Why Cost Accounting is Wrong

By David Hallett

Do you make critical business decisions based on information provided by your cost accounting system? Use of traditional cost accounting methods will often lead to poor business decisions and will encourage behavior that is in conflict with lean manufacturing and other contemporary improvement methodologies.

A History of Cost Accounting

In the early 1900's, Cost Accounting, or Managerial Accounting, was developed to enable manufacturers to determine profits for individual products. This differed from Financial Accounting, which simply determined what the profits for the company as a whole were. Cost Accounting was developed to enable Managers to make good business decisions on questions regarding:

• Equipment purchases
• Product pricing
• Make versus buy
• Etc.

Traditional cost accounting systems assign direct labor and direct material costs associated with manufacturing a product to the product. All other costs, which are considered overhead, are allocated across all products manufactured. Overhead is typically allocated based on direct labor. As an example, if the overhead rate is 250% and $10 of direct labor is assigned to a product, then $25 of overhead ($10 x 250%) would be assigned to the product.

This scheme makes sense based on when it was developed. 100 years ago, labor was typically the largest cost at manufacturing companies. The following table shows the typical ranking of cost components then and now.

Cost Component	1909	2009
Direct Labor	1	3
Direct materials	2	2
Overhead	3	1

Notice that this system has evolved from allocating our smallest cost across our largest to where we now allocate our largest cost across our smallest. Do you think this may create some distortions?

The Problem with Cost Accounting

Henry Ford famously said:

"One of the most noteworthy accomplishments in keeping the price of Ford products low is the gradual shortening of the production cycle. The longer an article is in the process of manufacture and the more it is moved about, the greater is its ultimate cost."

Essentially, what Henry Ford was saying is that the longer the lead-time, the greater the cost, which provides the following formula:

Lead-Time = Cost

This formula is the essence of Lean Manufacturing, which is focused on the elimination of non-value added activities. Typically, 95%+ of a product's lead-time is non-value-added time. Therefore, if we focus on lead-time reduction, we will inherently reduce non-value-added time and become "leaner".

In Traditional Cost Accounting, the only time a Job accumulates cost is during the actual step where labor or materials are applied to the product. This is typically a value-added step and accounts for less than 5% of the total lead-time. The time between steps, where the product is not having value added to it, are considered "free" by this Cost Account-ing system.

A graph of cumulative product cost throughout the lead-time to complete the product looks like this.

However, applying Henry Ford's philosophy of LT=Cost yields a graph that looks like this.

The Traditional Cost Accounting system tends to focus decisions and improvement initiatives at direct labor reduction. According to the first graph, this is the only direct way to reduce costs. As an example, if we buy a new tool that saves one hour of labor per week, how much have we saved? The "loaded labor rate" at most companies, which includes labor and all allocated overhead, is often in the $100 per hour range. The traditional approach will indicate that our one hour of labor savings per week will result in a savings of $100 (our loaded labor rate). Is this correct? Did any of the major components of overhead, such as buildings, equipment, utilities, indirect labor salaries, etc, go down as a result of this improvement? At best, the real savings is equal to our direct labor rate (maybe $15). However, unless the change resulted in an actual reduction in payroll, there are no savings at all (this often ends up being the case).

Alternatives to Cost Accounting

All costing tools and systems are at least somewhat flawed. With that said, several alternatives exist that are less flawed than traditional cost accounting. Some of the best include:

• Top down throughput decision making tools
• Lean cost accounting operating statements

If you would like to learn more about these contemporary approaches, contact David Hallett or Jack McGowan at Insyte Consulting at 716.636.3626.

David Hallett is an Insyte consultant with over 22 years of progressive management experience in a diverse range of industries and positions.