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.