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A Mid-Sized Forging Company
ABC Industries was a mid-sized, closed-die forging company located in Southeastern Michigan. Its annual sales of $25 million generated earnings before income taxes of $500 thousand.
After receiving steel bars, the company would cut them to the appropriate length, sand blast them and then perform one to three forging operations on presses of varying tonnage until the steel was forged into the required shape. Although some parts were complete at that point, many were finished in the company’s machine shop. When all manufacturing processes were complete, all parts went through a sorting process before being packaged and shipped.
ABC had been developing its cost information using traditional costing methods. It determined its product costs using a plant-wide, direct labor-based overhead rate calculated using the previous year’s actual results.
In creating a managerial costing model that more closely reflected the operation of the business, manufacturing activities – both value adding and non-value adding – were segregated into groups with similar cost structures:
Expenses and activities supporting production labor (payroll taxes, health insurance, human resource support. etc.) were segregated from those supporting non-labor production resources (depreciation, utilities, maintenance, etc.). These production labor-support costs were the only costs included in a labor hour-based rate used to assign direct labor costs to products.
Expenses and activities involved in the pre-production set up of forging presses – including the cost of lost capacity due to equipment downtime during set up – were segregated and incorporated into a “cost per set up” that was used to assign set up costs to products based on their production batch size.
Forging presses were divided into three groups based on their tonnage and machining operations were separated from forging activities. Non-labor related production expenses and activities (occupancy, depreciation, utilities, maintenance, etc.) were assigned to these four activity centers based on consumption metrics or estimates of knowledgeable individuals and these costs included in equipment hour-based rates used to assign indirect manufacturing costs to products.
Expenses and activities involved in sorting and packing parts were segregated and included in a direct labor hour-based rate used to assign sort and pack costs to products.
Expenses and activities involved in the in-process movement and storage of parts were segregated and included in a “cost per move” that was used to assign this direct – but non-value-adding – cost to products.
Expenses and activities that supported materials were also addressed. Those related to purchasing, receiving, quality testing, handling and storing steel bar stock were isolated and included in a “cost per pound” that was used to assign these costs to products.
Using this new costing structure, a cost model was developed that accumulated the total cost of operating the business under varying volume and mix scenarios and then translated those costs into “fully-absorbed” rates for costing individual products and customers.
The new “fully-absorbed” cost information (which was not determined at the company’s current volume but at its “practical capacity”) identified several of the company’s products that were losing a significant amount of money. One high-volume product – a driver pinion that sold for $9.18 – that the company believed generated a $1.38 profited turned out to be losing $.70 per unit sold. On the other hand, the new model also highlighted several recent quotations the company was not awarded because its former costing model caused it to quote prices far above those needed to earn its targeted return. During the next few years, the company was able to use its new cost information to stock its portfolio of core business with much more profitable products.
The business also capitalized on its new ability to perform accurate incremental cost analyses. It was able to take on several “non-core” products that contributed to its profitability in the short-term without damaging its ability to sell “core” products profitably. It was also able to accurately model the addition of equipment and floor space before committing to a project. Surprisingly, it was able to determine the overall savings it would realize when it increased the cost of performing set-ups while reducing the time they took. By reducing set-up time, they were able to avoid the purchase of two new presses during the first few years after adopting the new cost model.
Finally, their new understanding of activity and process cost radically changed they way they operated the business. The most powerful revelation was the cost of in-process movement and storage. Once this cost was isolated, they found ways to eliminate movement (and its cost) through increased use of progress dies, moving secondary operations next to primary operations, and scheduling so that former “move-store-move” activities were changed to “move only” activities.
Four years after the new costing model and methodology were adopted, our $25 million forging business had grown to a $60 million operation. More importantly, its $500 thousand pre-tax profit grew to over $6 million. Admittedly, more than just improved cost information was involved. However, all of the company’s actions were based on accurate and relevant cost information; information that would not have been available had they continued using their old, traditional approach to costing.
As a postscript to this case, ABC Industries was purchased by a $3 billion automobile industry supplier. In a classic case of “tail wagging the dog,” the new owner’s management was so impressed with the smaller company’s performance and the economic literacy of its management, that it adopted the company’s costing methodology throughout its $600 million forging division and later throughput the entire organization.
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