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Delving Into the Dark

By Richard E. Crandall, PhD, CFPIM, CIRM, CSCP | September/October 2012 | 22 | 5

Illuminate the black hole of your company’s overhead

Have you examined your overhead costs recently? According to the APICS Dictionary, these are expenses incurred that cannot be directly related to the individual goods or services produced by a business—heating or maintenance, for example. They are grouped into several pools (department overhead, factory overhead, or general overhead) and distributed to units of goods or services by a standard allocation method such as direct labor hours, direct labor dollars, or direct materials dollars. At the end of this definition, the dictionary says, “Syn: burden.” 

If you looked at the burdens your business has to bear, what would they entail? Here are some points to consider:
  • Overhead costs are getting larger as a percentage of total product costs. In the early days of manufacturing, direct labor expenses held a much greater percentage of total product cost. Today, however, with the increase in automation and information technology systems, overhead rates can be as high as 300 to 400 percent. 
  • Whereas direct labor costs were the target of cost reduction projects for a long time, the emphasis now has shifted to more lucrative target areas—namely, overhead expenses.
  • Historically, overhead was not a major concern of supply chain and operations managers—often because accounting systems didn’t make it easy to analyze these expenses in a meaningful way. As members of an Institute of Management Accountants (IMA) task force put it, “Financial accounting information is available in abundance, but is it an adequate tool for managerial costing? Or is it produced with principles that impair its usefulness for detailed internal decision support (White et al. 2011)?”
Overhead costs have great variety as to type of expense, and each type behaves differently. Therefore, assigning these indirect costs is rather complex.

Some clarifications

When studying your overhead expenses, it’s important to understand the following explanations.

Financial accounting versus managerial accounting. Financial accounting is the “use of generally accepted accounting principles to prepare reports to external agencies, such as investors and governmental agencies.” Managerial accounting is “a branch of accounting that uses techniques, such as break-even analysis, cost-volume-profit analysis, make-buy analysis, and others to provide information used in day-to-day decisions” (Blackstone 2010). 

These definitions from the APICS Dictionary clearly separate accounting that is externally oriented from accounting that is internally oriented—almost as if the two are completely separate functions of a business. Unfortunately, this separation is all too true in many cases. Often, financial accounting takes precedence over managerial, or management, accounting. The IMA task force (White et al. 2011) makes these points about the problems caused by this compartmentalization of accounting:
  • “In financial accounting, cost information is typically aggregated to more efficiently provide the more general information needed for external financial reporting and to simplify the audit process.
  • “Too often, managers believe external financial statements are the only correct view of financial information and don’t realize they are only one financial model of the organization with specific benefits and limitations.
  • “Attempting to source managerial costing data from the general ledger (rather than directly from financial and nonfinancial transactional data) will remain the routine practice for decision-making purposes, and it will continue to produce dysfunctional results.
  • “Managerial costing, a key source of the superior decision support skills of management accountants, will continue to be discounted in comparison to financial-accounting-based skill sets.”
Some earlier articles carried provocative titles suggesting the failure of cost accounting to help operations managers: “Cost Accounting: The number one enemy of productivity” (Goldratt 1983) and “Yesterday’s accounting undermines production,” (Kaplan 1984). Consequently, Goldratt introduced the theory of constraints (TOC) and Kaplan was instrumental in introducing activity-based costing (ABC).

Physical measures versus financial measures. Most supply chain and operations managers do not consciously spend dollars; they spend hours of labor or machine time and pieces of raw materials or components as resources used. They also count units produced as outputs. Only then do they convert the physical units to dollars of costs or revenues, if at all. This distinction between types of information carries over into accounting information. “General ledger data has been methodically stripped of nonfinancial data and must be laboriously reconnected to operational data to make it an analytically useful tool at most levels of the organization” (White et al. 2011).

Cost of goods sold versus cost of goods manufactured. Operations managers are interested in the cost of goods manufactured because that represents more precisely what is currently happening. Financial accounting reports the cost of goods sold because the accounting standards require the financial statements to closely match costs with revenues. While this difference may be minor in some cases, it also may be significant, especially when inventory is being built in anticipation of future seasonal demand or being reduced as part of a lean production implementation. 

“Common examples of problems created by the application of traditional financial accounting cost information are lean productivity initiatives that are stopped as a result of the short-term negative income statement impact of reducing inventories or production managers who face static product costs when excess capacity increases as the result of productivity improvements” (White et al. 2011).

Fixed and variable costs versus unavoidable and avoidable costs. Most supply chain and operations managers know well the distinction between fixed and variable costs as they relate to volume of production. It’s also possible to make a distinction between costs being fixed in the short term and variable in the long term. Some experts make the case that a better distinction may be unavoidable and avoidable, which are not the same as fixed and variable. Clinton and Merwe (2008) call this the “blended cost concept error” and suggest that some cost accounting methods are flawed as a result of not making this distinction. 

Management accounting approaches to product costing. In light of the difficulties using financial accounting information for management accounting purposes, a number of different cost accounting methods have been developed. (See sidebar).

The seven cost accounting methods shown in the sidebar can be grouped into three categories:
  • TOC and direct costs do not attempt to provide detail of overhead expenses. They focus on analyzing those expenses that are considered variable and devising ways to control and reduce them. In addition, TOC focuses on identifying the resource constraint bottleneck and taking action to increase throughput at the bottleneck in order to increase system output. Although both are worthwhile models, they do not address directly the need to examine overhead costs in detail. They also position most, or all, overhead expenses as fixed—at least in the short term.
  • Standard costing and absorption costing include all product costs. The difference between the two is that, in standard costing, the costs are predetermined so actual expenses show a variance from standard. Analysis of the variances can lead to actions to reduce unfavorable variances or extend favorable variances. Absorption costing includes all expenses and does not provide a direct approach to analysis or improvement. Its primary value is that it is the only approved method of reporting product costs in external, or financial, reporting. As with TOC and direct costs, neither standard expenses nor absorption costing is useful in analyzing the details of overhead expenses.
  • ABC, resource consumption accounting, and lean accounting attempt to provide closer examination of the details of overhead and thereby make possible analysis and improvement. 

ABC, resource consumption accounting, and lean accounting are the newest approaches in cost accounting, and the remainder of this department will focus on these three methodologies. However, first it’s interesting to compare overhead application using the absorption method with the ABC method. In absorption costing, all overhead expenses in a department or cost center are aggregated into one cost pool and could include a variety of costs, such as indirect materials, depreciation, occupancy, engineering, and supplies, to name just a few. Then, costs can be allocated to each product as one total cost. Figure 1 shows this method of overhead allocation to different products. The basis for allocation was direct labor hours or dollars or machine hours.

Delving into the Dark

Some scholars believed this method overcharged some products, especially mature products that did not consume as much of the overhead expenses as newer products. Consequently, ABC attempts to more correctly assign overhead costs by creating overhead cost pools for each overhead expense type. Using this method, overhead can be allocated to each product through multiple applications. Figure 2 shows this form of overhead application.

ABC was an intuitively appealing concept because it not only offered a way to more precisely assign overhead costs to products, but also required a careful examination of each overhead expense. This closer assessment often led to the identification of opportunities to reduce those costs. However, ABC necessitated a more comprehensive data collection and reporting system that proved to be more demanding than that in which some companies could or would invest. In addition, ABC did not make a strong distinction between fixed and variable costs (Perkins and Stovall 2011). And some felt it focused on activities and did not adequately relate overhead costs with resources consumed (Merwe 2009). As a result, ABC met with mixed results after an initial surge of popularity.

There are recent attempts to refine ABC, known as time-driven activity-based costing, that simplify its application. “Proponents of the time-based approach argue that only two estimates are required: 1) the unit cost of capacity supplied and 2) the unit time required for specific activities” (Perkins and Stovall 2011). This approach also allows for the measurement of excess resource capacity. The authors conclude, “An ABC system can yield the greatest benefit when the risk of cost distortion is high, such as when a firm offers a heterogeneous mix of products and/or services in a relatively complex environment … However, the long-run variability of costs assumed by the ABC approach can make the output from an ABC system irrelevant and misleading for short-term decisions in which many costs are fixed and, perhaps, inescapable” (Perkins and Stovall 2011). In a major critique of ABC, van der Merwe (2009) concludes that time-driven activity-based costing is an improvement over the initial ABC but still has weaknesses in its use as a decision support tool.

Resource consumption accounting is an outgrowth of a cost accounting system called Grenzplankostenrechnung, which was established in German-speaking countries in the late 1940s in an economy dominated by manufacturing. While Grenzplankostenrechnung has been widely used, resource consumption accounting is viewed as a desirable successor. It expands upon the benefits of Grenzplankostenrechnung and addresses many of its weaknesses. As such, it is an excellent approach for management accounting informational needs (von Zimmerman and Sedgley 2010).

“[Resource consumption accounting] combines the activity analysis of ABC, with detailed knowledge of resource capacities and cause/effect relationships that allow for the monitoring of cost behaviors at the resource level” (Perkins and Stovall 2011). It was refined and validated over the next few years, and a group of interested academics and practitioners established the Resource Consumption Accounting Institute in 2008. 

Resource consumption accounting analyzes overhead costs in detail and is built around the use of enterprise resources planning systems. Costs are divided between fixed and proportional, although proportional costs are not considered exactly the same as variable costs. Resource consumption accounting also builds up their costs from transactions instead of extracting them from the general ledger, as does ABC (Merwe 2009). “Regardless, fixed costs should be strictly separated from proportional costs and the cost of excess capacity should not be assigned to products” (Perkins and Stovall 2011). 

Resource consumption accounting, like ABC, results in a complex system that requires a great deal of work to implement. Krumwiede (2005) reports that Daimler uses a sophisticated system in which a typical plant may have upwards of 2,500 cost centers. While the information generated by resource consumption accounting may be valuable, the high level of complexity and the cost of implementation may be an obstacle for many businesses.

Brian Maskell says, “Lean management accounting aims to provide information useful to the people in production plants who are actively implementing and sustaining lean manufacturing.” He goes on to say, “In lean accounting, the accounting systems must themselves be lean. Transactions are to lean accounting what inventory is to lean manufacturing. All transactions are waste” (Maskell 2000).

Jerry Solomon points out, “Lean accounting is an accounting system that minimizes the consumption of resources that add no value to a product or service in the eyes of the customer by utilizing the lean tool kit.”

He then defines accounting for lean as “an accounting system that provides accurate, timely, and understandable information to motivate and support the lean transformation throughout the organization and improves decision making leading to increased customer value, growth, profitability and cash flow” (Solomon 2006).

Gerald DeBusk suggests a key part of lean accounting is the use of a value stream profit and loss statement, which includes only those revenues and costs that are directly attributable to the value stream. Costs requiring allocations are reported only at the business unit level and not assigned to costs. This interpretation places lean accounting close to the direct costing method, except lean accounting is oriented along the supply chain without regard to individual cost centers (DeBusk 2012).

The transition to lean manufacturing requires a change from the batch-and-queue methods of the past to a flow-along-the-value-stream approach. It also is necessary to switch from a transaction orientation to a process orientation. Because of these shifts in the manufacturing processes, two major problems result. First, inventories are reduced. Under absorption accounting, less inventory means less income because the additional flow of overhead costs (which had been stored in inventory) now must be included as added costs in the income statement. This leads many to conclude that lean manufacturing is actually increasing costs, not reducing them. Some executives have stopped the transition to lean as a result.

Secondly, lean manufacturing results in greater productivity and an excess of equipment capacity. Because lean usually involves the participation of employees in the improvement efforts, such as in kaizen blitzes, companies promise no layoffs will result from the improvements. Thus, increased productivity—which would mean fewer employees—is stymied by the commitment not to reduce the workforce. The same is true if excess capacity is reported as a negative, as it is in some accounting systems. Employees and equipment need additional volume of work to capitalize on the increased capability. Otherwise, there is no true improvement and no real reduction in costs.

Increased precision in relating costs to products requires greater complexity in the reporting system. While each method listed in this department has its supporters and detractors, all have merit—if applied in the right situation and with competence. Conversely, misapplication can be expensive and provide marginal or negative results.
As difficult as it is to identify and analyze today’s overhead categories, it will become even more challenging when companies start including risk management and sustainability expenses in overhead. A black hole is described as something that is difficult to penetrate is almost totally dark. As illustrated here, management accountants are working diligently to shed some light on financial accounting’s overhead cost structure for cost reduction and decision support purposes. 

  1. Blackstone, John H. Jr. 2010. APICS Dictionary. APICS The Association for Operations Management. Chicago, IL.
  2. Clinton, B. Douglas. and Anton van der Merwe. 2008. “Understanding resource consumption and cost behavior,” Cost Management. 22, 33-39. 
  3. Clinton, H. Douglas and David E. Keys. 2007. “Resource Consumption Accounting: The Next Generation of Cost Management Systems,” Focus Magazine
  4. Crandall, Richard E. and Karen Main. 2008. “Lean Accounting—Fad or Fashion?” Southeast Decision Sciences Institute Proceedings.
  5. DeBusk, Gerald K. 2012. “Use Lean Accounting to Add Value to the Organization,” The Journal of Corporate Accounting & Finance. March/April 2012, 35–41.
  6. Goldratt, Eliyahu M. 1983. “Cost Accounting: The number one enemy of productivity,” American and Inventory Control Society Annual International Conference Proceedings.
  7. Kaplan, Robert S. 1984. “Yesterday’s accounting undermines production,” Harvard Business Review. 62(4) 95.
  8. Krumwiede, Kip R. 2005. “Rewards and realities of German cost accounting,” Strategic Finance. 86 (10) 27-34.
  9. Maskell, Brian and Bruce Baggaley. 2004. Practical Lean Accounting: A Proven System for Measuring and Managing the Lean Enterprise. Productivity Press. New York.
  10. Merwe, Anton van der. 2009. “Debating the principles: ABC and its dominant principle of work,” Cost Management. 23, 20-28.
  11. Perkins, David and O. Scott Stovall. 2011. “Resource Consumption Accounting—Where does it Fit?” Journal of Applied Business Research. 27(5) 41–51.
  12. RCA Institute. 2012 rcainstitute.org/rcai-3-whatIsrca.php, accessed June 25, 2012.
  13. Staubus, George J. 1971. Activity Costing and Input-Output Accounting, Richard D. Irwin Inc.
  14. Von Zimmerman, Peter and Dawn Sedgley. 2010. “GPK: Cracks in the Silver Bullet?” Cost Management. 24(4) 43–48.
  15. White, L., B.D. 2011. “Why we need a conceptual framework for managerial costing,” Strategic Finance. 93(4), 36-42.
For a free bibliography of more than 50 articles on this subject, contact the author at  crandllre@appstate.edu.

Richard E. Crandall, PhD, CFPIM, CIRM, CSCP, is a professor at Appalachian State University in Boone, North Carolina. He may be contacted at crandllre@appstate.edu.

Definitions of Cost Accounting Methods
Theory of constraints (TOC) accounting:
A cost and managerial accounting system that accumulates costs and revenues into three areas—throughput, inventory, and operating expense. It does not create incentives (through allocation of overhead) to build up inventory. The system is considered to provide a truer reflection of actual revenues and costs than traditional cost accounting. It is closer to a cash flow concept of income than is traditional accounting. TOC accounting provides a simplified and more accurate form of direct costing that subtracts true variable costs (those costs that vary with throughput quantity). Unlike traditional cost accounting systems in which the focus is generally placed on reducing costs in all the various accounts, the primary focus of TOC accounting is on aggressively exploiting the constraint(s) to make more money for the firm (Blackstone 2010).

Direct (variable) costing: An inventory valuation method in which only variable production costs are applied to the product; fixed factory overhead is not assigned to the product. Traditionally, variable production costs are direct labor, direct material, and variable overhead costs. Variable costing can be helpful for internal management analysis but is not widely accepted for external financial reporting. For inventory order quantity purposes, however, the unit costs must include both the variable and allocated fixed costs to be compatible with the other terms in the order quantity formula. For make-or-buy decisions, variable costing should be used rather than full absorption costing (Blackstone 2010).

Standard cost accounting: A cost accounting system that uses cost units determined before production for estimating the cost of an order or product. For management control purposes, the standards are compared to actual costs, and variances are computed (Blackstone 2010).

Absorption costing: An approach to inventory valuation in which variable costs and a portion of fixed costs are assigned to each unit of production. The fixed costs are usually allocated to units of output on the basis of direct labor hours, machine hours, or material costs (Blackstone 2010).

Activity-based cost accounting (ABC): A cost accounting system that accumulates costs based on activities performed and then uses cost drivers to allocate these costs to products or other bases, such as customer markets or projects. It is an attempt to allocate overhead costs on a more realistic basis than direct labor or machine hours (Blackstone 2010).

Resource consumption accounting: A dynamic, fully integrated, principle-based, and comprehensive management accounting approach that provides managers with decision support information for enterprise optimization. The key innovations include the elevation of cause and effect as the guiding principle for resource consumption accounting ensuring clear linkages between operations (support and production) and their costs, the concept of value chain integration of management accounting into operational systems, eliminating dependency on the general ledger for management accounting information, replacing the principle of variability with the principle of responsiveness for operational modeling and modeling consumption behavior, and clearly defined rules guiding and limiting the use of activity-based concepts (RCA Institute 2012).

Lean accounting: An accounting system designed for lean manufacturing. The traditional accounting systems were designed for mass production, and lean thinking violates these rules. Lean accounting replaces traditional measurements with few and focused lean performance measurements that can motivate lean behavior at all levels of the organization; identify the financial impact of lean improvements and establish a strategy to maximize these benefits;  create better ways to understand product costs and value stream costs—and use this cost information to drive improvement, make better business decisions, and enhance profitability; save money by eliminating large amounts of waste from the accounting, control, and measurements systems; free up time of finance people to work on strategic issues, lean improvement, and change; and focus the business around the value created for customers (Maskell and Baggaley 2004).

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  1. Hector Topete October 15, 2012, 08:31 AM

    This document is definitely a great way to present and connect basic financial and operational concepts in an updated and very practical way, specially for all those individuals interested on learning and willing to break old practices and pursue for a significant and constant change.


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