for cooperation with the industrial engineers or process engineers who will supply the technical data required in developing the budget and or standards. As manufacturing processes change, the standards must change. Adoption of just in time (JIT) techniques may require, for example, a different alignment of cost centers. Further, with the increased use of robots or other types of mechanization, direct labor will play a less important role, while manufacturing expense (through higher depreciation charges, perhaps more indirect labor, higher repairs and maintenance, and power) will become relatively more significant. |
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The manufacturing department supervisors, who will do the actual planning and control of expenses, must be given the opportunity to fully understand the system, including the manner in which the budget expense structure is developed, and to generally concur in the fairness of the system. |
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The
account classifications must be practical, the cost departments should follow
the manufacturing organization structure (responsibility accounting and
reporting), and the allocation methods must permit the proper valuation of
inventories (usually under general accepted accounting principles), as well
as proper control of expense. |
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The
manufacturing costs must be allocated as accurately as possible, so the
manufacturing executive can determine the expense of various products and
processes. This topic is covered in
more detail later in this chapter, under activity based costing. |
Also,
industrial engineers will provide the technical data required for the
development of standards, such as manpower needs, power requirements, expected
downtime, and maintenance requirements. Finally, if an activity-based costing
(ABC) system is in place, then the manufacturing executive should work with the
controller to develop information collection procedures for resource drivers.
Appoach In Control Of Manufacturing Expenses
The diverse types of expenses in overhead and the divided responsibility may contribute to the incurrence of excessive costs. Furthermore, the fact that many cost elements seem to be quite small and insignificant in terms of consumption or cost per unit often encourages neglect of proper control. For example, it is natural to increase clerical help as required when volume increases to higher levels, but there is a reluctance and usually a delay from a timing viewpoint in eliminating such help when no longer needed. The reduced requirement must be forecasted and anticipated and appropriate actions taken in a timely manner. There are numerous expenses of small unit-cost items that may be insignificant but in the aggregate can make the company less competitive. Some examples are excessive labor hours for maintenance, use of special forms or supplies when standard items would be sufficient, personal use of supplies, and indiscriminate use of communication and reproduction facilities All types of overhead expenses must be evaluated and controls established to achieve cost reduction wherever possible.
Although these factors may complicate somewhat the control of manufacturing overhead, the basic approach to this control is fundamentally the same as that applying to direct costs : the setting of budgets or standards, the measurement of actual performance against these standards, and the taking of corrective action when those responsible for meeting budgets or standards repeatedly fail to reach the goal. Standards may change at different volume Levels ; or stated in other terms, they must have sufficient flexibility to adjust to the level of operations under which the supervisor is working. To this extent the setting and application of overhead standards may differ from the procedure used in the control of direct material and direct labor. The degree of refinement and extent of application will vary with the cost involved. The controller should make every attempt to apply fair and meaningful standards, not thinking that little is needed or that nothing can be accomplished.
Also,
the controller can use ABC to assign costs to products (or other entities, such
as production departments or customers). This approach is better than the
traditional method of assigning a uniform overhead rate to all production,
since it assigns overhead costs to specific products based on their use of
various activities, resulting in more accurate product costs.
Proper Departementalization Of Expenses
One of the most essential requirements for either adequate cost control or accurate cost determination is the proper classification of accounts. Control must be exercised at the source, and since costs are controlled by individuals, the primary classification of accounts must be by individual responsibility“responsibility accounting.” This generally requires a breakdown of expenses by factory departments that may be either productive departments or service departments, such as maintenance, power, or tool crib. Sometimes, however, it becomes necessary to divide the expense classification more finely to secure a proper control or costing of products to determine actual expenses and expense standards by cost center. This decision about the degree of refinement will depend largely on whether improved product costs result or whether better expense control can be achieved.
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A cost center, which is ordinarily the most minute division of costs, is determined on one of the following bases : |
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One
or more similar or identical machines |
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The performance of a single operation or group of similar or related operations in the manufacturing process |
The separation of operations or functions is essential because a foreman may have more than one type of machine or operation in his department all of which affect costs. One product may require the use of expensive machinery in a department, and another may need only some simple hand operations. The segregation by cost center will reveal this cost difference. Different overhead rates are needed to reflect differences in services or machines required.
If
the controller chooses to install an ABC system, a very different kind of cost
breakdown will be required. The ABC method collects costs by activities, rather
than by department for example, information might be collected about the costs
associated with engineering change orders, rather than the cost of the entire engineering
department. If management decides that it wants both ABC and departmental cost
information, then the controller must record the information twice once by
department and again by activity.
Variations In Cost Based On Fixed And Variable Costs
One factor that can cause costs to vary is that they contain both variable and fixed elements. The cost of most products is itemized in a bill of materials (BOM) that itemizes all the components that are assembled into it. An example of a bill of materials for a desk light is shown in Exhibit 5.1. Each of the line items in this BOM are variable costs, for each one will be incurred only if a desk light is created that is, the costs vary directly with unit volume.
In its current format, the BOM is very simple; we see a quantity for each component, a cost per component, and a total cost for each component that is derived by multiplying the number of units by the cost per unit. The only line item in this BOM that does not include a cost per unit or number of units is the overhead cost, which is situated near the bottom. This line item represents a variety of costs that are being allocated to each desk lamp produced. The costs included in this line item represent the fixed costs associated with lamp production. For example, there may be a legal cost associated with a patent that covers some feature of the desk lamp, the cost of a production supervisor who runs the desk lamp assembly line, a buyer who purchases components, the depreciation on any equipment used in the production process the list of possible costs is lengthy. The key factor that brings together these fixed costs is that they are associated with the production of desk lamps, but they do not vary directly with the production of each incremental lamp. For example, if one more desk lamp is produced, there will be no corresponding increase in the legal fees needed to apply for or protect the patent that applies to the lamp.
This splitting of costs between variable and fixed costs can occupy the extremes of entirely fixed costs or entirely variable ones, with the most likely case being a mix of the two. For example, a software company that downloads its products over the Internet has entirely fixed costs; it incurs substantial costs to develop the software and set up a web site for downloading purposes, but then incurs zero costs when a customer downloads the software from the web site (though even in this case, there will be a small credit card processing fee charged on each transaction). Alternatively, a custom programming company will charge customers directly for every hour of time its programmers spend on software development, so that all programming costs are variable (though any administrative costs still will be fixed). To use a variation on the software example, a software developer that sells its products by storing the information on CDs or diskettes, printing instruction manuals, and mailing the resulting packages to customers will incur variable costs associated with the mailed packages, and fixed costs associated with the initial software development. All three variations on the variable-fixed cost mix are shown in Exhibit 5.2. In the exhibit, the first graph shows a straight horizontal line, indicating that there is no incremental cost associated with each additional unit sold. The second graph shows a steeply sloped line that begins at the X-Y intercept, which indicates that all costs are incurred as the result of incremental unit increases in sales. Finally, the third graph shows the sloped line beginning partway up the left side of the graph, which indicates that some (fixed) costs will be incurred even if no sales occur.
To return to the BOM listed earlier in Exhibit 5.1, the format does a good job of itemizing the variable costs associated with the desk lamp, but a poor one of describing the fixed costs associated with the product; there is only a single line item for $ 6.20 that does not indicate what costs are included in the overhead charge, nor how it was calculated. In most cases, the number was derived by summarizing all overhead into a single massive overhead cost pool for the entire production facility, which is then allocated out to the various products based on the proportion of direct labor that was charged to each product. However, many of the costs in the overhead pool may not be related in any way to the production of desk lamps, nor may the use of direct labor hours be an appropriate way in which to allocate the fixed costs. This is a key area in which the costing information provided by controllers can result in incorrect management decisions of various kinds. For example, if the purpose of a costing inquiry by management is to add a standard margin to a cost and use the result as a product’s new price, then the addition of a fixed cost that includes nonrelevant costs will result in a price that is too high. Similarly, using the same information but without any fixed cost may result in a price that is too low to ever cover all related fixed costs unless enormous sales volumes can be achieved. One of the best ways to avoid this problem with the proper reporting of fixed costs is to split the variable and fixed cost portions of a product’s cost into two separate pieces, and then report them as two separate line items to the person requesting the information. The variable cost element is reported as the cost per unit, while the fixed cost element is reported as the entire fixed cost pool, as well as the assumed number of units over which the cost pool is being spread. To use the desk lamp example, the report could look like this: In response to your inquiry regarding the cost of a desk lamp, the variable cost per unit is $ 32.20, and the fixed cost is $ 6.20. The fixed cost pool upon which the fixed cost per unit is based is $ 186,000, and is divided by an assumed annual sales volume of 30,000 desk lamps to arrive at the fixed cost of $ 6.20 per unit. I would be happy to assist you in discussing this information further. We do not know the precise use to which our costing information will be put by the person requesting the preceding information, so we are giving her the key details regarding the fixed and variable cost elements of the desk lamp, from which she can make better decisions than would be the case if she received only the total cost of the desk lamp. This approach yields better management information, but, as we will see in the following sections, there are many other issues that can also impact a product’s cost and that a controller should be aware of before issuing costing information to the rest of the organization.
