Because cost is such an important metric, accountancy has developed techniques to have cost information in various efficient ways. One of the most useful techniques is the use of standard costs. This technique makes it possible to have useful cost information with a minimum of detail calculation. In most stable operations, actual costs and standard costs will be almost the same.
The application of TrueValueMetrics (TVM) is simplified by the use of standard costs. Standard costs are used in most corporate cost accounting systems and are a powerful way to reduce a large amount of data to something that can be readily understood and acted upon. TVM takes the concept of standard cost and also applies it to value ... making it possible to understand value impact more clearly than any other approach.
The standard cost is what something should cost based on technical considerations and experience. The standard cost can be calculated from the bill of materials, the bill of labor, the operating processes and the costs associated with everything. In a factory setting, this is a very normal thing to do. How much something should cost is determined by reference to experience, technical factors and prices. It is possible to calculate how much something should cost if the elements of the activity are understood. If experience in other situations is known, this may inform how much something should cost in another situation. What something should cost may be expressed as a standard cost.
It is relatively easy to check that a standard cost is right by comparing the standard cost of all the production in (say) a factory department with the actual costs incurred by the department. If the standard costs reasonably reflect the actual costs there will be little difference between the standard and the actual. This idea may be better understood by the following examples: (1) standard costs used in the construction of a pulp and paper mill; and, (2) standard costs for foundry production.
When cost data are weak, it is usual for operations to be sloppy and costs excessive. When cost knowledge is absent, addressing cost efficiency will not take place and the easy way to do something will usually be chosen over the better way to do it. Examples abound in international development assistance, such as, for example ... the use of high cost international experts is often chosen over much lower cost local staff.
Example Construction Costs: Pulp and Paper Mill
This experience relates to the oversight of a large cost plus construction contract for a pulp and paper mill in Texas. The consulting engineers costed the whole project in detail, with a budget cost for everything that was going to be built, and costs for each of the stages of construction ... excavation, foundation formwork ... foundation concrete ... backfill ... structure ... roof ... cladding ... and then going through the purchase, installation and testing of the equipment.
Each week the contractor advised what had been done. Each week the contractor advised how much had been spent and how much they were owed.
As field accountant, I compared what it should have cost for what had been done with what the contractors had spent. My analysis suggested that the contractor had done about 1% of the work (based on the budget or standard) but had billed for about 2% of what was the total contract cost estimate ... in other words about a 100% cost overrun.
The next step was to physically look at the work being done ... and to understand why the costs were out of line. Almost everything was “padded” as far as it could be. Too many people in each work-crew ... unused spare equipment onsite not needed but being billed ... supplies ... like form lumber used once near new being junked ... etc.
Thursday, about 3 pm, the senior manager of the consulting engineers reviewed my work ... by 10 pm he had concluded that it was credible and called the contractors for an urgent review next day.
Next day the contractors were ask to explain themselves ... and why 1,400 workers were on site? Monday the work continued with just 700 workers. The contract was completed on time and just 2% over budget!
Standard Costs – Foundry Costing
This experience goes back to being VP manufacturing for an air-break switch manufacturing company where we had a foundry to produce the castings we needed. We produced thousands of different castings weighing from around 100 pounds down to about a quarter of a pound! For decades the company had used a simple “per pound” cost to describe the cost of their castings, and as a result over time the engineers had reduced the weight of all our castings thinking they were reducing costs, but in fact doing more to reduce product quality and foundry productivity.
When we used standard costing to define the cost of each casting based on the cost behavior of all the processes in the foundry, and the use of each process in producing the casting ... it became clear that the small castings were far more costly to produce ... and weight much less important than, for example, scrap rates, the amount of cleaning required, and what sort of equipment was used in production.
We validated the standard costs by comparing the total of production quantity times the standard cost (by part) with the total department costs for the foundry department. There was a variance but not big enough to invalidate the approach.
We refined the standards so that the various elements of cost were taken into consideration. We also refined the department costs to have various sections ... especially important being the cleaning room labor costs. We ran the standard actual calculation for a month and found cleaning costs under-estimated into the standards. We then did daily standard actual for labor costs in the cleaning room and were able to find specific castings that were the worst offenders ... due to design that made casting very difficult. The engineers improved the design ... making the casting heavier ... and costs reduced.
This became the new practice for design engineering and costing ... a win win for the company.