The last time in “Show me the Money – Part 1”, we saw the dismay suffered by Operations people when their huge efforts at cost saving didn’t translate into bottom line profits for the company as a whole.

When we looked a little closer, we saw that sitting at the heart of this apparent mystery is the changing relationship between direct and indirect costs.

Traditionally, direct cost comfortably outweighed indirect cost for most manufacturers. Over the last few decades however, things have changed. Continuous improvement programs like Lean and Six Sigma have succeeded in driving down direct labor hours significantly, but in the background, they have quietly pushed up indirect costs.

For example, a rapid die changeover reduces direct labor and increases machine utilisation but does so by moving the setup outside of the operations time to be carried out using indirect labor. Add to that the cost of duplicating tooling and workspace area and the additional indirect cost starts to mount up.

The result of countless similar initiatives has been to alter the ratio of direct to indirect costs to a significant degree. This has created an unintended consequence which now presents a serious problem.

Consider the traditional Standard Costing model. You take your direct machine or labor hours, (which are easy to obtain), and apply a straight-line calculation which absorbs all your indirect costs, and voila, you’ve got your base unit production cost.

But in a world where the direct costs are falling and indirect costs are rising, the proportions are no longer linear, and the model is increasingly invalid.

The implications of this are serious. You might get away with using it for internal transfer pricing, but if you are selling into the marketplace without knowing your real cost, you are starting to play Russian Roulette with the viability of the company.

Until manufacturers get to grips with their actual costs, the problem is going to get worst, not better. Acquiring this knowledge is no longer a nice-to-have capability, but a vital component of company survival.