managment. lecture 10. capacity costing

how would you define the term “cost”?

‘resources consumed’ by a cost object

cost =

direct cost + indirect or overhead cost

cost object

can be products, services, treatments, customers or suppliers

direct cost

resources consumed that can be ‘easily’ traced to the cost objects

indirect/overhead cost

resources consumed that need to be allocated to the cost objects

how does allocation of indirect costs to cost objects happens

via an OH allocation base and an OH allocation rate

OH allocation base

can be production volume, revenues, direct costs,…

OH allocation rate

Total OH cost / OH allocation base

overcapacity

committed (overhead) resources not consumed by cost objects

why do firms have overcapacity?

• Errors in forecasting future demand

• Anticipating an increase in future demand (often in start-ups and scale-ups)

• Transition period (e.g. from on-premise server to a cloud server can lead to overcapacity on the on-premise server)

• Competition-related reasons (i.e. threat for competitors in the steel industry)

• Seasonality

reasons we should NOT include the cost of overcapacity in the cost of our cost objects

• cost is ‘resources consumed by a cost object’

• in the short-run, prices can be based on variable costs.

• internally: managers do not have decision rights to manage the full cost

reasons we should include the cost of overcapacity in the cost of our cost objects

• Overcapacity costs also need to be paid for if you want to be profitable

• Long-run profitability requires that your prices cover the cost of all your resources.

• External financial reporting rules require that COGS and inventory are based on full cost

the death spiral in costing

your prices change every time you do an update of the standard cost. stand cost increase leads to increased price, leads to lower demand, standard cost increase etc

how to solve for overcapacity

including practical capacity

practical capacity =

used capacity + excess capacity

how to determine the pracitcal capacity of an entire production process

by the bottleneck activity

cost driver rate =

overhead cost / practical capacity or overhead/used capacity

core equation of capacity costing

cost of supplying resources = cost of resources used + cost of resources unused

How to make the cost of overcapacity visible in internal reporting?

add a separate line item ‘ cost of unused capacity’ in the P&L section between the gross margin and net margin. You will never see this line item in a publicly available P&L because GAAP/IFRS does not allow this.

Total Quality Management (TQM)

Business philosophy that focuses on systematically and continuously improving the quality of products, processes, and services.

what happens if you implement TQM

cost of resources unused will increase

How can financial performance increase when TQM is implemented?

• Reduce the supply of resources leading to less OH (active cost management)

• Generate more demand for your product

• Set up new activities using the unused capacity

Cost savings through AI in finance&control?

• cost of resources used will decrease because you need less FTE for invoice processing and yearly development/usage costs will most likely be lower than the FTE cost.

• cost of resources unused will increase if you do not take additional measures ecause you need less FTE-time and thus the saved FTE-time becomes a cost of resources unused.

what additional measures can you take to realize cost savings after using AI in finance&control

• Limit the development and usage cost of the AI-tool by carefully screening the different options.

• Fire finance&control employees.

• Allocate finance&control employees no longer needed for invoice processing to other tasks.

• Accepting some overcapacity for finance&control employees could save other costs (less stress-related illnesses) or generate benefits (more time to innovate).

how to design the reporting system to minimize the risk on high overcapacity costs

track used and unused capacity, implying you need to know practical capacity of the production processes

how to design the organizational design to minimize the risk on high overcapacity costs

you can evaluate managers on a profit metric including the cost of unused capacity.

• controllability principle: you can evaluate managers on a profit metric including the cost of unused capacity.

• influenceability principle: managers can indirectly influence the cost of unused capacity by generating more sales or take other decisions such as firing employees.

how to design the soft controls to minimize the risk on high overcapacity costs

making the cost of unused capacity visible can have a profound impact on the culture in the firm, leading to increased responsibility to reduce the cost of overcapacity. This cultural impact is based on a positive spin of the McNamara Fallacy: from the moment you start measuring something, people will start to pay some attention to it.

costing for seasonality

allocate the costs of unused capacity in the slack months to the peak months