Measure Costs Right: Make the Right Decisions
When companies sell several products, managers need to make important decisions about pricing, productivity and profitability based on the costs associated with each product. Unfortunately, many managers base those decisions on distorted cost information. With few products consisting of similar production processes and raw materials, a company could use the costs of direct labor and materials as the basis of assigning costs to products. However, as product lines and marketing channels expand, those methods become increasingly inaccurate as they minimize the effect of rising overhead costs and costs associated with marketing and distribution. In designing a cost system, a company should evaluate the costs of all activities associated producing and delivering a product.
While many managers are aware of the distorted product costs, most do not know the degree of inaccuracy. The bad information can lead to significantly erroneous decisions. The reason for the poor data is the way most companies allocate costs. First, costs are assigned to the department responsible for generating the costs. Next, in an attempt to assign costs to specific products, production costs are standardized such that the cost of each product is directly related to its corresponding percentage of total output. One example in the article referred to a manufacturer of hydraulic valves that used a poor cost system, similar to that stated above, to maintain focus on the 40% of the products that generated only 1% of revenues.
To develop an activity-based cost system, the process is to trace costs from resources to activities to specific products. Gathering accurate direct labor and materials costs associated with the product is the first step. The second step is to examine the demand on resources by the product while considering three rules:
1. Focus on expensive resources....