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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 similar products have sales volumes that vary from 100 to 100,000 units.) The first plant has a simple production environment and requires limited manufacturing-support facilities. Few setups, expediting, and scheduling activities are required.

The other plant presents a much more complex production-management environment. Its 200 products have to be scheduled through the plant, requiring frequent setups, inventory movements, purchases, receipts, and inspections. To handle this complexity, the support departments must be larger and more sophisticated.

The traditional cost accounting system plays an important role in obfuscating the underlying relationship between the range of products produced and the size of the support departments. First, the costs of most support departments are classified as fixed, making it difficult to realize that these costs are systematically varying. Second, the use of volume-related allocation bases makes it difficult to recognize how these support-department costs vary.

Support-department costs must vary with something because they have been among the fastest growing in the overall cost structure of manufactured products.

As the example demonstrates, support-department costs vary not with the volume of product items manufactured, rather they vary with the range of items produced (i.e., the complexity of the production process). The traditional definition of variable cost, with its monthly or quarterly perspective, views such costs as fixed because complexity-related costs do not vary significantly in such a short time frame. Across an extended period of time, however, the increasing complexity of the production process places additional demands on support departments, and their costs eventually and inevitably rise.


The output of a support department consists of the activities its personnel perform. These include such activities as setups, inspections, material handling, and scheduling. The output of the departments can be represented by the number of distinct activities that are performed or the number of transactions handled.

Because most of the output of these departments consists of human activities, however, output can increase quite significantly before an immediate deterioration in the quality of service is detected. Eventually, the maximum output of the department is reached and additional personnel are requested. The request typically comes some time after the initial increase in diversity and output. Thus, support departments, while varying with the diversity of the demanded output, grow intermittently. The practice of annually budgeting the size of the departments further hides the underlying relationship between the mix and volume of demand and the size of the department. The support departments often are constrained to grow only when budgeted to do so.

Support-department costs are perhaps best described as ‘‘discretionary’’ because

they are budgeted and authorized each year. The questions we must address are:

What determines the level of these discretionary fixed costs? Why, if these costs are not affected by the quantity of production, are there eight people in a support department and not one? What generates the work, if not physical quantities of inputs or outputs, that requires large support-department staffs? We believe the answers to these questions on the origins of discretionary overhead costs (i.e., what drives these costs) can be found by analyzing the activities or transactions demanded when producing a full and diverse line of products.

Transaction costing Low-volume products create more transactions per unit manufactured than their high-volume counterparts. The per unit share of these costs should, therefore, be higher for the low-volume products. But when volume-related bases are used exclusively to allocate support-department costs, high-volume and low-volume products receive similar transaction-related costs. When only volume-related bases are used for second-stage allocations, high-volume products receive an excessively high fraction of support-department costs and, therefore, subsidize the low-volume products.

As the range between low-volume and high-volume products increases, the degree of cross-subsidization rises. Support departments expand to cope with the additional complexity of more products, leading to increased overhead charges.

The reported product cost of all products consequently increases. The high-volume products appear more expensive to produce than previously, even though they are not responsible for the additional costs. The costs triggered by the introduction of new, low-volume products are systematically shifted to high-volume products that may be placing relatively few demands on the plant’s support departments.

Many of the transactions that generate work for production-support departments can be proxied by the number of setups. For example, the movement of material in the plant often occurs at the commencement or completion of a production run. Similarly, the majority of the time spent on parts inspection occurs just


after a setup or changeover. Thus, while the support departments are engaged in a broad array of activities, a considerable portion of their costs may be attributed to the number of setups.

Not all of the support-department costs are related (or relatable) to the number of setups. The cost of setup personnel relates more to the quantity of setup hours than to the actual number of setups. The number of inspections of incoming material can be directly related to the number of material receipts, as would be the time spent moving the received material into inventory. The number of outgoing shipments can be used to predict the activity level of the finishedgoods and shipping departments. The assignment of all these support costs with a transactions-based approach reinforces the effect of the setup-related costs because the low-sales-volume items tend to trigger more small incoming and outgoing shipments.

Schrader Bellows had recently performed a ‘‘strategic cost analysis’’ that significantly increased the number of bases used to allocate costs to the products; many second-stage allocations used transactions costs to assign support-department costs to products. In particular, the number of setups allocated a sizable percentage of support-department costs to products.

The effect of changing these second-stage allocations from a direct labor to a transaction basis was dramatic. While the support-department costs accounted for about 50% of overhead (or about 25% of total costs), the change in the reported product costs ranged from about minus 10% to plus 1,000%. The significant change in the reported product costs for the low-volume items was due to the substantial cost of the support departments and the low batch size over which the transaction cost was spread.

Table 1 shows the magnitude of the shift in reported product costs for seven representative products. The existing cost system reported gross margins that varied from 26% to 47%, while the strategic analysis showed gross margin that ranged from −258% to +46%. The trends in the two sets of reported product profitabilities were clear: the existing direct-labor-based system had identified Table 1 Comparison of reported product costs at Schrader Bellows

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the low-volume products as the most profitable, while the strategic cost analysis indicated exactly the reverse.

There are three important messages in the table and in the company’s findings in general.

ž Traditional systems that assign costs to products using a single volume-related base seriously distort product costs.

ž The distortion is systematic. Low-volume products are under-costed, and high-volume products are over-costed.

ž Accurate product costs cannot, in general, be achieved by cost systems that rely only on volume-related bases (even multiple bases such as machine hours and material quantities) for second-stage allocations. A different type of allocation base must be used for overhead costs that vary with the number of transactions performed, as opposed to the volume of product produced.

The shift to transaction-related allocation bases is a more fundamental change to the philosophy of cost-systems design than is at first realized. In a traditional cost system that uses volume-related bases, the costing element is always the product. It is the product that consumes direct labor hours, machine hours, or material dollars. Therefore, it is the product that gets costed.

In a transaction-related system, costs are assigned to the units that caused the transaction to be originated. For example, if the transaction is a setup, then the costing element will be the production lot because each production lot requires a single setup. The same is true for purchasing activities, inspections, scheduling, and material movements. The costing element is no longer the product but those elements the transaction affects.

In the transaction-related costing system, the unit cost of a product is determined by dividing the cost of a transaction by the number of units in the costing element.

For example, when the costing element is a production lot, the unit cost of a product is determined by dividing the production lot cost by the number of units in the production lot.

This change in the costing element is not trivial. In the Schrader Bellows strategic cost analysis (see Table 1), product seven appears to violate the strong inverse relationship between profits and production-lot size for the other six products.

A more detailed analysis of the seven products, however, showed that product seven was assembled with components also used to produce two high-volume products (numbers one and six) and that it was the production-lot size of the components that was the dominant cost driver, not the assembly-lot size, or the shipping-lot size.

In a traditional cost system, the value of commonality of parts is hidden. Lowvolume components appear to cost only slightly more than their high-volume counterparts. There is no incentive to design products with common parts. The shift to transaction-related costing identifies the much lower costs that derive from designing products with common (or fewer) parts and the much higher costs generated when large numbers of unique parts are specified for low-volume products. In recognition of this phenomenon, more companies are experimenting


with assigning material-related overhead on the basis of the total number of different parts used, and not on the physical or dollar volume of materials used.

Long-term variable cost The volume-unrelated support-department costs, unlike traditional variable costs, do not vary with short-term changes in activity levels. Traditional variable costs vary in the short run with production fluctuations because they represent cost elements that require no managerial actions to change the level of expenditure.

In contrast, any amount of decrease in overhead costs associated with reducing diversity and complexity in the factory will take many months to realize and will require specific managerial actions. The number of personnel in support departments will have to be reduced, machines may have to be sold off, and some supervisors will become redundant. Actions to accomplish these overhead cost reductions will lag, by months, the complexity-reducing actions in the product line and in the process technology. But this long-term cost response mirrors the way overhead costs were first built up in the factory – as more products with specialized designs were added to the product line, the organization simply muddled through with existing personnel. It was only over time that overworked support departments requested and received additional personnel to handle the increased number of transactions that had been thrust upon them.

The personnel in the support departments are often highly skilled and possess a high degree of firm-specific knowledge. Management is loathe to lay them off when changes in market conditions temporarily reduce the level of production complexity. Consequently, when the workload of these departments drops, surplus capacity exists.

The long-term perspective management had adopted toward its products often made it difficult to use the surplus capacity. When it was used, it was not to make products never to be produced again, but rather to produce inventory of products that were known to disrupt production (typically the very low-volume items) or to produce, under short-term contract, products for other companies. We did not observe or hear about a situation in which this capacity was used to introduce a product that had only a short life expectancy. Some companies justified the acceptance of special orders or incremental business because they ‘‘knew’’ that the income from this business more than covered their variable or incremental costs. They failed to realize that the long-term consequence from accepting such incremental business was a steady rise in the costs of their support departments.

When product costs are not known

The magnitude of the errors in reported product costs and the nature of their bias make it difficult for full-line producers to enact sensible strategies. The existing cost systems clearly identify the low-volume products as the most profitable and the high-volume ones as the least profitable. Focused competitors, on the other


hand, will not suffer from the same handicap. Their cost systems, while equally poorly designed, will report more accurate product costs because they are not distorted as much by lot-size diversity.

With access to more accurate product cost data, a focused competitor can sell the high-volume products at a lower price. The full-line producer is then apparently faced with very low margins on these products and is naturally tempted to deemphasize this business and concentrate on apparently higher-profit, low-volume specialty business. This shift from high-volume to low-volume products, however, does not produce the anticipated higher profitability. The firm, believing in its cost system, chases illusory profits.

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