Manufacturing Company, Atlanta, GA

Manufacturing Standard Cost

I was retained by a manufacturing company in Atlanta to diagnose why their financial reporting showed significant losses from certain product lines.  They believed that their standard costs were accurate, and these models showed the products to be profitable.

So why was I sent St. Louis to Atlanta for this consulting project?  Because I was part of a local CPA firm with 50+ employees, this firm was part of a national network of independent CPA firms, and I had more expertise in cost accounting than anyone else in the national network.

I reviewed the Standard Cost calculations for the products in question.  I reviewed the financial statements, particularly standard cost variances.  I toured the plant floor and watched the products being manufactured.  The employees were highly skilled craftsmen, operating high tech CAM equipment; Computer Aided Manufacturing consists of precision machining equipment driven by computer programs that specify the finished dimensions desired and the steps to cut, grind, or polish every surface that must be machined. Most have access to a variety of tools built in, so that the machine automatically changes drill bits or cutting tools as required to perform each step in the process.  In this case the products were produced in a department separate from the larger group of manufacturing processes which produced higher-volume, less specialized products.

As in most manufacturing companies, someone had calculated allocations of overhead costs to each department.  Some of this is simple and easy to assign.  If a person spends X hours working on a function, and payroll taxes and benefits for the production employees as a whole are equal to 20% of direct labor costs, then all labor rates are increased, or “burdened” by 20%. Then overhead expenses are allocated, such as General & Administrative costs are 15% of direct labor, etc. Similar functions are applied to rent and other occupancy costs (perhaps some allocated by square footage occupied), and so on.

But, a fundamental assumption in all cost accounting systems is accurate measurement of labor involved, since most costs are allocated based on direct labor.  Here was the fallacy in this department.  Someone had measured that it took a certain number of hours to actually make one item of a particular product.  One widget requires ten hours of direct labor to produce.

However, they were employing a dozen people, at 40 hours per week, (12 x 40 = 480 hours) but producing only 34 finished products. Do the math: 48 / 34= 14 hours per item, not 10.

Simple truth: If the map and the ground don't agree, the map is wrong.  In this case, the “standard” said 10 hours per item, but the facts were 14 hours each.  A proper cost variance analysis would have shown 140 hours of labor as a variance each week (10 hours each multiplied by 34 items, deducted from 480 hours paid for labor equals 140 hours unaccounted for.  In real life, they were paying for 48 items but getting only 34.  A proper financial statement would have displayed this variance and a good cost accountant would have asked why.  Adjusting standard costs to real life should be standard practice.  The reasons for the variances were several, but essentially it was inefficiencies inherent in a low-volume, semi-custom environment.  Waiting for parts; excess setup time switching between products; not starting a new job when there were only 2-1/2 hours of a workday remaining.  But the company’s real problem was that middle management refused to admit that their cost accounting standards didn’t work as expected because those managers who developed and approved the standards would have been forced to admit to the owner that they did not really understand the business when they set up the new standards.  My depth of knowledge and expertise allowed me to diagnose the problem in one day and explain it to them in a few hours.  But I could not persuade them to admit their errors, and I did not have access to the owner, so he never learned the facts.

Lessons learned:

  • Technical expertise is not enough; effective communication with the decision makers is critical to implementing change.

  • Cost accounting is an art, not a science. Many companies, the majority in fact, make assumptions and end up with errors that distort the decisions about which products are profitable, and which are not, or less so.

  • Communication between all members of a team is critical. The workers on the shop floor knew that 10 hours didn’t work.  But the managers did not ask them, the accountants did the standard reports but never analyzed the results, and the owner did not understand the concepts well enough to ask the right questions.

Professional Services Company, Saint Louis, MO

Partners' Differences

This company had two partners, Mary and Bill.  Mary had founded the company 15 years earlier, and Bill had been admitted to partnership two years ago based on his purported ability in sales and business development.  Bill sought me out because he felt that his compensation did not adequately reward his efforts.  The company hired me to help them develop a sales compensation program.

Regardless of the plan options, all the proposals had in common a requirement that compensation be directly linked to personal performance.  However, once we had proposed plans on the table, it turned out that Bill did not really want to be held accountable for his performance.  Now the engagement changed.  I adapted, and we began to negotiate the junior partner’s withdrawal from the business.

We negotiated a price for Bill’s withdrawal from the business, and the terms and conditions of his termination.  This project, while traumatic at the time, had a very good outcome for the original partner.  As a result of this success and the knowledge of the company that I had acquired during the original phase of the engagement, I continued as an advisor, performing a variety of services for Mary and the company over time, including supervising the implementation of a new accounting software system, development of some new management reporting tools, and training new people.  This client has provided a testimonial.

By the way, this case illustrates one of the key issues of dealing with family-owned or partner-owned businesses: Who is the client?  Here’s my basic approach to that topic:  The Company is the client, and the Owners are the beneficiaries of the company.  If there is a conflict between owners, or between certain owners and the Company as a whole, the primary obligation is to the survival and future success of the Company.  That can mean that some owners win, or gain more than others, or lose.  It’s easier to decide who wins or loses if one or a group of owners have majority control; it’s far more complicated when the owners end up in two or more groups with equal ownership percentages.  The answer is to be fair to everyone.  If a price is offered to buy out a minority faction, for example, they should have the option, rather than accepting the buyout at that price, to be the acquirer and purchase instead, at the offered unit price.  Ultimately, survival and Success of the Company are the paramount objectives.

Privately Held Printing Company, Saint Louis, MO

Management & Ownership Succession - Three Brothers

Once upon a time a man started a business and built it up to a point that it supported him, and his three sons and their families. Then sometime after age 90, the founder passed away. The immediate result was that the three sons, who had previously owned less that 10% each in the business, now owned about a third each (the percentages weren’t exactly equal, before or after dad’s death, but close enough for this story). So that’s good, right? Dad treated everyone fairly. Now three brothers had to figure out how to manage a three-way partnership, and that isn’t always easy. Unfortunately, there was some dissension immediately. Dad understood the strengths and weaknesses of his sons, and had appointed Don, son # 2 in age, to be President. Son #1, Walt, wasn’t very happy about this; his concept that as the oldest son, he should be the favored one, coupled with his own naturally high opinion of his own value in the world, caused him to not accept his Dad’s choice, but Dad wouldn’t entertain any dispute, so nothing changed while Dad was alive. When he passed, Walt thought this would be a good time to assert his rightful position as the family leader. This situation was exacerbated by Walt’s wife, never satisfied with the fruits of Walt’s labors, so she encouraged her husband to dissent.

Then a new complication arose. The company had a line of credit with a local bank, who said, “Now that you each own significant shares in the company you all must personally guarantee the loan.” The personal guaranty threshold for many banks is ten percent ownership. The SBA requires personal guarantees for any shareholder with twenty percent or more. Two of the three brothers balked at this requirement. Brother #3, Tom, never thought of himself as an owner; his career had taken him in a different direction and he had only recently become an employee, and only because at age 55 he was having trouble finding a job. His brothers were willing to help out, so let him fill a vacant clerical position. But, he now owned a third of the company. The bigger problem was Walt, who even though he wanted to run the company, wanted no responsibility if it didn’t work out. He refused to sign a personal guarantee. The bank refused to renew the line of credit without full guarantees. The company was struggling, no way could they pay off the line of credit. What to do?

I was originally retained to coach the brothers in their relationship with the bank. I was referred to them by the bank’s loan officer. I helped them understand the bank’s position, and we evaluated a variety of alternatives. One opportunity that I discovered was the Don, son #2 and President, had loaned substantial sums to the company. The company was in a declining industry. People simply did not use the products as much as they had in the past; the world changes and this company had not adapted. All three brothers had the same opportunity to support the company in recent years, but only one had stepped up and put his personal resources on the line to support the company. The other two had other uses for their money, or had not saved any, and so they did not step up to help. I proposed a solution: We converted that shareholder debt into equity. Don converted his debt by buying additional shares; each of the three brothers was offered the same opportunity, at the same price, but none believed in the company the way Don did, and they were unwilling to invest in their own company. So, after the recapitalization, Don owned 82% of the company, and his two brothers owned 9% each. Don signed a personal guarantee. The bank did not require the “less than 10% owners” to guaranty, so they renewed the line of credit and the company survived. Walt retired, his wife quit her job at the company, and Tom stayed on and took over some of Walt’s duties.

I coached Don on a variety of business issues. The company moved to a less expensive facility. They upgraded their website; cleaned out old inventory; simplified their product offerings; focused on the portions of their product catalog with the best opportunities for growth; adapted to the world around them and made a reasonable life for themselves.

Not everyone was happy with the outcome. One brother fulfilled the role to which his Dad had appointed him and made the best possible future for the company. One brother quit, picked up his marbles and went home because he couldn’t get what he wanted. But, he had a choice; the offer was there, and he chose not to take any risks.

The solution worked because of a specific set of circumstances. Your situation will be different; you have your own facts and circumstances. The point is that I evaluated those facts and circumstances and proposed alternatives. One of those alternatives was the solution that worked. Some creativity, a deep understanding of business management, significant experience with the realities of dealing with lenders, and a depth of understanding about family dynamics, and an ability to coach various inter-personal relationships.

Perhaps we could help to find alternatives for your issues?