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.