Basic cost accounting for process manufacturing

As business aspects of running a process plant become more important to operators, it helps to understand some simple accounting concepts.

06/19/2013


The article last month on how process engineers and operators are getting more involved in the business elements of running a plant suggested that operators need to learn some basic concepts of accounting. While the fine points of “bean counting” may not be the most appealing to people more used to working with PID, the underlying concepts are really fairly simple. Given that people in the plant are most concerned with costs, we’ll stick to that side of the business rather than looking at more traditional financial accounting methods.

Accountants like to match costs with the activities that create products and value. This matching concept is fundamental and important to keep in mind. The income a plant generates is easy enough to understand because the output is sold at a specific price per ton. To figure out if you’re profitable, you have to compare income against cost.

Costs are a bit more complicated, and there are two main components. The first part is the direct cost (aka variable cost), which includes tangible things directly connected to production of your output. If your plant typically produces 100,000 tons of product per month, that requires a corresponding amount of feedstock, gas to fire boilers, operators to watch the process, electricity to run pumps, scrubbers, etc. What are the costs incurred to create that amount of product, or, reversed, what costs would not be there if we had not run production at all? Direct costs should vary directly with the level of output. Let’s say for the sake of argument, at normal production levels, direct costs for your plant add up to $600/ton, so total direct cost for a month is $60 million. (These numbers are all made up, so don’t read too much into them.)

Direct costs are the most obvious, and sometimes casual observers believe their plant is far more profitable than it is because they assume that is the only cost element. The other side of the accounting coin is indirect costs, and that’s where things get more complicated.

Every plant has costs that aren’t directly related to production, and there are lots of different kinds:

  • Rent or property costs for the facility
  • Maintenance (equipment and people)
  • Infrastructure (keeping the lights and air conditioning on)
  • Security services
  • Loading dock
  • Plant office building, equipment, and staff
  • Non-production utilities, and
  • Assorted ancillary things.

Since indirect costs do not change with production levels, they tend to be relatively stable and so are sometimes called fixed costs. (Capital equipment is usually handled differently, so buying a new reactor comes from a capital account.)

Accountants like to take all those indirect costs and add them up into one massive number for the month. Then they split it up into the number of units for the typical output of the month. So, continuing our model, let’s say indirect costs are $2,000,000 per month. We divide that according to our output of 100,000 tons, so the indirect cost per ton is $20.

That means the total cost per ton is $620. Anything beyond that will be handled farther up the food chain. Others will deal with the gross margin, etc. Ultimately, you can make things better or worse by making your cost lower or higher. So, how can you improve things?

Raw materials—You might not have any influence on what you pay for feedstock, but you should be able to help improve efficiency and reduce the amount lost in production.
Energy—Again, maybe you can’t control pricing, but you can help control consumption.
Output—Even though you probably don’t control indirect costs directly, any time you can increase production, the indirect cost gets divided by more units of output, so the indirect cost per ton goes down.

Your accountants establish standard costs for your products based on experience. When the actual cost deviates from the standard, it’s called a variance. Variances can be favorable or unfavorable. Unfavorable is when production goes down because of an outage, and now you have fewer units of output and the indirect cost goes up per ton. Or, your energy efficiency goes down because a heat exchanger is fouling and it drives up your direct cost. That’s a bad thing.

Favorable is when you can increase output, improve efficiency, or do something else to come in under the standard cost. Start looking for opportunities. That gets you the kind of attention you want.

Peter Welander is a content manager for Control Engineering, has an MBA, and got an A in his cost accounting class. pwelander(at)cfemedia.com 

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