Where cost accounting goes wrong

The bridge doesn’t hold

In Part 1, product cost pointed the wrong way six times out of six. It wasn’t bad luck or a careless accountant. The error is built into the method. Let’s find it.

Allocated costs don’t behave the way the report assumes

Look at how an indirect cost really behaves as production volume changes, and how the cost report shows it:

Wages, salaries, rent and depreciation don’t change when you make one more unit or one fewer. But once you divide them by volume, the cost per unit falls as volume rises, and the report invites you to believe that making more lowers cost. It doesn’t: it spreads the same cost over more units. Three consequences follow:

• Allocated costs don’t vary in proportion to volume or to the product mix, so the report can’t tell you what a decision will change.
• The error was small when labour was paid by the piece and overheads were small. Today, labour is paid by the month and overheads are a big share of the total, so the error is large.
• Allocation hides the effect of a decision on profit. It doesn’t show which revenues and costs will actually change.

The fairness trap

Cost accounting tries to be fair: products that use more of the company’s resources should carry more of its cost. That rests on a hidden belief: the importance of anything in the organisation is proportional to what it costs.

• What if the expensive machines are non-constraints, with time to spare?
• What if a cheap machine, or one worker like B, is the constraint?
• What if there is no constraint on the shop floor at all, and the market is the limit?

In each case, the minute that costs the most on the report is not the minute that matters most for profit. The erroneous paradigm is that you can measure an area’s impact on profit by how much money it absorbs or frees.

The assumption behind every method

Absorption costing and activity-based costing differ in how they pick allocation bases. But both rest on the same necessary assumption:

It is possible, at least in the long term, to match capacity to demand. So any excess capacity should be cut until it matches demand.

If capacity really matched demand, every minute would be used and allocation would be harmless. TOC says this assumption fails in reality. Try it.

Balancing a line to disaster

A plant matches capacity to demand exactly: five stations in a row, each able to handle 3.5 units a day on average, which is exactly the demand. On paper, no waste at all. But real stations vary from day to day.

The balanced line misses its plan, and work piles up between the stations. Two effects combine: dependency (a station can’t process what hasn’t reached it) and variation (slow days happen everywhere). A slow day anywhere is lost for good; a fast day downstream can’t make it up if there’s nothing to work on.

Now add protective capacity: let the stations around the constraint work faster than it. The line makes its plan and work in progress falls. The “excess” capacity that the cost report wants removed is what makes the output possible.

Why capacity can’t be matched to demand

In most organisations, several things guarantee that many resources will always have spare capacity:

• Synchronisation between resources, a changing product mix and uncertainty are everyday reality. A stable service level needs significant spare capacity on most resources.
• The right amount of protective capacity isn’t known in advance, so more is kept than strictly needed.
• Demand changes faster than capacity can be bought or sold.
• Capacity comes in chunks: a whole machine, a whole person, a whole shift.

So excess capacity is normal, and the allocation rules make it look like waste.

Allocation and efficiency

Because allocation spreads cost over volume, it creates an illusion: if every machine is fully utilised, product cost comes down. So managers keep every resource busy. In reality:

• Plant output comes down, as non-constraints flood the floor with work the constraint can’t use and the wrong items get made first.
• Inventory goes up, and with it lead times.
• Quality and other inventory-related costs go up.

The local optimum the cost report promotes increases the company’s costs.

The conclusion

The wrong assumptions behind cost accounting make its estimate of a decision’s effect on profit wrong. It believes that a local impact equals the impact on the organisation. So:

1. Don’t use product cost to make decisions. Products don’t have costs beyond what truly varies with them.
2. Don’t allocate period costs to products.
3. Remember that labour isn’t paid by the piece any more, so it isn’t a variable cost.

What matters is not the cost of a product, but the impact a decision will have on the company’s profit. The rest of this course shows how to measure that.

Check your understanding

Answer all five. Get four right to complete the lesson.

1. The assumption behind every cost accounting method is that…

• Prices are set by cost
• Labour is the biggest cost
• Capacity can be matched to demand, at least in the long term
• Inventory is an asset

If it held, every minute would be used and allocation would be harmless.

2. Why does a perfectly balanced line fall short of its plan?

• Dependency plus variation: lost time on slow days can’t be recovered downstream
• Workers are lazy
• Demand is too high
• The plan was wrong

That’s why most resources need protective capacity.

3. Allocation makes managers believe that keeping every machine busy…

• Raises inventory
• Lowers product cost
• Hurts quality
• Lowers output

The illusion: more volume spreads the cost thinner. In reality output falls and inventory rises.

4. Which is a reason capacity can’t be matched to demand?

• Machines are always broken
• Accountants forbid it
• Demand never changes
• Capacity comes in chunks, and demand changes faster than capacity can be bought

Along with synchronisation, mix changes and uncertainty.

5. “Products don’t have costs” means…

• Products are free to make
• Material should be ignored
• Beyond truly variable cost, a product’s “cost” is an allocation that doesn’t change with the decision
• Only services have costs

Judge decisions by their impact on the whole company.