Limitations of the Standard Cost System
Srikanth and Umble tell us that many of the problems that plague American industries today are a direct result of the application of standard cost principles throughout the organization. They further explain that many manufacturing problems derive from the view that manufacturing management’s goal is to control and reduce the standard cost of each individual operation. To illustrate the problems of the standard cost approach, Srikanth and Umble demonstrate how this approach might be misapplied to a typical investment decision. The following is a case study on how Srikanth and Umble illustrate these points.
Suppose the plant manager of a manufacturing firm is considering a proposal to purchase a new and faster stamping machine. The basic information available to analyze the decision is as follows:
- The old machine is able to process material at a rate of 100 units per hour (one every 36 seconds) The new machine is three times as fast, producing material at a rate of 300 units per hour (12 seconds per unit). This saves 24 seconds, or 0.00666 hours, per unit processed.
- The stamping machine is operated by one machinist, who is available to work approximately 2,000 hours per year (40 hours per week for 50 weeks). This is true for either the new machine or the old machine.
- Approximately 150,000 units per year are processed at the work station where the stamping process is performed.
- The cost of direct labor is $15 per hour.
- The overhead factor for this process is 280% of direct labor.
- The net cost of the new machine is $27,000 (This includes the salvage value of the old machine).
The standard cost approach would be to determine whether or not the proposed investment has a sufficiently high return. In most cases, the return is measured in terms of cost savings, and the projected savings would be compared to the initial investment to calculate the payback period. The expected savings from the purchase of the new machine would typically be calculated in the following way:
- Annual direct labor cost savings = reduction in process time per unit x units produced per year x direct labor cost.
In most cases today, the standard cost procedures generally charge overhead to an are based on the amount of direct labor consumed in that area. Therefore, any savings in direct labor cost for an area will eventually result in less total overhead being charged to that area. Thus, any projected savings in direct labor cost can further be projected to reduce the overhead charged to that area. The projected amount of annual overhead cost savings can be calculated by applying the appropriate overhead factor:
Annual overhead cost savings = annual direct labor cost savings x overhead factor
And the total annual cost savings for the area are calculated as follows:
Total annual cost savings = annual direct labor cost savings + annual overhead cost savings
While the exact procedure for the above calculations may differ from firm to firm, the fundamental approach is the same. Continuing with the illustration of the stamping machine:
Annual direct labor cost savings = 0.00666 hours per unit x 150,000 per year x $15 per hour = $15,000 per year
Annual overhead cost savings = $15,000 x 280% = $42,000 per year
Total annual cost savings = $15,000 = $42,000 = $57,000 per year
Since the net cost of the new machine is $27,000, the direct labor cost savings of $15,000 translates to a payback period of 1.8 years.
In my next post, we will complete our decision-making analysis on whether or not to purchase the new machine. We will then look at a more realistic way to appraise the information to make a better decision. As always, if you have any questions or comments about any of my posts, leave me a message and I will respond.
Until next time,
 L. Srikanth and Michael Umble,Synchronous Management – Profit-Based Manufacturing for the 21st Century, Volume One – 1997, The Spectrum Publishing Company, Wallingford, CT
Don't miss out!
Stay on top of the latest business acumen by subscribing to the Manufacturing Breakthrough blog.