By the way, what does an incremental cash flow cost of zero do to traditional EOQ or lot size calculations, if you use zero instead of average, fully absorbed cost? Since the change would be zero (S=0), the EOQ formula would reduce to the square root of zero. Then, what about the transfer price for items? Should your department or anybody’s department really have to absorb the transferred consequences of an upstream arbitrary decision on overhead costs?  No, do transfers at prime material cost. 

A more important measurement of an activity’s cost is its impact on throughput (sales revenue - totally variable costs). Any interruption in production at a bottleneck or revenue pacesetter is very expensive in terms of cash flow. More activity at a non-bottleneck work center usually only affects total costs and cash flow by consuming additional materials. If at the non-bottleneck you do more work, you’ll incur additional material cost, but not much else. Therefore, if you sell something from this additional effort for more than the cost of materials, you will make a positive contribution to overhead and profit.

To help everybody in your organization really understand what's happening, map your process flows or value streams so you will know where your bottleneck is for your current product mix. Ask your accounting department to do a little research to show how much total costs actually vary when volumes change, except for materials. You will almost surely find that for the vast majority of time periods, expenses or costs were fixed in the design stage of the product and business. With very few exceptions, the only business expense that fluctuates with production volume is the amount of materials consumed.

To illustrate: An organization has an internal constraint which will not be solved for some time. Work center 1 only has capacity for 50 per month and because of horizontal and vertical dependency, the whole organization and the supply chain is therefore constrained to 50 per month. Fortunately for this business (though not for consumers), economic and political barriers to entry keep its competitors from rushing in to seize upon this unsatisfied demand opportunity. Such barriers won’t last forever! Cost accounting has determined that the overhead at all departments is $140/hour. One unit is sold approximately every day, generating $6,000,000 in profit.



Now consider the following “opportunity” to sell a component product to a customer for $300. You can make the product for $100 in materials using 3 hours of labor and you don’t need to use the constrained (bottleneck) resource to produce it.  Or, you can outsource it for a mere $200.  What should you do? 

Since 3 hours of labor X $140/hr + $100 in materials = $520 of cost compared to the $300 of sales revenue which leads to a loss of $220, traditional cost accounting would say it’s too expensive to make,  so “Buy it”!  However, that’s not the right decision because if you buy it those are real dollars going out the door and those pesky, relatively fixed, period costs won’t change. 

You should “Make it”, since the totally variable cost of materials is only $100 and the sales price is $300 for a positive cash flow and contribution to profit of $200. 

Scenario:  Cost accounting has determined overhead at all departments to be $140/hour. One end item gets sold every day, generating $6,000,000 in profit.

Now consider the following “opportunity” to sell a component product to a customer for $300. You can make the product for $100 in materials using 3 hours of labor but you need to use the constrained (bottleneck) resource to produce it.  Or, you can outsource it for a mere $200.  What should you do? 

If using the bottleneck resource, you should “Buy it” because 3 hours of work on the constraint costs the organization approximately $750,100 of throughput ($6,000,000 / 24 hours = $250,000 / hr X 3 hours plus $100 of materials), not merely the $520 estimated by traditional cost accounting methods.

Again, if you have unused (non-pacesetter, extra, excess, protective) capacity already in-house, then use it to make things that will sell. The incremental cost will probably only be materials and the result in the case of a sale will be more revenue (contribution to overhead and profit) than the cost of those materials. In the case of an internal transfer, the result will be better utilization of your fixed assets and better return on total investment. (Incidentally, I hope you do have extra or protective capacity in-house, but that’s another article!)

To Summarize:
    1. Assignments of most costs to time periods or events are arbitrary (even if in accordance with GAAP and IRS) and became relatively fixed at the time when you acquired the resource or asset (land, buildings, machinery, information systems, people’s services, etc.).
    2. Know where your revenue flow bottleneck is.
    3. Marginal cash flow cost at the non-bottleneck is usually only materials.
    4. A transfer is not a sale (even if your software labels it as such) and does not generate real profit.
    5. Using your non-bottleneck capacity to generate income from sales (not transfers) will generate cash flow and profits for you.

Hank Barr, CPIM-F is a past President and Director of Education for the Puget Sound, WA, USA chapter of APICS and a retired US Air Force Supply & Logistics officer. He is an active speaker and has taught Operations Management at several universities in the Pacific Northwest.  Hank’'s certification clients include Tektronics, Boeing, Starbucks, Amazon, and Port of Seattle.