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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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The cumulative effect of decisions on product design, introduction, support, discontinuance, and pricing helps define a firm’s strategy. If the product cost information is distorted, the firm can follow an inappropriate and unprofitable strategy. For example, the low-cost producer often achieves competitive advantage by servicing a broad range of customers. This strategy will be successful if the economies of scale exceed the additional costs, the diseconomies of scope, caused by producing and servicing a more diverse product line. If the cost system does not correctly attribute the additional costs to the products that cause them, then the firm might end up competing in segments where the scope-related costs exceed the benefits from larger scale production.

Similarly, a differentiated producer achieves competitive advantage by meeting specialized customers’ needs with products whose costs of differentiation are lower than the price premiums charged for special features and services. If the cost system fails to measure differentiation costs properly, then the firm might choose to compete in segments that are actually unprofitable.

∗ From: R. Cooper and R. S. Kaplan, ‘‘How Cost Accounting Distorts Product Costs,’’ Management Accounting (April 1988): 20–27. Reprinted with permission.


Full vs. variable cost Despite the importance of cost information, disagreement still exists about whether product costs should be measured by full or by variable cost. In a full-cost system, fixed production costs are allocated to products so that reported product costs measure total manufacturing costs. In a variable cost system, the fixed costs are not allocated and product costs reflect only the marginal cost of manufacturing.

Academic accountants, supported by economists, have argued strongly that variable costs are the relevant ones for product decisions. They have demonstrated, using increasingly complex models, that setting marginal revenues equal to marginal costs will produce the highest profit. In contrast, accountants in practice continue to report full costs in their cost accounting systems.

The definition of variable cost used by academic accountants assumes that product decisions have a short-time horizon, typically a month or a quarter.

Costs are variable only if they vary directly with monthly or quarterly changes in production volume. Such a definition is appropriate if the volume of production of all products can be changed at will and there is no way to change simultaneously the level of fixed costs.

In practice, managers reject this short-term perspective because the decision to offer a product creates a long-term commitment to manufacture, market, and support that product. Given this perspective, short-term variable cost is an inadequate measure of product cost.

While full cost is meant to be a surrogate for long-run manufacturing costs, in nearly all of the companies we visited, management was not convinced that their full-cost systems were adequate for its product-related decisions. In particular, management did not believe their systems accurately reflected the costs of resources consumed to manufacture products. But they were also unwilling to adopt a variable-cost approach.

Of the more than 20 firms we visited and documented, Mayers Tap, Rockford, and Schrader Bellows provided particularly useful insights on how product costs were systematically distorted.1 These companies had several significant common characteristics.

They all produced a large number of distinct products in a single facility. The products formed several distinct product lines and were sold through diverse marketing channels. The range in demand volume for products within a product line was high, with sales of high-volume products between 100 and 1,000 times greater than sales of low-volume products. As a consequence, products were manufactured and shipped in highly varied lot sizes. While our findings are based upon these three companies, the same effects were observed at several other sites.

In all three companies, product costs played an important role in the decisions that surrounded the introduction, pricing, and discontinuance of products.

Reported product costs also appeared to play a significant role in determining how much effort should be assigned to marketing and selling products.

Typically, the individual responsible for introducing new products also was responsible for setting prices. Cost-plus pricing to achieve a desired level of gross margin predominantly was used for the special products, though substantial


modifications to the resulting estimated prices occurred when direct competition existed. Such competition was common for high-volume products but rarely occurred for the low-volume items. Frequently, no obvious market prices existed for low-volume products because they had been designed to meet a particular customer’s needs.

Accuracy of product costs

Managers in all three firms expressed serious concerns about the accuracy of their product-costing systems.

For example, Rockford attempted to obtain much higher margins for its lowvolume products to compensate, on an ad hoc basis, for the gross underestimates of costs that it believed the cost system produced for these products. But management was not able to justify its decisions on cutoff points to identify low-volume products or the magnitude of the ad hoc margin increases. Further, Rockford’s management believed that its faulty cost system explained the ability of small firms to compete effectively against it for high-volume business. These small firms, with no apparent economic or technological advantage, were winning high-volume business with prices that were at or below Rockford’s reported costs. And the small firms seemed to be prospering at these prices.

At Schrader Bellows, production managers believed that certain products were not earning their keep because they were so difficult to produce. But the cost system reported that these products were among the most profitable in the line. The managers also were convinced that they could make certain products as efficiently as anybody else. Yet competitors were consistently pricing comparable products considerably lower. Management suspected that the cost system contributed to this problem.

At Mayers Tap, the financial accounting profits were always much lower than those predicted by the cost system, but no one could explain the discrepancy. Also, the senior managers were concerned by their failure to predict which bids they would win or lose. Mayers Tap often won bids that had been overpriced because it did not really want the business, and lost bids it had deliberately underpriced in order to get the business.

Two-stage cost allocation system

The cost systems of all companies we visited had many common characteristics.

Most important was the use of a two-stage cost allocation system: in the first stage, costs were assigned to cost pools (often called cost centers), and in the second stage, costs were allocated from the cost pools to the products.

The companies used many different allocation bases in the first stage to allocate costs from plant overhead accounts to cost centers. Despite the variation in allocation bases in the first stage, however, all companies used direct labor hours in the second stage to allocate overhead from the cost pools to the products. Direct


–  –  –

labor hours was used in the second allocation stage even when the production process was highly automated so that burden rates exceeded 1,000%. Figure 1 illustrates a typical two-stage allocation process.

Of the three companies we examined in detail, only one had a cost accounting system capable of reporting variable product costs. Variable cost was identified at the budgeting stage in one other site, but this information was not subsequently used for product costing. The inability of the cost system to report variable cost was a common feature of many of the systems we observed. Reporting variable product costs was the exception, not the rule.

Firms used only one cost system even though costs were collected and allocated for several purposes, including product costing, operational control, and inventory valuation. The cost systems seemed to be designed primarily to perform the inventory valuation function for financial reporting because they had serious deficiencies for operational control (too delayed and too aggregate) and for product costing (too aggregate).

The failure of marginal costing

The extensive use of fixed-cost allocations in all the companies we investigated contrasts sharply with a 65-year history of academics advocating marginal costing for product decisions. If the marginal-cost concept had been adopted by companies’ management, then we would have expected to see product-costing systems that explicitly reported variable-cost information. Instead, we observed cost systems that reported variable as well as full costs in only a small minority of companies.

The traditional academic recommendation for marginal costing may have made sense when variable costs (labor, material, and some overhead) were a relatively high proportion of total manufactured cost and when product diversity was sufficiently small that there was not wide variation in the demands made by


different products on the firm’s production and marketing resources. But these conditions are no longer typical of many of today’s organizations. Increasingly, overhead (most of it considered ‘‘fixed’’) is becoming a larger share of total manufacturing costs. In addition, the plants we examined are being asked to produce an increasing variety of products that make quite different demands on equipment and support departments. Thus, even if direct or marginal costing were once a useful recommendation to management, direct costing, even if correctly implemented, is not likely a solution – and may perhaps be a major problem – for product costing in the contemporary manufacturing environment.

The failure of fixed-cost allocations

While we consistently observed managers avoiding the use of variable or marginal costs for their product-related decisions, we observed also their discomfort with the full-cost allocations produced by their existing cost systems. We believe that we have identified the two major sources for the discomfort.

The first problem arises from the use of direct labor hours in the second allocation stage to assign costs from cost centers to products. This procedure may have been adequate many decades ago when direct labor was the principal value-adding activity in the material conversion process. But as firms introduce more automated machinery, direct labor is increasingly engaged in setup and supervisory functions (rather than actually performing the work on the product) and no longer represents a reasonable surrogate for resource demands by product.

In many of the plants we visited, labor’s main tasks are to load the machines and to act as troubleshooters. Labor frequently works on several different products at the same time so that it becomes impossible to assign labor hours intelligently to products. Some of the companies we visited had responded to this situation by beginning experiments using machine hours instead of labor hours to allocate costs from cost pools to products (for the second stage of the allocation process).

Other companies, particularly those adopting just-in-time or continuous-flow production processes, were moving to material dollars as the basis for distributing costs from pools to products. Material dollars provide a less expensive method for cost allocation than machine hours because, as with labor hours, material dollars are collected by the existing cost system, A move to a machine-hour basis would require the collection of new data for many of these companies.

Shifting from labor hours to machine hours or material dollars provides some relief from the problem of using unrealistic bases for attributing costs to products.

In fact, some companies have been experimenting with using all three allocation bases simultaneously: labor hours for those costs that vary with the number of labor hours worked (e.g., supervision – if the amount of labor in a product is high, the amount of supervision related to that product also is likely to be high), machine hours for those costs that vary with the number of hours the machine is running (e.g., power – the longer the machine is running the more power that is consumed by that product), and material dollars for those costs that vary with the value of material in the product (e.g., material handling – the higher the value


of the material in the product, the greater the material-handling costs associated with those products are likely to be).

Using multiple allocation bases allows a finer attribution of costs to the products responsible for the incurrence of those costs. In particular, it allows for product diversity where the direct labor, machine hours, and material dollars consumed in the manufacture of different products are not directly proportional to each other.

For reported product costs to be correct, however, the allocation bases used must be capable of accounting for all aspects of product diversity. Such an accounting is not always possible even using all three volume-related allocation bases we described. As the number of product items manufactured increases, so does the number of direct labor hours, machine hours, and material dollars consumed. The designer of the cost system, in adopting these bases, assumes that all allocated costs have the same behavior; namely that they increase in direct relationship to the volume of product items manufactured. But there are many costs that vary with the diversity and complexity of products, not by the number of units produced.

The cost of complexity The complexity costs of a full-line producer can be illustrated as follows. Consider two identical plants. One plant produces 1,000,000 units of product A. The second plant produces 100,000 units of product A and 900,000 units of 199 similar products.

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