revenues to expenses. The standard costing model is stated as:
Unit Cost = Variable Cost + Fixed Cost/x
where “x” is the number of units associated with the fixed cost. The unit cost is used to determine total expected cost based on volume of units produced and then managers are measured to their variances from expected cost. The unit costs are also used in financial statements for all the purposes listed above. The conflict occurs because the standard cost model implies that producing more units will ultimately lead to lower unit costs and thereby improve profitability and cash flow. In addition, this model and common intuition promote the idea that employing capacity at highest possible utilization levels, preferably 100%, will result in the best possible financial performance for a company. While the standard costing model is fine for allocating revenues to expenses, it is not a good operations performance model. Therein lies the opportunity for a truce in the “war” between Accounting and Operations and a productive path forward.
A fundamental problem with the standard costing model is it does not take variability into account. The operations science of Factory Physics® concepts describes the fundamental relationships between inventory, response time, capacity and variability. For more detail see Chapter 3 in Factory Physics for Managers. For a quick blog post explanation, click here. A fundamental relationship between utilization and time is described by Kingman’s equation, also known as the VUT (Variability, Utilization, Time) equation. Unfortunately this relationship is not widely understood in Operations, much less in Accounting. At a recent industry conference, participants were handed a blank sheet of paper and asked to draw the relationship between cycle time (the time a job takes to be completed from the first step of a routing to the last, for instance, fabrication-assembly-test-packaging). The results were documented on a flip chart and are shown in the following picture:
The red line highlights the correct relationship but this same type of confusion has been demonstrated by thousands of participants tested on fundamental operations science relationships during Factory Physics workshops and training sessions. This would be like a physicist not knowing the implications of E = mc2 or a home owner not understanding the relationship between the mortgage interest rate and their mortgage payment.
The following graph provides both the VUT equation and a graphical interpretation of the interaction of variability, capacity utilization and cycle time in the real world.
Note that cycle time blows up sooner with more variability. The gold star represents perfect performance: 100% utilization at nominal process time (t0). One of the laws of operations science is that work will not be released to a production or service process at 100% utilization over the long term. Because of variability, releasing work at 100% utilization eventually results in such poor performance, increased cycle times and inventory, that something will be done to work at less than 100% utilization to get performance back to acceptable levels. So the appropriate level of utilization depends on the amount of variability in a process and the desired response time. A job shop typically has a tremendous amount of variability and a planned utilization of 70% would make sense to provide acceptable response times. For a commodity operation, a higher level of utilization would be targeted—maybe 85%. This is where the opportunity for a truce occurs.
It is Operations’ responsibility to demonstrate this relationship to Accounting and help determine the most profitable level of resource utilization for a company. If this relationship is not understood, what typically happens is that those controlling the purse strings (Accounting) determine the performance expectations and targets. Since Accounting’s model of performance is the standard cost model, this often leads to 100% utilization targets, chaotic and less profitable performance.
In summary, the standard co