The rate, the base, and the volume nobody sold

Three decisions inside one number

The line on Tanwir's cost sheets reads factory overhead, USD 0.030 a standard minute. It looks like a fact. It is three decisions, and two of them were taken years ago by somebody who has left.

1. What goes in the pool. USD 121,680.00 a month of fixed factory cost.
2. What the base is. Standard minutes, rather than pieces, machine hours, direct labour dollars or revenue.
3. How many units of that base to divide by. 4,056,000 minutes, which is the factory's full capacity.

The first is bookkeeping. The second and the third decide whether every price the factory quotes is right or wrong. Neither is ever revisited. A rate that has sat on the sheet for four years stops looking like an assumption.

The base: why minutes and not money

Take the base first. It is the one that shapes everything in lesson 6.

Tanwir could recover its USD 121,680.00 as a percentage of revenue. On March's revenue that is 121,680 / 974,360 = 12.49% of FOB, and it would have recovered the pool exactly. The method looks defensible and it is wrong. The reason is physical, not accounting.

The factory's fixed cost is eaten by time, not by money. The rent runs whether the garment on the line sells for USD 3.85 or USD 15.05. The mechanic, the compressor, the depreciation on a bar tack machine: all of them are spent per hour of running. A line runs at the same cost whichever garment is on it.

So a garment eats overhead in proportion to the minutes it occupies. A base of revenue charges it in proportion to something it does not eat at all. Look at the two extremes in March's book.

The revenue base charges the shell 3.30 times what the minute base charges it. It charges the pyjama set 58.3% of it, for a garment that occupies a line 44.7% longer. Every merchandiser who has argued that "the expensive style is carrying the factory" was usually reading a rate built on the wrong base.

Minutes are not the only honest base. A factory whose bottleneck is a laser or a bonding press should absorb on hours of that machine. The test is simple, and it is not an accounting test. Absorb on whatever runs out first.

The volume: the number that has never been true

Now the third decision. This is where Tanwir's money went.

The rate was set on 4,056,000 minutes: twelve lines, twenty-six days, 13,000 earned standard minutes a line-day. That is the factory at 100%.

Tanwir has been running for twenty-six months. Its average sold volume over those months is 274 line-days. It has never once reached 312. The closest month was 296.

So the rate is built on a denominator the factory has never hit. The consequence is arithmetic, and there is no way round it. The rate under-recovers every single month, structurally, for as long as the factory exists. Good months under-recover a little and bad months a lot. There is no month in which it does not.

Rebuild it on the volume the factory actually sells.

• Normal volume: 274 line-days × 13,000 = 3,562,000 minutes
• Rate: 121,680 / 3,562,000 = USD 0.034161 a standard minute
• Per line-day: 121,680 / 274 = USD 444.09

That is 13.87% more overhead in every quotation the factory has issued for two years.

Suppose every March order had been quoted with the honest rate and won at the same margin. Revenue would have been USD 14,765.91 higher, and the month's loss would have been USD 3,862.89 instead of USD 18,628.80.

What the standards say, and what they leave to you

There is a rule about this, and it is worth knowing. It decides where the money lands in the accounts.

Fixed production overhead is allocated to the cost of stock on the basis of normal capacity. Normal capacity is what the site is expected to achieve on average over several periods, after allowing for planned maintenance and the ordinary loss of capacity. Overhead that is not allocated is treated as an expense of the period it happened in. You may not push it into the value of the stock on the shelf.

So a bad month is a bad month in the accounts. You cannot smooth it away by valuing garments higher. That is the accounting side, and it is not optional.

The pricing side is entirely yours. Nothing obliges you to quote at the same rate you value stock at, and plenty of factories quote at full capacity because it wins work. Doing that knowingly is a strategy. Doing it because nobody looked at the denominator is what happened here.

What to take away

1. An absorption rate is three decisions: the pool, the base, and the volume. Only the pool is bookkeeping.
2. Absorb on the thing that runs out first, which is minutes in a sewing factory. A revenue base charges a garment for money it passes through instead of time it uses up.
3. Set the volume on normal capacity, the average you really achieve, not the capacity you own. A rate built on capacity you have never reached under-recovers in every month of the factory's life.
4. At Tanwir the honest rate is 13.87% higher than the one on the sheet, and it has been wrong in that direction for twenty-six months.
5. Never re-cut the rate to chase a single month's volume. That loop raises your price when you are emptiest.