Cost Estimation Essay, Research Paper
Generally Accepted Accounting Practice
The main purpose of searching for a new method to estimate cost if due to the erroneous practices of accounting. There is a wide recognition of this problem but most companies still have not gone to a different approach. The GAAP principles do not provide the kind of cost detail and information focus required in today’s capital intensive, automated, and complex manufacturing and distribution. It generates an erroneous and inverse relationship between computed product cost and current production volume. This is the major problem- the inverse relationship between production volume and inventory value because these indirect expenses are all fully charges to the current product. In periods of declining sales, the apparent cost of the product rises, bringing suggestions of price increases in the face of weak sales performance. In good sales periods, apparent cost of product declines, suggesting either a lowering of prices or higher profits. Neither inventory valuation reflects the true cost of manufacturing the product. The typical distribution an accrual accounting practice often distorts operating cost information and performance criteria to accommodate financial policy, management practice, and current tax law requirements. Some manufacturers even overproduce to absorb overhead in the false assumption that this reduces their product cost.
Many different methods have been tried to fix this inaccuracy, such as activity bases costing, machine labor costing, process costing, productive hour rate costing, life cycle costing, and technology accounting. All of these methods have common weaknesses. None of these methods isolate the definition of the cost of the product form the definition of the overall performance of the business. All of these techniques cause the apparent cost of the product to vary with volume yet manufacturing has done nothing different when volume increase or decrease.
One of the major philosophical changes is the conversion of the costing base from the variables of materials, labor, and volume to the constant of time and time use of capital facilities in each operation. By allocating all indirect expenses to time use of facilities, indirect and general and administrative expense can be fully absorbed and the correct share of these costs can be precisely assigned to each product, past and operation independently from production volume.
The “Use Rate”
The “use rate” is a rental charge for the use of things. It is a vehicle for the collection and application of all period, indirect, burden, overhead and general and administrative costs into the product or operation on a level-by-level, operation by operation, time use of facility basis. Unused facility expense and overhead is not charged to the product. Some principles that the use rate includes that is extremely important is the following:
? Price s independent of cost
? Price is set by the market and competition
? Cost is a function of design and management skill
? Profit is the difference between price and cost and is the scoreboard of success
? Time is the only reliable element and it should be the basis for defining and managing all other aspects of the operation
? Cost should be allocated based upon the time use of facilities plus material costs at every operation and level of production.
? The flow of material and product is the flow of money
? Level by level control of the material and product flow through a process assures management of the control of the enterprise.
? All production costs must flow into the value of inventory (raw, WIP, finished goods) al all levels
? All production revenue comes from the disposal of inventory
? Overhead absorption variances, which result from capacity utilization variances or profit variances and not product, cost variances or manufacturing performance cost variances.
? The cost system, manufacturing management system and material management system should be tied together through a universal numerical bill of material and a matrix type part numbering and activity coding system.
Time Use of Facilities
The primary objectives of the cost system are to provide management with a reliable tool for measuring and managing the performance of the manufacturing and distribution operations. The actual cost of a product as compared to pre-manufactured costs estimates and market process is also determined. Another objective is to provide information for designers who design to cost and apply value-engineering principles in product development.
The time use of facilities corrects variable product valuation problem. It offers a better basis for allocating the actual accrued cost share of facilities, burden, overhead, and direct expenses to the product. The time use of labor, machine, and plant facilities provides a measureable and definable cost standard for each operation. These costs can be accrued into the product’s inventory valuation on the basis of operation time.
The time use of facilities and how it fits into he use rate calculation will no be explained. A use rate is calculated for each workstation. It includes all indirect, burden, and overhead costs, which are attributable to the workstation. It is charged to the product and operation just for the time used during the operation and is based on the standard annual hours of use of the workstation. The time use of facilities sue rate defines the impact of schedule or performance base under or over utilization of the facility. This is a variance and is an adjustment to profit. It adds charges to the labor cost for work cycle time of labor operation and total operation cost is added to the material cost to compute level by level inventory valuation at each step.
Level by Level Total Absorption
This is the complete allocation of indirect expenses to the product based on the bucket concept. This is the costed WIP inventory of each item attached with all elements of labor, material, burden, overhead, and G&A costs accumulated on a time use of facility basis. The basic principles of level by level total absorption is that each activity or performance element in a manufacturing, warehousing, transportation, or merchandising operation involves the use of facilities and equipment, the use of materials and supplies, the expenditure of labor, and the use of money. By using work measurement techniques, the direct and variable cost elements of labor, material, and supplies can be defined, computed, and predicted for each operation with a reasonable degree of accuracy. Indirect and overhead charges can be assigned to the costs of operation in direct and equitable proportion to their time contribution to each function or activity by applying a time use of facilities approach and a workstation use rate.
With this total absorption costing method is it possible to isolate cost of individual parts, item, and operations. One can quantify the impact of methods or product design and changes. The cost impact of capital facility and data control feedback improvements can be defined by comparing standard costs accumulated in the WIP inventory record and the actual costs accumulated. One can identify and promote higher margin products and services.
The primary differences between the conventional method and how the use right applies indirect and period costs to the product is that the use rate applies the capital investment burden (depreciation), manufacturing burden and overhead, indirect costs, general and administrative expense to a stable predictable measurement unit (square feet and time) on a time sue of facilities, total absorption, standard costs basis. Burden and overhead costs are usually fixes (nearly stable) and have not normally fluctuated with production volume, labor or material costs. This method uses that portion of the plant’s manufacturing capacity and operating time, which is scheduled and actually used to support the operation and the production schedule. An example of the difference between the conventional method and the use rate method: In a Just in Time environment, batch sizes have moved down and frequency of movement has gone up. The GAAP principle says that transportation and set up costs go up because frequency is going up. But the use rate method says that since there is no adding of labor, it is really the same since there should be no volume relation. If losing production of a non-bottleneck, really not losing anything.
Different Types of Labor
Direct labor is people who change the product’s condition, status, shape, packaging, appearance or function.
Indirect labor are people who logistically support, handle, move, inspect, control, set up, affects the product’s flow through the manufacturing process without changing the product itself. In use rate calculation, treated as overhead.
Burden labor are people who provide supporting supervision, clerical or administrative personnel, labor relations, maintenance, safety without direct product contact. Examples are department managers, supervisors, and engineers. Treated as general overhead in use rate calculation.
Manufacturing management labor are people like the vice president of manufacturing, MIS, inventory control, personnel, etc. Treated as overhead in use rate calculation.