Understanding True Costs: What You Risk Missing


Many manufacturing companies use absorption costing methodologies that simply add up all costs and divide by the number of hours worked in a given year. This equation typically yields an average cost per hour for each department, or a blanket cost per hour (i.e. everything in the shop costs $120 per hour). This approach is quite easy to calculate and it provides a safe way to make sure all costs are ‘covered’ in terms of determining costing rates. While there is a lot to be said for simplicity, this approach is fraught with dangers that can have serious negative business implications…

Absorption costing makes a lot of assumptions, which are simply not true when it comes to how much any given activity really costs to perform. What gets lost in the lump-sum absorption equation are universal business truths, such as:

  • Activities that have larger footprints cost more in terms of building occupancy expenses.
  • Activities that require more maintenance or tech support often cost much more to perform.
  • Activities that consume larger amounts of electricity, water or gas cost more to operate.
  • Activities with equipment of varying age have varying depreciation costs.
  • When a process is running (and you are charging enough), you are making money; When a process stops running, it is costing you money. Dividing costs by payroll hours is quite different than dividing by actual machine running hours.
  • When a company writes a check to buy material there is an overhead rate associated with buying the material, bringing it to the workplace, moving it through the process and shipping it out (i.e. $1.00 of material really costs $1.15). Not adequately marking up material costs often leads to losses, especially on high volume jobs.
These are just a few examples of how absorption costing can lead to bad business decisions. The choice to use top-down general ledger data is tempting because you already have to keep score in order to pay your taxes. If simplicity is the goal, then using general ledger information to run the business seems like a safe, easy bet. If informed business decisions and profitability are desired, measuring activities from a sideways, or activity-based perspective often changes the way companies look at themselves and the way that they do business.

Categories: Finance