quite different from the typical accounting definition of
“variable cost,” as shown in Figure 1.
In the second example, Plant A has the same three lines,
but the question is how many lines must be in operation in
order to maximize profit or minimize cost. In this example,
we suggest making the same calculation for the variable cost
and also calculating the total cost that would be saved if a
given line were to be shut down. This would represent the
“line fixed cost.” Again, this cost may be very different from
the costs calculated by a company’s accounting department.
Additionally, those costs that truly qualify as overhead—
that is, they occur whether the manufacturing (or distribution) activity happens or not—represent fixed costs for
either the asset or the location being used. It is important to
get these distinctions correct in order to accurately project
the TDC by product and customer.
Finally, when determining any of these costs, consideration should be given to the volume of product that can be
moved through the plant, line, warehouse, or distribution
fleet on a single shift or straight time versus the volume that
can be moved by changing to two shifts or with overtime.
Adding a shift will increase capacity as well as the fixed
cost, and it may or may not change the variable cost per
unit of throughput, whereas adding overtime will generally
increase only the variable costs.
Fixed costs: In order to capture the total delivered cost
of a specific product to a specific customer, TDC must
include allocated fixed costs associated with the assets used
to make (and possibly to ship and warehouse) the product.
However, there are some challenges companies commonly
encounter when making those calculations.
The first is how to properly allocate manufacturing costs.
Many companies allocate manufacturing costs by volume,
but in many cases that is incorrect. More often than not,
capacity is a function of time, and therefore the fixed costs
should be allocated by time consumed on the asset. This
way, slow-running products will, appropriately, be allocated more of the fixed cost than will fast-running products.
For example, a chemical product that has a batch cycle time
of six hours for a 5,000-gallon batch should receive twice
the asset allocation as a product that has a cycle time of
three hours per 5,000-gallon batch. It is important to identify the unit of measure in which capacity constraints exist,
and allocate based on that unit of measure.
The second challenge is how to correctly allocate fixed
costs when assets are underutilized in some time periods
and not in others. Should the fixed costs be allocated by
time periods to only those products made on the asset
within the given time period, should they be allocated to all
production across the entire production horizon, or should
it be something in between? There is no one-size-fits-all
answer to this question. Making sure the approach is accu-
rate and understandable should be the priority. Most often,
the most effective way to make this allocation is to use
the same time bucket that’s used in the planning process,
because the business will already have a sense of the cost to
run the asset for that amount of time.
Inventory carrying costs: The activities of sourcing raw
materials, manufacturing intermediates and finished
goods, and then transporting them to a distribution center
or warehouse all accrue costs that are included in the final
TDC calculation. But what happens when the product is
held in the warehouse for an extended period of time as
part of a planned inventory build-up? The total delivered
cost associated with those units of inventory increases
because the holding cost of that inventory becomes part
of the TDC. And then when it finally comes time to draw
down the inventory and deliver those products to customers, that accrued inventory holding cost must be accurately
reflected in the product delivered to the customer.
This carrying forward of TDC from the time the product
enters inventory until the time it is pulled from inventory
and delivered is one of the most overlooked aspects of TDC
analysis, especially when used as part of a planning process.
Unfortunately, this oversight can have a big impact and distort the TDC picture. A key to using TDC successfully is to
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Volume through the line
Total delivered cost (TDC) approach to production line costs
Typical cost accounting approach to production line costs
SOURCE: AUTHORS
