Sometimes It Is NOT OK to be wrong OR confused!

Posted on May 28, 2012 by

I had the pleasure of reading Gary Cokin’s blog post last week and simply could not stop thinking about his closing.   “So which is worse? Being wrong or being confused? They are both bad with adverse consequences. Why not be smarter and safer at the same time?”

This vocabulary accurately describes my conversations with clients on a daily basis.  Looking at these words in an abstract form, not applying it to any particular situation, it seems totally logical that one would agree on any level.  It always makes sense to have the right information (from a documented source) and applying that knowledge to the current situation (lack of confusion).  Take my kids for example.  I struggle every day with this very same concept.

No less than every day each one of the four comes home and tells me stories about his or her day.  Last week my oldest was convinced that when she started her freshman year of high school in the fall that they were changing EVERYTHING just for her class.  Translated:  freshman would be isolated from the rest of the school and she would have to repeat courses her freshman year that she has taken in honors 8th grade.  Needless to say, her information was not from a documented source but instead from her friends who had heard it from other friends who had incorrectly communicated what the teacher was overheard saying. Obviously she was angry and frustrated about the information she was receiving.  It took me a series of phone calls and eventually speaking with high school principal to ascertain the facts. Ultimately this led to a very long and painful conversation with her about  the truth which cleared up the confusion.  It is kind of like the telephone game, but on a much different playing field.

Let’s extrapolate this small gossip chain in eighth grade to a manufacturing organization.  The people in accounting are trying to determine what production is doing, and not just ONE individual or process on the shop floor, but a whole host of different disciplines, machines, processes, products, and personalities.    On the accounting end,  try figuring out the telephone game in numbers when it reaches your desk WITHOUT the right information to begin with.  Let me give you a clue:  it will NEVER happen, and if it does, it was nothing short of a coincidence, an accident, or complete one-time anomaly.

What I mean by this is that many Companies are still way behind the eight ball in gathering the correct data; much like this client was when we met.  Much like many clients when we first meet!  In addition, often they think they are gathering the right data, only to find out after a precursory review that all of their spreadsheets and assumptions are not logical.  It really does not take long to look at a series of excel spreadsheets, linked or not linked together, to see where they have started a new thought or concept related to their costing technique. It bears absolutely no relationship to all of the calculations they have been doing OR numbers have been carried over that are incorrect.  Unfortunately, I spent my morning identifying those discrepancies for a new client.

I will echo Gary’s words in a different light in my closing.  With all of the emphasis on costing and management accounting recently, it is simply not acceptable to use the excuse of being confused OR wrong.    Every single business owner or Controller that I have talked with regarding a costing problem KNOWS that there costing system is inadequate (wrong) and has for some period of time chosen not to make change.  If you are WRONG or CONFUSED about the results you are getting, the time has come in the words of Gary, “to be smarter and safer at the same time.”

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What’s Controlling Your Process?

Posted on May 24, 2012 by

One of our recent cost assignments involved us reviewing overhead allocations and other components of a cost system to see if we could identify any recommendations relative to improvements in the overall process. The particular company we visited made a variety of parts generally on presses that are highly automated and automatically loaded and unloaded.

As we toured the manufacturing operation, the management team was quick to point out that they had made discretionary cuts on some of what would otherwise be considered overhead.  As part of this process, they discovered accurate ways of assigning costs such as shop supplies and die maintenance directly to the jobs that were using those resources.  In effect, they had converted what would be a general indirect overhead to a very specific direct cost associated with that job.  Such efforts are highly beneficial to actual job costing because instead of making arbitrary allocations, they assign specific costs for more accurate identification. However, as we toured the plant and subsequently met with the client, we learned that the accuracy that they had achieved for identifying direct costs to a job was not duplicated in those indirect costs that had to be allocated.  In fact, one of the standards of apportioning overhead, which the company was still using, revolved around using direct labor cost to specifically identify overhead to a job.  In an environment such as we saw, it seemed to us that other allocation bases would be more appropriate.  I suspect the method is a direct result of having done the same thing for many years, or perhaps decades with little attempt to rethink how it might be done.

Shortly after high school one of my first jobs was as a press operator in a pressroom. In my personal experience, this pressroom was totally labor driven. I loaded the press, I manually activated the press and then I unloaded the press manually. The press could not make a part without my assistance because every step of the operation was controlled by me. That was the case for every other press in that pressroom. Each press was assigned one operator and that press could not work without that operator. For that company and those operations, direct labor was a very appropriate allocation base.

However, in this company’s highly automated manufacturing environment, those kinds of operations are rare.  In many cases, labor controlled operations represent a very small secondary part of most manufacturing operations today. As times change, cost accounting methods and thought processes need to change accordingly.

On March 9, 2011 I wrote a blog post titled “It’s Easy to Get This Wrong”.  In that post I mentioned several guidelines for determining what allocation base might be the most appropriate as cost managers are considering how to structure or restructure the cost systems they’re working with.  I suggest if you are thinking about restructuring your cost system, that you review that blog post because there are a number of very specific suggestions that you might find helpful.

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Is your capacity just right?

Posted on May 21, 2012 by

When determining your budget for overhead allocation you often hear: “assume reasonable capacity.” Well, what is reasonable capacity?  I think we all know what full capacity is or over capacity right?  When you go to your favorite restaurant and the hostess tells you it will be an hour wait, you understand that restaurant is at over capacity.  And contrary to that, when you are seated right away the restaurant is under capacity.  Well, if I haven’t lost you to being hungry and wanting a snack now, how do you determine capacity for your manufacturing environment?

Ideal or maximum capacity is when you can produce the largest volume of output possible.  This of course requires continuous operation and no losses of any kind, including those that would be considered normal or unavoidable.  I do not know about you, but from my experience, the real word hardly ever follows a text book term.  If you use ideal capacity as your capacity level in your budget you will always have an unfavorable variance as that capacity is impossible.  Of course if you try to run at maximum capacity it may be a recipe for disaster.  Although in the short-run you may have more to spread your costs over, in the long-run you may have machine shut-downs and periods of no utilization.  If you do not allow for down time for routine machine maintenance your machines will eventually fail.  Also, it is important to give employees reasonable breaks or they too will wear down and possibly become ill from the pressure and may eventually quit.

Opposite of this is low capacity.  The way most financial minds think, I would not suspect anyone would plan to run at low capacity.  Low capacity is normally a by-product of some other issues.  Some causes could be a major machine is not working properly, seasonality, competitor taking over market share, etc.  Unless there is a long-term reason you expect to be running at low-capacity, this would not be reasonable to use in a budget, but would be an explainable variance from a reasonable capacity budget. Plus if there is a long-term reason, there will be many other concerns and issues to deal with-like staying in business.

Not to get too childish here, but this is starting to flow like a Goldie Locks and the three bears story.  The ideal capacity is too much, the low capacity is too little, and reasonable capacity is just right!  In all seriousness though, we do work in the real world.  Reasonable capacity assumes around an 80% possibly up to 90% capacity.  This allows for the routine machine maintenance, employee breaks, and other reasonable issues.  In my opinion 80% is the most reasonable and conservative approach to take and that is what I would recommend using when determining the budget for overhead allocation.  There may still be some variances in your overhead, but they should be explainable.  For example, had to bump up capacity for a big project that had to be done, or the other direction a machine was down for an unplanned repair.

Be realistic when determining where your reasonable capacity lies, or you will constantly have variances that have to be explained.  A good budget is realistic and allows for reasonable explanations when variances do occur. So take Goldie Locks’ advice and make sure it is just right!

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Out-Of-Date Costing Systems: Don’t You Want to Get Better?

Posted on May 17, 2012 by

Our most recent cost assignment involved a meeting with a client that had a very large manufacturing operation. During the first hour of the discussion, we learned that they were very sophisticated in their manufacturing processes and were state-of-the-art in many of the operations they are doing on the shop floor (as far as efficiency and manufacturing processes). Productivity was at the highest levels it has ever been in the history of the company and the entire manufacturing team was focused on continuous improvement.

However, we also learned that their entire cost system was woefully out-of-date and nowhere near complete.  The system could not provide information or management direction on any part of the manufacturing process. What started this conversation was the external accountant who was having difficulty ascertaining if inventory was correctly valued as a result of the incomplete system the company has been using to value the inventory. That led to a more thorough discussion about how costing was being done at the operation, and ultimately led to the meeting that included myself and Jennifer Kinzel who discussed improvements in the overall costing system. Later in the day we got a chance to visit one of the locations of the manufacturing operation and were impressed by the sophistication of the manufacturing processes and how well they had done in keeping their operations at the cutting edge of technology. With this fact pattern, it would be a logical conclusion that a management team that was so focused on efficiencies, utilizations, and productivity would be equally as demanding on their cost systems. However, in this case they were not! It is not surprising to us that such lack of sophistication in their costing systems is present.

I am consistently amazed when we talk to participants of our cost forum about how out-of-date or unsophisticated many of the cost systems are in today’s manufacturing world. Companies of all sizes, from the very largest to the very smallest, are dealing with cost issues that could be fairly simply solved.  However, these problems are often left to intensify over a number of years, in some cases decades, in spite of readily available solutions and advancements in the technology that are available in today’s manufacturing arena.

The real question is, why do the best manufacturing managers in the world allow their operations to languish with less than state-of-the-art cost systems while focusing almost exclusively on the manufacturing operation? The answers to this question are varied and not nearly as clear to me as I would like them to be. I believe that companies take a look at their cost systems with one or more possible points of view. The first is, we have survived without it thus far and we are still profitable, so why do I need to spend more time and money on a system when everything seems to be going just fine. Another possible alternative is, “we don’t know what to do to fix it.” Yes, we recognize there are problems. However, there are no immediate repercussions to those problems. Well at least nothing obvious – so let’s just leave that problem unattended and focus on other things where we know what benefits can be derived by investing our time and money. A further possible answer is, “if we try to change what we already have, we may create even more problems.” There are likely other possibilities why cost systems are allowed to suffer unimproved for long periods of time, but those I have listed seem to be common themes that we have heard over and over again.

The entire process amazes me because many consultants I have spoken with lately seem to be more and more focused on cost accounting solutions that don’t necessarily involve a change to some major new software, or cost accounting theory solution. I’ve even heard some consultants argue that as a result of diversifying needs for cost accounting information, there is no one solution that fixes all problems; rather a working knowledge of the existing systems that allow them to be tweaked in ways that make them valuable to the manufacturing team. From my experience and expertise, I believe this to be very accurate.

Circulating amongst cost accounting consultants are a long list of stories of how their expertise has made a huge impact in their clients operations. Stories about changing cost systems that has saved companies, improved profitability, secured jobs, and improved a companies’ position in its market. Why is it that those kinds of successes don’t provide the foundation to lead companies to make the kind of changes that are necessary to achieve dramatically improved results?

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The Definition of Success

Posted on May 14, 2012 by

I recently received a phone call from a client who was a past attendee of one of our cost forums.  When he attended, he was not a client!   When he left the forum he was adamant that his company had no cost structure in place and he was not even sure where to begin.  Of course, that’s where we came in.  The Company has now hired a cost analyst and with her help has upgraded the existing software and implemented the costing component of the ERP system.  The process is moving forward.

To get to the point, the subject matter of the phone call was no longer simply “how do I cost my product,” but  instead , “how do I measure my performance?”

Whether or not the client recognizes it, but this is a clear definition of SUCCESS on the costing journey.  One year ago today, the Company had nothing.  No way to measure anything and really no way to even consider measuring performance.  In fact, one of the first questions we tackled was trying to identify the direct costs for one specific product and that was really a difficult task given the lack of systems and information in place.  Now they are collecting voluminous amounts of data, but need some direction on how to apply and analyze it.

I shared with the Controller some findings from a 2012 report issued by Deloitte & Touché related to analytics for manufacturers.  The Controller’s concern was measuring profitability for significantly differing volume levels and extremely volatile per unit costs due to the materials being consumed.   After a long conversation, I concluded that there was a great deal of background (analytical) work yet to be done.   For one product in particular, no matter what the cost was (it could range from $5 per case to $25 per case) the markup was always $1.  You can imagine how the gross profit margin appeared on the monthly statements – very erratic.  $1 profit on $5 is significantly different than on $25.  Our conversation led to why it had always been $1, and if that was truly part of the plan for management’s targeted ROI.  These questions led to silence (profound thought on his end!) and an answer I am all too familiar with, “that is just what the sales people have always sold it at – $1 per case and management does not understand the monthly reports!”

I advised him to start with the end in mind.  What is that ROI that management is targeting overall?  By product? By any other segment?  That is where he needed to start, and work backwards.  In addition, the salespeople (who, by the way, are each selling based on their own ideas – sound familiar?) need to be part of this process.  It is a team effort! They need to ASK THE RIGHT QUESTIONS – exactly as the Deloitte report indicates.  If you don’t know what you are trying to achieve, how will you ever get there?  I believe based on my experience with him that the ball is already rolling in this direction, and the questions are being formulated so that he can start applying the data to obtain relevant and accurate answers.

By any definition, this is success!  The Company is able to identify its costs and the next step is to use the data that they are capturing to start analyzing the information and using it to make change!

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ABC is really outdated anyway-right?

Posted on May 10, 2012 by

A couple years ago, Bill, Jennifer, and myself became acquainted with Doug Hicks.  Doug is a consultant who often talks about Activity Based Costing (ABC).  Bill decided to ruffle Doug’s feathers a bit and one of the early questions he asked him when we first met was-ABC is really outdated anyway-right?  Doug of course chuckled at this and he answered ABC really just determines what driver should be used based on what is using it the most, and there really is some truth to that.  In my opinion a full-blown ABC costing system is somewhat outdated, in that it is more of a cookie cutter approach.  ABC was popular in the early 90’s but has since lost ground because often times there are so many drivers assigned it is too complex to maintain.  We have seen systems with seventy-five plus drivers-that is next to impossible to keep up with! 

There is some truth; however, if you think about determining drivers when setting up a standard cost system some of the principles of activity based costing can be beneficial.  It is important to select the correct driver when determining the allocation base for overhead or the allocations may not be accurate.  Of course flawed information from the onset will produce flawed information on the outset.  Accountants often say garbage in, garbage out!  So why not determine the most accurate driver possible and have the most accurate information possible-do not just guess when you do not have to.   

Is your driver the correct driver to use?  Do you review your standards annually and verify the driver is still accurate and the allocation is correct?  Analyze your individual situation and ask yourself am I using the right driver? Is this what is used the most? Or am I just blindly doing what I have always done?

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Applying Standards: Can You Really Use This?

Posted on May 9, 2012 by

I was reading a book concerning applications of standard costs in a variety of different manufacturing environments and one part of the book was devoted to determining at what point in the process of manufactured goods does one apply the standards. The author had concluded that there were two logical points in the process at which standard cost could be applied.

The first possible point was at the very beginning of the process when raw materials are purchased, or when labor is expended converting raw material into a finished product.  This author also suggested that the early stages of conversion from raw material to a finished good could be done at actual, with the standards not being applied until the manufacturing process had ended and the goods entered the finished goods inventory. It appears that the theory is once all costs are expended and you are left with an item of inventory, the applications of the standards are used from that point forward to monitor the inventory and determine cost of sales.

I have never seen a current day manufacturer actually use this method.  In virtually every system I am familiar with, the application standards begins at the first step of the manufacturing process.  In fact this author was clear to point out that that was the preferred method.  By beginning with the application of standards at the start of the process, you are then able to capture any variance of standard at every step of the manufacturing process until the end regardless of how many steps there might be.  Furthermore, you have tools available by analyzing these variances to determine what steps need to be taken in the manufacturing process to correct inefficiencies.  Additionally, if you would like to present your financial statements with standard costs reconciled to actual cost, you now have sufficient details to do so with adequate background information to allow a proper presentation.

The author was quick to point out that if you use the second method, any variances created as part of the manufacturing process will now be all lumped together in one giant variance when you converted the actuals incurred to the standard cost. The ability to analyze those variances and take corrective action would be extremely difficult, if not impossible.  Along those lines, any work-in-process inventories created during the manufacturing process would have to be valued at actual cost, which could result in radically fluctuating inventory cost for the same item at a different period in time.

Having thought about this for some time after reading this article, it would seem unlikely to me that a modern-day manufacturer, with its sometimes elongated processes and more complex cost structure, would find it very easy to manage using a system that only applied standards at the end of a production run.  However, if you were producing a product that had a very short and simple production period  and perhaps a limited time in inventory after the production period was over, then the application of standards at the end might prove to be a simplified method of control.  I cannot think of a process that I have seen where this might work. However, there is a likelihood that some process exists where this might meet a need.  It is important whatever method you are using is what is necessary for your particular process.

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Communication-is it really that important?

Posted on May 3, 2012 by

When I was a child and my brother and I would argue our mom would often say if you cannot say something nice do not say anything at all.  Of course we are all grown up now and do not too often say hurtful things to each other, but I think that still stands true somewhat today.  I’m not suggesting constructive criticism is not necessary for improvement, but the notion of putting someone down or saying something cruel is not motivating.  Effective communication does not always mean you have to be the one talking, but a recent article in the CGMA magazine Survey highlights most common mistakes managers make with employees  says that managers need to say something and say something nice.  So see I guess my mom did know what she was talking about-don’t tell her I said that!

According to this article though 40% of CFOs say the biggest mistake companies make managing their employees is lack of communication.  Following closely, 28% said that lack of recognition and praise was the next most common mistake-which also is a form of a communication error.  All companies large and small have communication problems. What makes companies stand apart is how they deal with those communication issues.  Ignoring them and hoping they will go away does not work, all that does is invite great employees to go away.  They will stop communicating with you as they do not feel they are being heard, and if they do not leave they will stop participating as they feel their opinion is not important-no one ever listens anyway!  I am not suggesting you constantly have to pat your employees on the back, but praising an employee in a way that is exciting for them can be an important factor in your success.  Happy employees often are better performing and more dedicated.  It is important though that you speak their language when you are rewarding them.  One employee may like outward recognition while another may like a quiet-hey you did a great job-make sure your communication is effective.

Re-evaluate your communication and make sure you are empowering your employees to talk to you when they have an issue and that you are encouraging behavior you want and effectively discouraging unwanted behavior.  It may seem juvenile to you, and I know often the tendency is to think this is a business world-suck it up! But I think that is ill-advised and you risk losing excellent employees.  Communication is not something that is easily fixed; it truly is a continuous ongoing problem.  Just do not give up, you may have some brilliant employees you will squander or lose if your communication is lacking.

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Wrestling and Costing?

Posted on April 30, 2012 by

I have spent many hours at wrestling tournaments over the last four months with my seven year old son, Mike.  He is still too young to know about all of the “cheating” that goes on in the wrestling world, he just knows it is a great way to get out some of his energy in a somewhat constructive way.

This entire season he has been a winner – coming in first or second at every meet.  That’s great for him, and for the school, because Dundee is known statewide for its wrestling program.  Hopefully he is well on his way to really being successful.  Unfortunately for him, this past Saturday (the LAST match of the season) did not quite go his way.  We talked about it and kind of knew what to expect.  You see, his seventh birthday was last Wednesday, which moved him up to a new age group in which to compete.  He was competing against 5 and 6 year olds all season, and Saturday, he had his first match with 7 and 8 year olds.  Mike was very nervous, and had inkling it might not be a winning day at the onset, but he pushed on.

The boys are still grouped by weight class, but at the end of the day, the experience level and dexterity of the other kids taught him a few hard knocks.  He battled harder than I have ever seen him fight, but did not even place for the day.

How on earth could this possibly relate to manufacturing OR costing?   As I was watching his third match, the boy he versed was CLEARLY more experienced than Mike.  His name was Braeden, and he was eight years old.  Mike was holding his own until about halfway through the round when they were about 7 or 8 feet apart on the mat, and Braeden took a running start, took Mike down and sucked the wind right out of him.  As a mom, I was horrified and wanted my little boy OFF THAT MAT.  But as any good wrestling mom does, I got down and started yelling “GET UP MIKE!” repeatedly until he got up.  He was visibly shaken, and needless to say, he did not win that bout.  But I was proud of him because he put up an awesome fight!

That moment when he hit the mat is equivalent to where SO MANY manufacturers are today, right now.  They are at a pivotal point where they can continue making their product without a great deal of knowledge related to the true cost of the product or worse yet, knowledge that is based on incorrect facts.    I can say with complete honesty that every time we consult with a manufacturing company regarding their costing methodology, there is always a major fallacy in the theory they are using that can result in material differences in the resulting product cost.

This “pivotal point” typically requires the CFO to make some major decisions about systems and the ability to gather data from operations also.  It is imperative that you make the right choice now, rather than waiting until you need to.  Sure, many of you are profitable and wonder why it matters.  For many reasons, possibly the subject of another post, it matters!  BEFORE your profits start declining or customers start complaining, you need to make the FIRST move.

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Putting Forth the Effort DOES Pay Off in the End

Posted on April 26, 2012 by

As Bill mentioned in our previous post, we recently gave a seminar on the current trends in cost accounting. One of the attendees discussed how to determine the allocation of fixed overhead.  He acknowledged that around 20% of his company’s total costs were fixed overhead. The remaining percentage was variable, which can all be determined and followed. After thinking about his statement, I believe the issue is judging the importance of measuring and capturing such a small percentage of your total cost. Is this really that significant? The answer of course is, but it also depends on other factors!

It can depend on a variety of different influences, but what is most important is that you fully understand what your purpose is, and it is important that you have the best information possible?  Sometimes resources are limited and you need to focus efforts on areas where the most changes can be made. Of course if that is the case, then efforts should be focused on the majority; which of course is variable costs as seen in the scenario above. However, on the other end of the spectrum is the perfect world where you can trace and identify everything.  Although 20% is not a majority, it is still a considerable amount and a lot of it should be traced and allocated appropriately. If only 2%, or even 4% cannot be determined that may not be as significant. I guess the question comes down to what is “a lot”?  How you define “a lot” is probably different than my own interpretation, and even the next person. In the end, the main goal of having the best information possible must be met.

As many of my posts conclude, make sure your goals are reasonable and realistic. Having the highest quality information possible is crucial. Do not just settle for mediocrity, but really focus on being the best.  Why not have the best information possible when it comes to making critical decisions. Yes, this may entail working harder and putting forth more effort, but isn’t that worth it?  If it’s not, then I think you may need to reconsider where your focus is, and perhaps your boss will need to reconsider some things as well!  Putting forth the effort it is ALWAYS worth it!

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