Standard Cost: Setting Overhead Cost Standards

February 27, 2012 by  Filed under: Management 

When it comes to setting cost standards, overhead is the biggest problem. Why? Today, aside from material costs, overhead is the largest component of product cost and the least understood.

Historically, overhead cost averaged 20% to 40% of labor cost. It was a minor consideration to product cost and was not significant in management decisions. Today, overhead cost may range from 400% of labor to thousands of percent of labor. Overhead is now much more significant to decision making. With this significance, a sloppy relationship tied to labor cost cannot be tolerated.

Another significant consideration for overhead cost standards is the purpose for which they are established. If the standard is used only for external financial reports, the requirements are very different from those for internal management decisions. Essentially, external reporting concerns the overall company financial health and must follow rules set by auditors, stock exchanges, and the government.

When the standard is used for internal management decisions, decision makers are trying to discern the health of individual products, processes, and customer relationships. Many more discrete and refined measures are required. When management makes good decisions and their market agrees, then external financial reports will show a robust, healthy company.

Some measures that management must consider for internal diagnosis include:

  1. Capacity. Which products utilize capacity productively? Which products use capacity nonproductively? How much idle capacity do we have? How much reserve capacity do we need to buffer peak demands and continue to provide quality service? Where are capacity bottlenecks?
  2. Fixed and variable costs. While fixed and variable costs are frequently discussed, the exact definition of what is fixed and what is variable is never exact. This fuzzy definition results from a fuzzy time horizon because time must be factored into the definition. Is the cost fixed over what period of time? Is the cost variable over what period of time. While management must take cost variability into consideration, they will receive dangerously little help from external financial reporting.
  3. Cause and Effect. If we change the level of one particular activity, does it impact the cost under consideration?
  4. Business sustaining activities and their costs. Certain activities must be performed regardless of the level of product output. While external financial reporting will simply pool these costs together with all other overhead and spread it all across products on a selected base, this procedure will not help make good management decisions.

In my experience, the need for management to understand and manage overhead is the driving force of Activity-Based Cost or ABC. A well-built ABC model will provide insights into these measures. Instead of one big cost pool to spread around, ABC can focus on individual activities and processes and examine their relationship to products and customers. This is a far different world than that of external financial reporting.

And then, as a valuable fringe benefit, use the information from your ABC model to set your overhead cost standards. You may have a battle with your auditors since they come from a different world. But don’t let them drive how you make internal product, process, or customer decisions. Overhead cost is too significant to just allocate.

There is a big difference between reading about standard cost and actually using standard costs. Alan Stratton has real experience managing standard cost systems in variety of companies and has consulted with many others on cost issues including Activity-Based Cost. Understanding cost is critical to understanding profitability and to management decision making. Come to for more tips and useful information.

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