3,000 Tons of Wreckage and Cost Variances
“3,000 to 4,000 tons of bridge wreckage laying on the vessel.”
The Baltimore bridge collapse has created huge supply chain issues for businesses that are waiting to receive items stored on the ship.
According to the Mayor of Baltimore, the ship weighs as much as the Washington Monument.
Staggering.
As reported in the Wall Street Journal, the ship carries: “paper products, machinery, scrap metal and lumber, shipments bound largely for India and other parts of Asia that experts say may be tied up for weeks at the harbor outside Baltimore.”
Tied up for weeks…
This article explains the potential accounting impact of shipping delays, and how a business may pivot to meet the challenge.
An example
To illustrate, let’s assume that Maurice operates Eifel Tower Furniture in Paris, and Eifel Tower produces furniture for corporations. Maurice is waiting on a shipment of maple wood to complete an order for 50 cabinets that will be installed at a business client in two weeks.
The maple wood is stuck in Baltimore.
How can Eifel Tower fill the order?
Well, Maurice may be able to find another supplier, but the cost paid for maple wood might be much higher. After all, the supplier has all the negotiating leverage, because Maurice really needs the raw materials to complete the furniture.
The furniture cost includes 3 types of costs.
Understanding direct materials, direct labor, and overhead costs
Here are the costs incurred to manufacture the furniture:
Direct materials: Material costs that can be directly traced to the product. This includes wood and the cost of metal fixtures, including metal handles.
Direct labor: Labor costs that are traced directly to the product. Cutting wood, assembling furniture, adding handles and other fixtures are labor costs. This includes manual work, and the cost incurred for employees to operate machinery.
Overhead (Indirect costs): Costs that cannot be traced to a product. Instead, these costs are allocated, typically using an activity level. The cost to repair and maintain machinery, for example, might be allocated based on the number of machine hours needed to produce 100 pieces of furniture. For example, $10,000 cost / 2,500 machine hours.
Why knowing total costs is critically important
A key point: Every cost must be accounted for and assigned to a product or service you sell.
I’ll say it another way: Businesses spend money to generate sales and profits. The idea that a company “just absorbs” or “eats” a particular cost isn’t how business should be conducted. All spending must be recouped based on a product or service you sell.
Here’s an example:
Let’s say that Eifel Tower Furniture has scraps of lumber left over from a production run. Small pieces that remain after the bulk of the lumber was used to create furniture.
Accountants record an expense for scrap material.
However, the scrap expense should be allocated to products sold to customers. If, on average, 2% of lumber costs end up as scrap expense, that 2% should be an additional cost added to the total cost of each piece of furniture.
The price should be increased to account for the additional scrap expense.
Again, the goal is to trace or allocate every cost to a product or service you sell.
Working with cost variances
OK, back to the supply chain issue. The maple lumber is stuck in Baltimore, and Eifel Tower has to purchase lumber from another supplier. Lumber cost per cabinet increases from $250 budgeted lumber costs to $285 actual cost per cabinet.
Eifel Tower has a material variance of ($285 actual cost - $250 budgeted cost), or $35. The variance is unfavorable because actual costs are higher than budgeted costs. If Eifel paid less for materials than budgeted, the company has a favorable variance.
My 5th book, 50 Stories That Explain Personal Finances, comes out in Fall of 2024. Email me at ken@stltest.net for more details.
The lesson
Compare actual vs. budgeted costs for all costs, including direct labor, direct materials, and overhead costs. Research any variances from budgeted costs and determine why the variance occurred. Understanding variances can improve your planning and budgeting process.