Beware Unit Cost Traps

Recently in an online cost management forum, someone contributed a story to show the danger of a particular costing methodology. However, his conclusion was misdirected.

The story went something like this:

There was an old baker who became ill and had to go to the hospital. His son came home from the university to keep the profitable bakery running in his father’s absence. This son was very anxious to do a good job and impress his father with what he had learned at school. A while later, the son visited his father in the hospital and said: “Father, you must get well and quickly come back to the bakery”. “Why.” The son continued: “I have good news and bad news. The good news is that I’ve completed a cost analysis on all the products – the baguettes are losing $1 dollar per loaf.” The old baker asked: “if that’s the good news, what’s the bad news.” “Oh father, you must come back soon, the baguettes are selling better than ever. We’re going bankrupt.”

What was the problem with our profitable bakery? Certainly not a particular costing methodology. I can tell the same story substituting nearly all costing methodologies. The problem is ignorantly turning fixed costs into unit costs.

What is a unit cost? Strictly speaking, a product’s unit cost is simply its total cost divided by its volume. Mathematically speaking, there is no problem here. In real life, however, the trap has been set. The trap is well camouflaged because it is easy to unitize cost and use this unit cost to make useful, quick and dirty comparisons to price and to estimate profit for a product. A unit cost is valuable – but like any tool, it must be used in its proper context.

The first trap comes when fixed costs are unitized. The trap is sprung when business managers then use this cost as if it were a variable cost.  By definition, fixed costs are “Fixed”, they don’t change with volume changes. In this way, the total cost is the same for one unit of output as a million units of output. But the unit cost did change dramatically with this sort of volume change.

Another trap comes when business managers multiply a unit cost by a new volume estimate to estimate a new total cost. Since fixed costs are “Fixed”, this overstates the new total cost.

Just when you think you’ve avoided these traps, many stumble into yet another trap. Since fixed costs are “Fixed”, you avoid the first traps by keeping fixed costs the same for new volume levels. So where’s the trap? It is that fixed costs are “NOT Fixed”. They never remain the same with significant changes in volume. Fixed costs are not one simple cost category; they result from many different activities, many different processes, and many different productive capacities.

How to avoid these traps? First, education so managers know how to use different costs in decision making. Second, use a robust costing methodology – I suggest well-designed Activity-Based Cost. And lastly, when predicting costs, use a good cost model that takes into account capacities before making critical decisions. Even then, recognize that the model outputs are an estimate.

These traps are all too common – but a little education, analysis, and modeling go a long way to avoid them.

Customer Profitability: A One Way Street

Accountants love to tick and tie numbers, and sometimes become insanely excited when their numbers balance. This insanity is to their advantage when they are providing their “Control” function. In case others reading this article don’t know, accountants have multiple roles or functions in business. One is “Control” – Make sure money and assets are where they’re supposed to be. Another is “Advisor” – Providing information essential to making good management decisions. There’s more — Read on…

Activity-Based Cost: More Than Numbers

Activity-Based Cost or ABC has gained wide acceptance as a modern cost methodology incorporating cause and effect and cost visibility. ABC provides relevant information for management decision making. However, some have criticized ABC for a singular focus on cost and profits. This criticism is misguided. While Activity-Based Cost does have a strong cost base, it is more than simply numbers. There’s more — Read on…

Activity-Based Cost: Three Reasons To Avoid It

Activity-Based Cost or ABC has proven itself to be superior over traditional costing methods. Most traditional methods evolved during the early industrial age when life, while more complex than an agrarian culture, was simple. The introduction of computers and modern data processing triggered the rise of ABC giving people the power to manage data driven cost models. There’s more — Read on

Three Cost Allocation Myths

Cost allocation is used in all sorts of business and government enterprises to distribute the money the entity spends to those that “deserve it”. For some, this means that cost incurred by one department should be spread between other departments that benefited from the expense. For others, this means that cost must be distributed to all products. Every dollar spent needs to find its appropriate home for who or what is responsible for the money. But over the years, we’ve developed some dangerous myths on cost allocation. For the rest of the story…

Fake Cost Drivers for Administrative Overhead

A recent discussion in an online cost modeling forum related to “Which cost drivers can you use to assign administration overheads to a wide product range in a manufacturing concern.” As the discussion evolved, one response said “it is best done through the driver of turnover of the product produced. … because the efforts of administrative departments are in proportion to the production / sale achieved.” Read More…

Fixed and Variable Costs — The Dilemma

Back in my college days, the university required two courses in economics: Macro Economics and Micro Economics. It was hard to reconcile the two courses. What is hard fact in one was flakey in the other – and vice-versa. As a student it drove me crazy. Read More…

Budgeting for Standard Costs: Why Bother?

Recently I attended a conference addressing planning and budgeting. Most presenters and attendees wanted to reduce their reliance on formal budgeting processes. However, at lunch, I sat at a table with two attendees from one company. As our discussion evolved, they were worried about having to expand their budgeting processes. As this direction ran counter to the conference theme, I asked additional questions. Primarily, why were they expanding their budget process? Read More…

Financial Reporting versus Costing: Which is Right?

When attempting to calculate the cost of products and services, people often cite practices used for external financial reporting. Then they attempt to use these practices for internal decision making. Perhaps in an ideal world, this may be a valid path. However, we live in a world far from this ideal. In our world, external financial reporting and internal decision making are often in conflict. Why? Read More…

Customer Service: Nothing So Useless?

In recent years, I’ve observed a much needed trend toward better customer service and “Listening to the voice of the customer”. In general, I applaud this trend and support this goal. However, even a worthy objective does not prevent us from doing something stupid. Sometimes, an ideal, such as customer service, creates an environment where we do certain tasks very efficiently. But without the critical components, nothing could be so useless. Read More…