• Operations Rx

Shortcomings of the Standard Cost System

As anyone who has been in Operations for any amount of time knows, the Standard Cost system is often used as a key operational measurement and decision-making tool. But is this really the best system to use to make decisions that ultimately impact the financial performance of the entire organization? Too often decisions are made that may benefit an area, department, or site without considering the impact on the organization as a whole. Often these decisions, driven by the Standard Cost System, end up having a negative impact on the financial performance of the company.

 

The basic assumptions of the Standard Cost System, such as 1) the total cost of the system is equal to the sum of the cost at each operation, 2) how overhead is allocated, 3) the impact of decreasing costs for a single process will result in a proportional decrease in costs for the entire system, actually encourage decisions that are far from optimizing the total system. For example, a typical analysis used to justify purchasing a new piece of equipment will take into consideration the direct labor savings associated with the increased output of the new piece of equipment along with the associated overhead savings based on the direct labor reduction. However, how often is 100% of the projected direct labor savings achieved? Often the labor is just moved to another department, especially if the reduction is less than a full person (i.e.: 1.5). In addition, since overhead costs are normally tied to direct labor hours there is an assumption that these costs will decrease in proportion to any labor reductions. However, what often occurs is that the total overhead costs remain the same and are instead spread over the remaining labor costs, resulting in higher costs for products that are not produced on the new equipment. Finally, is the added capacity needed?

 

Given the limitations of the Standard Cost System, Drs. Umble and Srikanth in their book Synchronous Manufacturing recommend the use of a system that measures the impact of a decision on the entire organization. They developed three Operational Measurements: 1) Throughput – the sale of finished product. 2) Inventory – note that inventory is not treated as an asset.  3) Operating Expense – the cost to convert inventory into throughput. All three of these measurements are global in nature and not just for a specified department. 

If the above measurements are used the resulting decisions will often be different than when using the Standard Cost System. The goal is to consider the impact on the total organization. Each of the new measurements will measure the impact on the bottom line of the company and thus start to drive decisions that have a positive financial impact on the company, not just on a department on plant. After all, the goal of every organization is to make money!