CHAPTER 5

Basic Product Costing Systems

Reading 5.1, Robin Cooper’s Does Your Company Need a New Cost System, poses a critical
question for managers: “Do I really know what my products cost?” Answering this question, will
allow managers to determine whether their costing system is reporting accurate product costs. In
order to address this question. Cooper suggests that managers look for symptoms that often point to
poor system design. For example, one symptom of a poor system occurs when a firm’s customers
completely ignore price increases, even though the firm’s manufacturing costs haven’t changed. In
this instance, the cost system may be under estimating product costs, and, thus, the associated
markup is still below market. Cooper outlines a number of other design flaws that managers should
understand as they attempt to develop more accurate systems.
Consistent with Robin Cooper’s article, Norm Raffish argues in How Much Does That Product
Really Cost (Reading 5.2) that the business world has changed so much that traditional cost
accounting is no longer applicable. For one thing, the relative proportions of what go into product
costs have changed significantly with direct labor content dropping to between 5 an 15%, materials
content falling between 45% and 55%, and overhead soaring to between 30% and 50%. Raffish
builds the case for activity-based costing as a much more accurate method for determining (among
other thins) more accurate product costs.
William Baker, Timothy Fry and Kirk Karwan’s article, Reading 5.3, The Rise and fall of Time-
Based Manufacturing. Presents a case study of Knussman Corporation’s Brice Plant (a fictitious
name), an automotive supplier, that established quality and time-based performance measure in
order to help it compete more effectively. Unfortunately, the company’s managers continued to rely
on a traditional cost accounting system that emphasized standard costing and evaluation based on
direct labor variances, both of which resulted in manager behaviour that obviated the effects of the
quality and throughput time measures. The authors suggest alternatives such as just-in-time
manufacturing and activity-based costing that the company could have used to be more consistent
with its new performance quality measures.

READING
CHAPTER 5

5.1 Cost Management Concepts and Principles

Does your company need a new cost system?
Robin Cooper

Almost a quarter of a century ago. Peter F. Drucker wrote “Managing for Business Effectiveness”
for the Harvard Business Review. I don’t know how much effect that article had then, but it has
little or none today, in my opinion, that is a tragedy.
Drucker argued that management’s primary responsibility is “to strive for the best possible
economic results from the resources currently employed or available. “Then he exposed how
ineffective cost accounting can obfuscate the route management should take to satisfy this
responsibility. Drucker concluded his article with the following advice.
“And while the job to be done may look different in every individual company, one basic truth will
always be present: every product, every operation, and every activity in a business should,
therefore, be put on trial for its life every two or three years. Each should be considered the way we
consider a proposal to go into a new product, a new operation or activity.
The underlying message is clear. Every product should be reviewed to ensure that the company
benefits from its production and distribution. Even if a firm is making an acceptable profit,
management should still ensure that every product is making a profit or that there is a strategic
reason for selling it at a loss (e-g., razor with blades).
In the past two decades, cost accounting has undergone few innovations. Practitioners have
developed an “if it ain’t broke, don’t fix it” mentality, and academics have paid little attention to
cost accounting. The major changes that have occurred—the increased use of machine-hour and
material dollar costing—unfortunately do little to overcome the most serious problems in existing
cost system designs.
In most companies, a product profitability analysis offers valuable insights into the sources of
profits and losses. Such an analysis requires accurate measurement of each product’s production
and marketing costs. In most firms, the cost accounting system is expected to perform this task.
Unfortunately, considerable evidence suggests that these systems fail to accurately report product
cost, for two reasons. First, they were never designed to report accurate product costs; their primary
objective was to report inventory values. Second, they have not been modified as production
processes have changed. These systems no longer adequately measure the flow of a firm’s costs. In
effect, they are obsolete.

THE SYMPTOMS
To determine whether a firm’s cost system is reporting accurate product costs and to guard against
its obsolesces management should periodically evaluate it. Managers should ask themselves. “Do I
really know what my products costs?” Answering this question requires a detailed analysis of the
firm’s cost system—an expensive and time-consuming process. Fortunately, management can
significantly reduce the risk of undertaking such an analysis unnecessarily by looking g for
symptoms that usually accompany a part designed or obsolete costs system. These ore discussed in
the following g sections.
Products that are very difficult to produce and reported to be very profitable even though they are
not premium priced. Not all products are easy to manufacture; some are new, and the work force is
still learning how to make them; others are just inherently difficult to make. The second type
provides a good test of how well a cost accounting system is operating. If the system is capering the
additional manufacturing costs, these difficult in manufacture products should either be selling at
prescient or have low margins.
All too often, however, these complex products appear to be highly profitable. They may be sold at
a small premium, reflecting the market’s willingness to pay more to be product, but their reported
product costs do not reflective difficulty of manufacturing them. In this case, the costs system fails
to capture actual costs and instead reports costs the reflect average levels of manufacturing
difficulty.
Profit margins cannot be easily explained. Management should usually be able to identify why
some products are more profitable than others. Factors that influence profitability include market
share, quality differenced.
Production process differences and economies of scale. If the cost system is accurately reporting
product costs, management should be able to explain the overall patterns of product profitability. If
management cannot explain the pattern, yet believes it understands the market, the cost accounting
is probably to blame.
Some products that are not sold by competitors have high reported margins. If there is no simple
explanation for this situation, the cost system may be at fault. It may be reporting phantom profits;
the competitors system did not. Obviously, this explanation in invalid if the firm has such
competitive advantages as patent protection, high brand recognition, or proprietary production
process.
If the competition purchases the firm’s products, repackages them, and then resells them at a higher
price, or as part of a larger order at the same price, these products are probably improperly costed
and priced. Alternatively, if the competition goes out of its way to identify the firm as the sole
source for these products at the listed price is detrimental.
The results of bids are difficult to explain. Firms that commonly bid for business can sometimes
use the outcomes of their bids to determine how well their cost accounting system is working. If
management is unable to accurately predict which bids they are going to win, the cost system may
be reporting in accurate product costs. Management should look for bids that were expected to lose.
If the aggressively priced bids are frequently lost and the high-priced bids win, the cost system
should be examined.
The competition’s high-volume products are priced at apparently unrealistically low levels. When
smaller competitors with no apparent economic advantage are pricing high production volume
products at very low level and are simultaneously making good returns, the cost system is the
primer suspect. Cost systems tend to report averaged costs. High volume products are inherently
less expensive to produce than low volume products, and most cost system fail to accurately
account for this difference. In fact, high volume products are usually overcosted and low volume
products are undercosted. Smaller companies that manufacture fewer products, however, often
suffer less distortion and a better understanding of their product costs.
Even if cost plus pricing is not used, this volume based distortion of reported product costs can be a
very serious problem. Because the low volume product appear more profitable, the full line
producers is tempted to concentrate on them and leave the high volume product to the focused
competitors, if the cost system is distorting the source of profits, the firm could be chasing
imaginary profits and the profitability may be slowly deteriorating. This deterioration may be
difficult to explain because no clear competitive disadvantage exists and no changes in the
fundamental market structure have been made.
Vendor bids for parts are considerably lower than expected. Parts are often put out to bid because
they appear to be too expensive to manufacture in house. If vendors’ bids on these parts are much
lower than expected given the estimated production economies involved, the cost system may be at
fault.
Cost information plays an important role in make-or-buy decisions. Unfortunately, conventional
cost systems cannot provide the appropriate cost data. In particular, these systems fail to accurately
specify the amount of overhead that is actually avoided by buying. They overestimate the savings,
thus favoring the buy decision. When this bias is couples with the overestimation of product costs,
the buy decision might be adopted too frequently.
Customers ignore price increase, even when there is no corresponding increase in cost. When prices
increase, customers usually react negatively. If there is little or no reaction, the cost system may be
underestimating product costs. This concern is increased if the competition’s prices also increase
and the firm is not the price leader.
If customers don’t complain, they were probably paying less for the product than its perceived
value. If competitors also raise their prices, they may have been aware that the product was
unpredicted but wanted another firm to take the risk of increasing prices. For cost plus pricers, the
apparent excess profitability is the final clincher. By supplying costs that were too low, the system
caused management to under-price the product in the first place. These symptoms can be detected
only if the cost system is reporting product costs that are significantly incorrect. This occurs only if
the design of the cost system is badly flawed.

THE DESIGN FLAWS

Cost accounting systems can be flowed in several ways. The flaws discussed in this section are very
common and can result in a significant distortion in reported product coasts.
Only directed labor hours (or dollars) are used to allocate overhead from cost pool (cost centres) to
the products. The dependence on direct labor can be traced on the very origins of cost accounting.
At the end of the last century, managers installed elaborate directed labor measurement systems to
keep the directed labor force productive. The designers of early cost accounting systems look
advantage of these systems and adopted direct labor hours for all allocation purposes, even when
other bases would have been just as effective. At that time, this simplification was acceptable
because manufacturing processes were highly labor-intensive, overhead was a smaller percentage of
total cost, and product diversity (i.e. the change of different product cost structures) was lower.
Under such conditions, the quantity of direct labor in a product was generally a reliable measure of
the total value added.
Today direct labor costs are usually less than 10 percent of the total production cost of the product,
whereas overhead is more than 30 percent of total cost. No longer are direct labor hours necessarily
a good predictor of the value added to a product. Nevertheless, most cost systems still rely heavily
on direct labor hours to allocate costs to the products.
Only volume related allocation bases (e.g., labor hours, machine hours, and material dollars) are
used to allocate overhead from cost pools to products. These bases assume that the cost of
producing a production lot is directly proportional to the number of items in that lot. This
assumption is correct for volume related activities (e.g., direct labor, production supplies, and parts)
but not for such non volume related costs as inspection, setup, or scheduling. These costs vary with
the number of inspection performed, the number of setups and the quantity of scheduling,
respectively.
Allocating a non-volume-related cost requires the selection of an allocation base that is itself non-
volume-related. In manufacturing processes whose percentage of non-volume-related costs is high,
cost systems using only volume-related bases produce inaccurate product cost. The error in reported
product cost increases significantly if products are manufactured in highly varied lot sizes. Many
non volume-related costs depend on the number of lots being manufactured. Traditional cost
systems usually under cost the small-volume production lot products and over cost the high-volume
production lot products
The early designers could ignore this problem for two reasons. First, the percentage of no volume
related costs was much smaller. Consequently, the error in reported product costs from using only
volume related allocation based was much lower. Second, a single facility typically manufactured a
smaller range of products in less diverse lot sizes. Today, the percentage of non volume related
costs is high and often accounts for about 25% of total production costs. Therefore, low production
volume products may be significantly overcosted. This distortion in the reported product costs also
distorts the strategy selected by the firm. Low volume products appear to be more profitable than
they really are, tempting management to focus incorrectly on low volume, specialty business.
Cost pools are too large and contain machines that have very different overhead cost structures.
This problem is caused by simplifications made by the early designers. First, the production
processes that they dealt with were much simpler than today’s although different machines might
have been used in the process, within each major step the machine tended to have similar overhead
cost structures. This allowed each step to be treated as a cost centre without a major distortion in
reported product costs. Second, to minimize the number of calculations require to cost products,
early designers kept the number of cost centres as low as possible. This constraint reflected the high
cost of performing calculations in a precomputer society.
Because of extensive automation, cost centers now contain a mixture of conventional and
automated machines. This guarantees the reporting of distorted product costs. Although automated
machines generally have higher overhead costs than their conventional counterparts, they require
less labor. The cost system charges each product an average overhead charge that is too high for
conventional machines and too low for automated machines. Products manufactured on labor
intensive conventional machines are allocated higher proportion of the overhead costs than they
warrant.
The cost of marketing and delivering the product varies dramatically by distribution channel, and
yet the cost accounting system effectively ignores marketing costs. Cost accounting principles are
applied only to production costs; other costs (e.g., marketing) are ignored and treated as single line
items, this omission reflects the domination of the inventory valuation objective in cost accounting
principles, marketing costs must be treated as a period cost and written off. Therefore, marketing
and distribution costs are not allocated to products by conventional accounting system.
Many firms currently sell their products through a multitude of distribution channels, and the costs
associated with these channels can be as high as 25% of total cost. For example, one channel might
require a specially trained skill force that frequently calls the customer before the sales made,
whereas in another channel the customer can single call and place an order. Obviously, the cost of
doing business in the two channels is very different, but if the firm is trying to maximize gross
margin, this difference is ignored. Cost accounting systems similarly ignore a wide range of selling
and administrative expenses because they are period costs. If these costs differ systematically by
product or product line using gross margin to rank products is a dangerous technique.

CONCLUSION
Distorted knowledge of product costs makes it difficult the management to know how to best
employ the resource available and, in Dracker’s terms, satisfy its primary responsibility.
Unfortunately, although it is relatively easy to prove that a cost system is reporting inaccurate
product costs, it is extremely difficult to prove that the firm is suffering because of it. No business
decision depends solely on production costs; product cost information is commonly used in
decisions that rely on wide range information.
The symptoms of reliance on distorted costs can be used to determine whether the cost system
needs redesigning. This approach is advantageous because it is relatively fast and inexpensive. It is
not, however, a perfect ten. First, the symptoms are not always easy to detect, and the initially to
detect them does not guarantee that the firm is suffering. Second, there are several competing
explanations for each symptom, and it is not always possible to rule them out. The risk of unfairly
blaming the cost system can be reduced by determining whether it suffers from one of the more
common design flaws.
It is not sufficient just to check for the design flaws. There is no easy way of telling that the
distortion in reported product costs is sufficient to cause problems. The level of distortion depends
on the production process, the range of products produced, and the distribution channels used. It is
the joint occurrence of the symptoms with the flaws that heralds the need for a new cost system.
Robin cooper is an assistant professor of business administration in the Graduate School of
Business Administration at Harvard University.

Notes
1. P. F. Drucker. “Managing for Business Effectiveness.” Harvard Business Review (May-June
1963): 33-60 (Reprint No 63303).
2. R. S. Kaplan “The Evolution of Management Accounting.” Accounting Review (July 1984):
390-418.
3. H. T Johnson and R. S. Kaplan. Relevance Lost: The Evolution of Management Accounting
(Boston: Harvard Business School Press, 1987): R. Cooper and R. S. Kaplan. “How Cost
Accounting Systematically Distorts Product Costs. “Harvard Business School Working Paper.
(1986).
4. R. S. Kaplan “Yesterday’s Accounting Undermines Production.” Harvard Business Review
(July-August 1934): 95-101 (Reprint No 84406).

RECOMMENDED READING
R. G. Eiler, W. K. Goletz, and D. P. Keegan. “Is Your Cost Accounting System Up to Date
Harvard Business Review (July-August 1982): 133-139 (Reprint No 82403).
M. J. Sandretto. “What Kind of Cost System Do You need?” Harvard Business Review (January-
February 1986): 110-118 (Reprint No 85113).
From R. Cooper, “Does Your Company Need a New Cost System?” Journal of Cost Management
(Spring 1987): 45-49. Reprinted with permission.

Question
5.1 What are there of the symptoms that Cooper says accompany a poorly designed or absolute
costing system? Do each of these definitely mean that the existing system needs to be abandoned?
5.2 How Much Does That Product Really Cost?
Finding out may be as easy as ABC.
By Norm Raffish

It’s not that traditional cost accounting doesn’t work—it’s that the world it was designed for is
rapidly disappearing. Product costs used to consist primarily of direct labor and material; today we
have a manufacturing environment in which direct labor usually accounts for a ballpark figure of
5% to 15% of the costs and material accounts for 45% to 55%. That leaves us with a whopping
30% to 50% for over head (see Figure 1). And the overhead is shifting from variable to fixed as a
result of our investments in automation. Given this scenario, it’s not difficult to imagine that our
current cost accounting systems probably don’t reflect the true costs of our products.
What clues do we have that this description is true? An article by Professor Robin Cooper of
Harvard University in the Harvard Business Review, January-February 1989, was titled “You Need
a New Cost System When….” The article describes several symptoms of problems with existing
cost systems. Cooper says it may be time to redesign your costs system if:
• Functional managers want to drop seemingly profitable lines;
• Hard-to-make products show big profits;
• Departments have their own cost systems;
• You have a high-margin niche all to you self;
• Competitors’ prices are unrealistically low.

We need to recognize that our existing cost systems were meant primarily to value inventory and
provide data for the profit and loss statements. They really were never designed to discriminate
between product lines or products within those lines. Cost systems were meant to focus on: how
much,” not “why.” It is understanding the “why,” however, that permits management to focus on
the issues that require action.