Strategies may be conceptually brilliant, but if they are based on faulty […]. Strategies may be conceptually brilliant, but if they are based on faulty information about the cost of a product, they are likely to fail in the marketplace. Many have. But redesigning a cost system is expensive and time consuming. Do you really have to do it? There are two ways of finding out. An obsolete cost system sends many signals, so one way to discover if you need a new system is to learn how to read those signals. See the insert for a definition of an obsolete cost system.
Taking infinitesimal measurements of each bit of material and each second of direct labor can be expensive and time consuming. The expense is necessary only when the consequences of relying on inaccurate information are severe. When, for instance, margins are paper thin and the market moves quickly, basing decisions on inaccurate cost data can put a company out of business in a hurry.
A good cost system trades off the cost of measurement and the cost of errors from inaccurate information in a way that minimizes total cost see accompanying graphs. The optimal cost system minimizes total costs and changes when information technology improves or when errors become more costly.
An optimal cost system is a moving target. Competitive conditions are dynamic, so the cost of errors changes. Similarly, as information-processing technology changes, so does the cost of measurement. It is important to remember that product diversity has a great deal to do with accuracy. As diversity increases—as high volume is mixed with low volume, or labor intensity is mixed with automation—costs are more likely to be skewed.
To achieve the same level of accuracy, companies will have to spend more on measurements than when products were more homogeneous. They gradually outlive their usefulness as they fail to adapt to change. So a second way to tell if your system has deteriorated is to analyze the changes that have occurred in your organization and in its environment since you first implemented the system. Production managers know when a product is troublesome. You can use their knowledge to test your cost system. Ask them to list the ten established products they would most like to drop.
If there is nothing special about those items, and yet they still show high profits, the cost system may be failing to capture their true complexity. He was confident that he was doing a good job and believed the product should be competitive. Years later a revised cost system showed that because the product used more direct labor than any other, it was being charged too much overhead.
Unfortunately, by then, competitors had introduced similar products and the opportunity was lost.
Such products will have higher than average costs and, unless they are priced at a premium, will have low margins. If they are not premium priced but appear to be highly profitable, the cost system is failing to report their true cost. When functional managers have completely lost faith in the official cost system, they may develop systems of their own. Personal computers make it fairly easy to do. Bad or complex designs came out looking like big profit makers, while products the engineers knew to be well designed appeared to be losers.
The engineering department responded by developing its own system for costing products. Where the official system used direct labor to allocate costs, the private system used a number of different bases. Also, the engineers tracked costs they considered to be product related but that the official system treated as period expenses. The department ignored the official system and used its private system to steer design work. Some decisions require more accurate information than others.
A decision on out-sourcing a high-volume product, for example, is important enough to warrant more detailed and accurate cost data. Accounting departments often set up special teams to study such situations. If its failure to do so makes lengthy special studies routine, the cost system is probably obsolete. This was the case at one company, where half of the accounting staff was working on special projects, some of which took more than six months to complete. Unless barriers to entry exist, companies should expect competition.
If there is none, the cost system may be reporting fictitious margins. One company found that as its niche expanded, overall margins fell. A redesigned cost system showed that products the company thought were earning high profits were actually losing money.
Another company discovered that a competitor was buying its products and then repackaging and selling them. When other successful companies, especially smaller ones, charge less for items you produce in high volume, your cost system is suspect.
Selected Publications – Eva Labro
It is likely the system averages product costs among your high- and low-volume items. The smaller company probably makes products whose production volumes are similar, so averaging creates less cost distortion. Customers will certainly never ask for price increases.
Customers paid the higher prices without complaint; sales volume dropped off only slightly. Unless the market is chaotic, managers should be able to estimate the competitiveness of their bids.
When one cutting-tool manufacturer kept winning high bids and losing low bids, the president suspected that the cost system was the culprit. A new cost system solved the problem. If the bid price varies widely from the cost of making the product, the cost system may be at fault. In one case, the vendor bid was below the variable cost of the product, yet there were no indications that the vendor was that much more efficient.
If a new GAAP regulation changes your costs even when materials prices and manufacturing costs are constant, chances are you tailored your system to meet financial reporting requirements—not to provide accurate cost information. When direct labor is used as an allocation base, the introduction of automated production processes such as flexible machining systems can cause the system to fail.
The new machinery uses less direct labor but usually requires more support for programming and engineering. Products made through automation tend not to be charged enough overhead, while products manufactured conventionally are charged too much. One company had completely revamped its production process to move from machines that required continuous direct-labor supervision to machines that required virtually no operator attendance.
A system based on machine hours corrected the problem. An integrated-circuit manufacturer introduced a new line of chips, which was a good strategic fit but did not fit well with the cost system. Production of the new product was highly automated, so when it came time to allocate overhead, as always, on the basis of direct labor hours, the new product got off easy.
Cost Accounting, Process Control, and Product Design
The cost system was distorted. Even worse, the existing products were charged with too much overhead and appeared unprofitable. Subsequently, the company moved their production offshore. If a new product requires different kinds of support from existing lines—more detailed inspection, for example, or longer setups—the amount of overhead allocated to it will likely be incorrect. These distortions can creep in slowly.
For example, one company introduced a new line of plastic products to complement its sheet metal business. Initially, volume was relatively low, so little distortion arose from allocating the overhead needed only for metal fabrication to both plastic and metal products. Over time, however, sales of the plastic products increased dramatically, and the distortion became serious.
The decision to market in a low-volume niche means smaller production volume. In contrast, the decision to move from experimental parts to production parts means higher volume. When production volumes vary widely in the same company, cost distortion arises. If production volumes are fairly similar—say, volume of one product is no more than five times that of any other—product costs will probably be accurate.
Accuracy falls off rapidly as the range grows to more than 10 to 1. One company produced some products in batches of under 50 and others in batches of more than 1, Its traditional direct-labor-based cost system grossly undercosted the low-volume products and made them appear more profitable than they were.
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Costing Systems provides a structured overview of costing system research to explain the co-existence of different costing practices. This body of research has come to prescriptive conclusions, which will of be valuable and insightful to practitioners designing costing systems and managers using reported cost data.
The monograph is structured around four primary purposes of cost measurement: decision-making, cost management, inventory valuation for financial and tax accounting, and control and performance measurement. Part 1 of the monograph relates to the production or supply choices made by costing system designers. Part 2 moves onto the demand side for cost information. This monograph aims to be useful both to novices in the costing field who are searching for a primer on this literature as well as for people familiar with the literature who are interested in a structured overview and thoughts on where future research avenues may lead.
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