Cost Variability (#117)
/In this podcast episode, we address the extent to which various costs are actually variable. Key points made are noted below.
How Cost Variability Applies
Let’s say that you need the cost of a product in order to make a decision, like whether to accept a customer’s offer to buy the product at a certain price. This is a fairly routine question. The accounting staff goes to the bill of materials for the product, prints the page, and hands it over. They say you should use the total cost listed at the bottom of the bill of materials. Not so fast.
Costs can change under a lot of circumstances, and you have to know what those circumstances are in order to arrive at the correct cost. You may find that the product cost in the bill of materials is the wrong cost.
Let’s go through some of the scenarios.
The Direct Labor Scenario
The first item is direct labor. This is the labor cost of manufacturing the product. Now, the traditional view is that direct labor varies with production quantities. Actually, that’s not entirely true. The production manager has to have a certain number of people in the manufacturing area to staff all of the machines, so there’s a minimum number of people who have to be on hand in order to run the operation at all. It may be necessary to add direct labor staff as production volumes go above a certain level, but it tends to be in the form of step costs. That means the company adds a whole group of employees at once when it opens up an additional assembly line, or adds a new machine.
So, the point here is that the incremental cost of direct labor depends on not only the incremental volume involved in the decision, but also how much capacity is already being used. If you have an incremental decision to make about selling a few more units of a product, the incremental labor cost really could be zero, because the minimum staffing level is already on site, and there’s no need to add more people to produce the products. On the other hand, if any additional production means that you have to add a new shift, then the entire labor cost of that shift should be assigned to the extra units that you want to produce – and that could be an astronomical cost.
The Purchased Components Scenario
Cost variability is also an issue for purchased components. Suppliers sometimes package their products in sizes that are convenient for them to store and transport. That means they prefer you to buy in quantities of a dozen, or a hundred, and they offer a good price on a per-unit basis if you buy the quantities that they want you to buy.
But what if you just don’t need the quantity that they’re offering? Or what if your production schedule demands a really large quantity? Well, in the first case, the supplier will likely charge a higher price for an odd-lot purchase, and you may get a really low price in the second case. And the pricing difference between these two extremes could be massive.
But if the accounting staff just gives you the cost listed on the bill of materials, that states what the component usually costs, based on the company’s normal purchasing quantities. If you’re collecting information for a production quantity that’s not normal, then you’re dealing with incorrect cost information – again.
So in this case, there needs to be additional investigation into the quantities needed.
To summarize the situation so far, you have to recognize that a company’s existing product cost information is only valid within a very specific range that depends on the current level of production capacity that’s being used, and the incremental quantity of components that you need to purchase.
The Batch Size Scenario
Another issue with cost variability is the cost of a batch. For example, if there’s a lot of equipment retooling involved to manufacture something, then you need to consider the labor cost of the retooling, and the scrap that results from doing test runs on the equipment.
But at an incremental level, you can ignore most batch-related costs. The main reason is that the company is going to pay the wages of the people retooling the equipment, irrespective of whether a specific batch is run or not. Those people are a fixed cost, so for the purposes of deriving an incremental cost for a specific production run, you can ignore their cost.
But this is not the case for any scrap that’s created when they test equipment for the production run. Scrap is an incremental cost, and you should assign that cost to the product.
The Experience Curve Scenario
Another cost consideration when you’re looking at production volumes is the experience curve. This is the concept that your production cost declines by some percentage every time that your production volume doubles. This doesn’t apply to too many situations, since it only creates a major cost savings if you have a monster ramp-up in production. Still, it can be a consideration, and it may result in more cost variability.
The Need for Detailed Costing Investigations
All of this means that you can’t simply ask the accounting staff for a product cost. You need to give them more specifics about the situation for which you need the cost, and they have to conduct an investigation based on the information that you give them.
This also means that they can’t simply print out the bill of materials and call it the product cost. They really have to create a report that defines the exact parameters within which the costs apply. And for a major cost decision, it helps to compile a set of three costs, that apply to the most likely scenario, as well as to lower and higher production assumptions.
Cost Variability Based on Time
Now, so far, the discussion has centered around the incremental cost of a product. But you can also discuss cost variability based on time. The basic concept is that every single cost is completely variable over the long term. The cost of a 30-year lease is fixed for 30 years, but it’s variable if you add on one more day.
This is all quite obvious, but what a lot of people miss is that they don’t track the dates on which fixed costs become variable – and there’s usually a very specific date associated with each fixed cost. Instead, people just assume that those committed expenditures keep rolling on forever.
What you should do is create a table for every large fixed cost in the business that includes the cost and the earliest date on which you have the option to terminate or at least modify it – and then start incorporating that table into your planning process. And by doing that, you’ll find that cost variability applies to everything.
The Perception That a Cost is Fixed
And a final consideration is that some costs are fixed because you perceive them to be fixed, because that’s the way you’ve always treated them. For example, if there’s an advertising line item in the budget, or one for research & development, you may perceive it to be fixed, because that’s what you’ve always spent, and you believe it’s critical for maintaining the viability of the company over the long term.
Over the long term, you’re probably right. But on a very short-term basis, it’s entirely possible that some of these expenditures can be reduced or even eliminated, and they won’t really have much of a short-term impact on the business. If you keep not paying for these items a little longer, there could be a very serious impact on the company. But depending on the time period involved, you may be able to get away with not making these expenditures. So here you have a case of costs being variable simply by changing your mindset about them.
And on top of all these considerations, you can also look at cost variability from the perspective of throughput analysis, which I covered back in episodes 43 through 47.