Keeping the Lights on (Part 1): Costing in China

Tuesday, December 23, 2008 1:59
Posted in category From the Factory Floor

As the economic down turn begins to take hold in China many companies are looking to the accounting department to help control costs. Unfortunately some of the accounting tools in use are a double edge sword one in particular is standard costing.

Most FIE’s that have manufacturing operations in China are on some type of a standard costing system.

For the laymen a standard costing system could be thought of as a budget for one unit of a product, where standards are set during the budgeting processes at the beginning of the year. Standard costs are usually classified as one of three components of budgeted costs (direct labor, overhead and materials), with each department being incentivized for keeping their department’s costs under budget; a process that creates some natural tensions between purchasing and production departments.

In the good times, when the plant is running at or near full capacity, the gains of lower raw material costs will often be offset by higher direct labor costs as processing time and rework is usually traded for a lower cost material.

In Standard costing all manufacturing costs are absorbed into the product including direct labor, materials and overhead, and at each month’s accounting close the actual costs are tracked against those standards with variance reports. This, in theory, will allow management to quickly see a problem and take action if needed.

This is a great control, tool however this tool is often misused in sales policies. Often management will set sales policy based on this standard as they believe it is their true cost. What needs to be realized is that fixed cost is an integral part of the standard cost and because of its nature exists whether there is no activity or the plant is run at full capacity.

As economic activity decreases, the orthodox approach is to reset the standard for the new budget at a lower volume which will force the standard cost per unit to increase as the overhead allocation increases to reflect the fact that fewer units are being produced.

By doing this however, a company can quickly find itself priced out of the market, as the revised standard cost will be higher and management it follows the above sales policy and refuses orders below their standard cost. This refusal of orders will cause the cycle to be renewed again and like a death spiral with ever increasing standard costs.

A new standard for overhead absorption
An alternative is to set the standard cost at full capacity of the plant less any planned down time for maintenance. It is important to set each product in the product portfolio as if it was the only product being produced.

Setting the standard in this way shows management the opportunity cost of any given product in the portfolio and gives a much truer picture on how it contributes to the bottom line. This allows for better decision support should the plant experience temporary capacity issues.

This Standard costing system has the control benefits of the orthodox method while aligning the cost accounting system with cash outlay and more closely aligns economic profit and accounting profit.

At month end, under absorbed overhead is immediately expensed into a separate COGS account. Breaking out overhead in this way shows management the cost of its extra capacity or its “real option” for future orders and other product lines.

Any finished goods Inventory is recorded on the balance sheet at the full capacity standard.

Holding inventory at this cost reduces management’s incentive to build inventory thus preserving cash more effectively. Chinese managers are notorious for only managing the income statement and will often overproduce as they are usually incentivized based on the bottom line only. This over production shows up on the income statement as higher profits as more overhead is absorbed by the inventory on the balance sheet.

By absorbing labor, usually a fixed cost in China, and overhead as if producing at full capacity, there is less management incentive to build up unnecessary inventory.

At year end, ending inventory can absorb the under absorbed labor and overhead for statutory accounting, PRC GAAP and IFRS purposes and as management is not incentivized to build inventory this should not be a very large adjustment.

Note: For FIE’s that manage their plants on US GAAP, there is a new FASB ruling SFAS No 151 Inventory Costs and Amendment of ARB No 43 Chapter 4 Requires that excess Idle capcity cost be reported as a period expense.

Optimization of cost components
The Controller or CFO needs to have a solid analysis as to the trade offs between materials and labor. In our experience when a plant is running at a high capacity it usually pays to have narrow material spec as the better material allows for faster throughput and frees up capacity to produce other products.

However, in economic downturns, when there is a lot of excess capacity the trade off between material and labor is not as important as before (labor in China is usually a fixed cost) In times like these it pays to widen the raw material specifications as total cash outlay is reduced.

When doing this type of analysis it is important to look at fixed costs, Semi fixed, variable costs, avoidable costs and unavoidable costs.

It is also important for management to look at how the bonus system is set up. If the production department is incentivized by process time, incentive programs may need to be modified to prevent push back from production.

By adjusting the standard accordingly, management can take advantage of the control functions that standard costing provides while reducing the normal downsides of a traditional standard costing system.

In part two of “keeping the lights on” we will discuss managing for cash maximization.

©Jay Boyle – Expat-CFO Services LTD.

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2 Responses to “Keeping the Lights on (Part 1): Costing in China”

  1. dm says:

    December 23rd, 2008 at 8:49 am

    It’s much like Soviet decision making. They imported the machinery, and they had engineering workforce to produce spare parts from what they had in-house.
    The same reason for IT in-house development – if we pay those fixed costs, they should work hard.

  2. W. Jollymore says:

    January 1st, 2010 at 7:48 pm

    Our local China finance staff insist that standard costing is not permitted in China. If I read this right, it can be used as long as the under/over absorbed labour and O/H are allocated to inventory at year end. Is that correct? I ask because we are required to report to the government monthly, not just at year end.