Standard Costing- Common Problems (And How to Solve Them)

Standard Costing

Dec 29

Throughout my corporate career, I've spent 10+ years working for 7 organizations, all in manufacturing. As I rose from humble cost accountant to manager to director, I have had a rare view of each organization's costing and product profitability. For most of these organizations, there was typically a problem to solve, and unknown "profit sinks" no one could quite explain or resolve.

My role has been to go into these organizations, plug them in quickly, and then help them "grow up" in collecting, analyzing, and using their data. The more I did and the more places I went, the better I got at operational controlling, eventually developing my expertise.

Like any operation controlling role, much of this isn't done from an office; it's done on the factory floor. By building relationships, cost accounting professionals can understand and align the 3 pillars (People, Process, & Systems).

From my experience, I will share common themes and pain points manufacturing organizations share. In addition, I will share what worked to solve these problems and other bits of advice and information where applicable.

Standard Costing Problems- Lack of intimacy between cost accountants and the manufacturing facility

The first organization I began my career with was an organization that sought to cut costs and standardize by pulling cost accountants from the manufacturing plant locations to a shared service center.

Standard Costing- Common Problems (And How to Solve Them)

Here, cost accountants were responsible for several plants, and the work they were responsible for was transformed into a cookie-cutter approach. The cost accountants would visit the sites once or twice a year, which was deemed adequate.

As a result of this transition, the old cost accountants were given a choice to relocate or lose their jobs. Many declined the relocation offer, and thus, crucial knowledge was lost. As the organization hired new accountants, the job became more about moving numbers around in SAP and Excel than understanding the manufacturing processes and ensuring the numbers reflected reality.

Without a sense of purpose or meaning in the job, turnover was high, leading to even further standardization and loss of accountant engagement. Many of the special projects and initiatives accountants got involved with were around corporate buffoonery and office politics. Out of an initial elite development class I joined with, nearly no one remains with the organization today.

The organization has since changed leadership multiple times and has divested itself into multiple companies.

Standard Costing Solutions- Cost Accountants Must Know Manufacturing

For a manufacturing organization, one of the most important roles to have experts in is cost accounting. Cost accounting is a connector of the people, processes, and systems that hold the data and insights to understand manufacturing costs, profitability, and opportunities.

Cost accountants should be headquartered as close to the manufacturing facility as possible and spend considerable time on the factory floor and learning the systems and processes while building relationships with the key stakeholders.

When disconnects form between processes and outputs, cost accountants are crucial to identifying the issue, raising the alarm, and then building the support and initiative to fix the problems. If cost accountants are not near the factory or do not understand manufacturing, then they are of little value.

Looking at spreadsheets won't reveal why profits don't match expectations; walking the facility and asking in-depth questions with the production or receiving managers will. Then, knowing how to bridge these gaps is where cost accountants add actual value.

Standard Costing Problems- Lack of data lineage throughout production

A food manufacturing organization I worked for could not understand why profit was consistently lower every month. Looking at the variance reports and data available, it was clear that the system was not configured to match their business model.

This business purchased dairy raw materials, all of which contained varying %s active components of the materials that the purchase prices were based on. Milk, for example, has a fat content between 2-4%, where the standard cost was based on a static 3%. Because of this setup, milk, and cream, accounting for 70% of the product costs, were subject to incredibly high variances each month.

Compounding the issue was the lack of traceability, or data lineage, throughout production. Each month, they know the total pounds of dairy and other ingredients consumed, and they knew the totals pounds of finished product produced. However, there were too many unknowns. The total pounds of WIP (work in process), scrap, rework, and other inventory classifications were a mystery (accounting for 10% of the total inventory at times).

Worse, the manufacturing plants could not precisely tell which raw materials and in which quantities at what cost were consumed to produce a finished good. Compound that with the fact that direct and indirect labor was assigned with rough estimates, and there were real issues the executives could not grasp.

On top of all this, new sales quotes were priced with back-of-the-envelope math using inaccurate product cost and usage estimates. So, product costing was out of control, and pricing was being done inaccurately.

Standard Costing Solutions- Use business intelligence to identify problems and process improvement to fix them

Over 2.5 years, we made progress in getting our footing to understand the current processes and data issues and then fix them. One of the most significant improvements was using business intelligence to automate, scale up, and improve reporting.

By creating an analysis that went from a high-level summary to complete granularity, we could identify what didn't make sense and begin working to understand and fix the process issues. Often, the issues were a combination of poor data collection, manual entry processes, and misconfigured systems.

Going after each of these pain points took time and effort, but once it was resolved, we could keep an eye on it to ensure that once fixed, it stayed fixed. Some challenges were much tougher to resolve as they involved multiple departments and legacy processes, but we made improvements.

Even better, we created more accurate pricing quotes using the business intelligence tools using accurate consumption and current dairy pricing.

By the end of my tenure, we could clearly and confidently articulate the remaining problems and provide recommendations on what was required to fix them. Using data and tying that into truly understanding manufacturing processes and building relationships, we improved product profitability.

3. Standard Costing Problems- Lack of professionalism and best practices

I spent 6 months with one local food manufacturer who sold their organization as one ready to mature and grow up, securing private equity financing to go from a family-owned shop to a national producer.

While that sounded good, once inside, I faced the realities of a finance organization that had lived in its own bubble of what good looked like. For an organization with four distinct farms, each with its own growing cycles and cost structure, the head of finance determined it was "good enough" to calculate the annual standard by dividing the total costs of all production/overhead by the number of total units produced.

I almost fell out of my chair when I first saw and heard this. He had a straight face and was dead serious. As this was his first and only job out of college, and for the last 20 years, he self-taught himself accounting and finance. The organization, on its part, didn't have the stomach to ensure the right people with the right skill levels were positioned throughout the organization.

Part of my role in helping this organization was to help them produce a more accurate product costing by farm and product line. However, the complete lack of digitization, inconsistent record keeping, home-built "ERP solutions," and the like made this an incredibly tough challenge.

At the end of this role, they decided to give annual budgeting their first try. The processes, methods, and leadership throughout the process were like a Dilbert cartoon in real life. I thanked them for the opportunity and left.

Standard Costing Problems- data digitization and highly skilled finance professionals, are a must

When you ask for data to perform product costing and are pointed to a filing cabinet with hand-written notes, nothing good can come from this. Having good data built from robust processes that accurately and consistently feed into industry-standard ERP systems is a must to perform accurate product costing.

Sure, sure, you can do some high-level financial modeling with data sampling or without data at all, but to set standards that you expect to compare against actuals requires comparing like-for-like.

Cost accounting is not an easy field. It requires multiple disciplines, including accounting basics, systems, business partnering, process improvement, Excel mastery, and awareness of FP&A best practices. Thus, ensuring you have highly skilled professionals who understand what good looks like is critical.

Cost accounting has undergone an incredible transformation over the last 20 years in how it's done. If you live under a rock or run by intuition, you're in the wrong field. Your organization must hire and train the right people or otherwise invest in experts to help you with this process in one form or another.

4. Standard Costing Problems- Too much corporate meddling

At one of the manufacturing organizations I've worked for, I can remember the moment I was ready to review the costing results with the CFO. First, we would start with a high-level summary of the total product cost.

We arrived at this number by multiplying the sales budget volume for each product by the total product cost. The total product cost was a roll-up of the updated and accurate BOMs (Bills of Materials), which reflected actual usage/yield by our best estimates for component pricing that year. Many hours were spent ensuring each BOM, price, and other factors were carefully scrutinized and reviewed with the manufacturing teams.

However, the CFO didn't like the total cost number. "No, no, that won't do. It has to be much lower," he said to me. I must have looked at him like he had three heads. I asked how the costs would be lower. Would we invest in new machinery? Has a new recipe been developed to improve yields? Have we negotiated better raw material pricing?

Nope. He just didn't like the number. So, he instructed me to go back and make the numbers "right." To do this, I had to adjust the product yields for multiple products and then run and rerun the cost estimates until I got to a number he liked.

Standard Costing Problems- Keep politics out of product costing

When the product costs are calculated, you can like the number or not like the number. The question shouldn't be, "how do we fix the output," but "how do we improve the business to produce better results and profitability?" This, however, is the tricky part.

Throughout the years, I have seen all forms of gaming the product cost system to reflect a different reality than the one that exists. Cost center managers overestimate their costs, plant managers overestimate their effectiveness, and executives want costs and profit estimates to match a number in their heads. It goes on and on, but the outcome is never a good one.

To improve product costing, whether you are using standard costing or an alternative method, you need to build processes and systems that generate the truth. The step after that should be to accept the truth and inspire the organization to invest and do more with their resources rather than explain away what you believe to be a calculation error.

Standard Costing Problems- Conclusion

Standard costing is a very challenging problem that requires getting a lot right on the backend to get reliable, consistent results when performing analysis, budgeting, or profit determination.

Compounding the issue is the lack of real, meaningful insights into challenges and remedies like the one discussed above. Part of what I am working on this year is to fix this problem by providing education and insights for practitioners to improve how product costing is done. We have some big plans in the works, and I hope you tune in and follow along. This is a consistent pain point that must be resolved to ensure our manufacturing organizations are on the right track to consistent profitability and ensure that decision-makers have reliable insights to build from.

Ben

Check out my other articles on standard costing here: