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Manage around the unit cost.

Article Excerpt
EXECUTIVE SUMMARY

Manufacturers use unit cost to gauge their productivity and efficiency, but is that the right measure? In reality, tracking unit cost creates a sea of confusion and ambiguity because unit cost takes simple numbers and turns them into incomprehensible values. There are better ways for manufacturers to figure out how successful they are.

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It is interesting how tied to the unit cost we are. Manufacturing uses unit cost to determine how effective, productive, and efficient its operations have been. Plant managers and other manufacturing and accounting personnel measure costs and variances at degrees that surpass the rules of significant digits so that the unit cost can be determined at what appears to be a highly precise level. It has also been argued that via the learning curve and the resulting improvements in the time required to manufacture products, the unit cost actually goes down with increased experience. The result is the belief that unit prices can be reduced accordingly, therefore maintaining unit margins.

In an ideal world, managing unit costs and unit margins would be a desirable approach. However, business is not the ideal world; it is the real world in which unit cost has limited true validity and usefulness. There are two reasons for this bold claim. First, the cost dynamics of the unit cost are not aligned with cash flow. Using unit cost to manage cash flow can lead to decisions that are not realized on the bottom line. Second, people who have accepted the first statement often suggest as an alternative that the unit cost is a measure of efficiency.

In reality; unit cost is not an efficiency measure for two reasons. First, when using total costs and total units as a way to determine the cost per unit for efficiency purposes, the cost measure is actually an input and total units is an output, suggesting that the ratio of cost divided by unit is the inverse of efficiency, Second, when using aggregate numbers, the ratio is often misinterpreted. If a plant spends $1 million to produce 100,000 units, it is assumed that each unit costs $10 to make. This, too, is incorrect, as the ratio suggests that for an investment of $1 million, the plant made 100,000 units, and that's it. The bottom line will not see an increase of $10 for each additional unit produced because most of the costs that make up the $1 million are independent of output. As an efficiency measure, it suggests that the $1 million invested in capacity yielded 100,000 units, and if that same investment could yield 110,000 products for which demand exists, the company has operated more efficiently and may increase its financial performance as a result.

Unit cost anatomy

Making such statements about unit costs requires an analysis of unit...

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