I have thought often about the need to say something about cost accounting because of its importance in creating a profitable business, but I knew the mention of the term would put even most accountants to sleep. So rather than talk about cost accounting, a few words about capturing profits might be worth a few minutes of your time. Chapter 8 of my book goes into the topic in some detail, but perhaps the summary points at the end of the chapter will whet your appetite to delve just a little deeper into the subject. After 14 pages of terminology, examples, and definitions, these are the key take-aways that close the chapter on capturing profits through manufacturing:

  1. Cost accounting is about protecting and growing gross profit by understanding and managing the details of the cost of sales, i.e., the costs incurred in producing the revenue.
  2. Knowing the costs and gross profit margins on each product a company sells is a critical tool for managing overall gross profit. This is true for all kinds of businesses, but it’s more challenging for a manufacturing company because of the complexity of the business.
  3. Cost accounting is possible only when detailed production costs are collected at the source, on the shop floor, where workers are honestly recording what they are doing.
  4. Understanding how costs behave is key to controlling them. Tools such as standards, budgets, and classifications such as “controllable,” “variable,” and “direct” help us to do that.
  5. Variance analysis is the way managers use standards and management by exception to reduce variation from predicted outcomes.

Actually it was that last point that first drew me to write this post, because variance analysis is a poorly utilized tool, in my experience. Any financial report that shows a variance from what was expected is not, as it is often used, an opportunity to offer a reason why it didn’t matter or an excuse why it should be ignored. It’s a call to action. Every variance – well, material ones anyway – requires a conscious decision by management to do one of three things:

  • For a negative variance, make a change to prevent it from happening again,
  • For a positive variance, explore what is needed to keep it from disappearing next month, or
  • Acknowledge that the expectation was incorrect and ensure the creator of that expectation has the information to avoid making that miscalculation again.

Of course, each potential decision presumes that management has first asked and answered the question “What caused the variance?” Without that answer any decision is a management guess that will sooner or later manifest itself in lower profit margins and a reduction in the value of the business. Anyone still sleeping out there?

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