Printer Friendly

The bottom line; victim of cost accounting.

The Bottom Line Victim of Cost Accounting

Product design, new product introduction decisions and the amount of effort expended on trying to market a given product or product line are influenced by the anticipated cost and profitability of the specific product. Accurate cost accounting data are necessary in order to determine accurate product figures. If the accounting data upon which the decisions are based are not relevant, then the outcome of these decisions cannot be relied upon to achieve the desired results.

The cost accounting system is the driving force behind product related decisions. Decisions which are critical to a firm's existence are based upon the outputs of this cost system, which requires the firm to spend a great deal of resources in establishing the system. In the development of this accounting system a little common sense can be much more beneficial than merely following the "traditional" cost accounting formats and formulas.

In their 1987 article "Is Management Accounting Irrelevant?" Johnson and Kaplan indicated that rather than attempt to revise all of the historical cost accounting groundwork, most firms should merely attempt to modify their current cost accounting systems. By simplifying and streamlining their existing systems, most firms would be able to determine exactly what information was necessary to make decisions. By using a more basic approach, most firms would be able to solve many of their planning and control problems. This simple adjustment should allow many firms to improve their "bottom line" problems.

Form Over Substance

In order for product costs to have relevance, they must be properly allocated. The review of 13 studies by many of the top researchers in the managerial accounting field was conducted by the Harvard Business School in 1986. This review showed that the most common characteristic among all companies in the field was that they employed a two-step cost allocation system. In the first step, costs are assigned to cost pools, and in the second step these costs are allocated from the cost pools to the products. The companies studied used a variety of methods to allocate these costs in the first step, but all companies then used direct labor hours to allocate overhead from the cost pools to the products in the second step. All of the costs allocated into overhead were then assigned to individual products on the basis of a single factor.

In practice, most firms will generally use only one system of cost allocation. Problems that arise with this fact may show that not only is the system outdated, but that a particular cost accounting system which is concerned with maximizing external reporting results could, in fact, be detrimental to product costing. Companies will occasionally be more concerned with form rather than substance when collecting and evaluating cost accounting information. This point was emphasized by Ford Worthy when he stated that the typical cost accounting system is designed more as a means of valuing inventory than as a measuring tool for product costs and product cost assignment. While this approach may benefit the balance sheet, it will ultimately be detrimental to the decision making process.

Traditional Cost

Accounting

The biggest problem with traditional cost accounting could very well be the fact that it is too traditional. Virtually all management accounting practices in use today were developed before 1925.

The cost systems in place today were more than adequate at the time of their development; most likely in the early 1900s. At that time the factors that created the cost were easily identifiable. In many instances a firm had only one product line. Therefore it was known who worked where and for how long. Raw materials were traceable through the production process and their costs were allocated properly. Because of this limited product diversity, material and labor costs, costs which could be easily calculated, provided the bulk of the product costs for which a firm had to account.

Before World War I, most companies were concerned with minimizing the cost of information and communication. Without advanced modes of transportation, or far reaching means of communication, it was difficult for most firms to concentrate on concepts such as market share and advertising strategy. Products were standardized, and gaining the advantage on the competition was a cut and dry concept: reduced costs resulted in larger market share and higher profits. Johnson and Kaplan believe that the management accounting systems in use today were developed during this era and that these companies paid little or no attention to logistics, marketing and distribution costs. Instead, they attempted to minimize direct labor costs and to economize on data collection and processing.

The conditions that exist in today's environment are drastically different from those earlier conditions. Markets are now international, the costs of information and communication have been greatly reduced and flexibility has become a necessity. The combination of this global economy coupled with extremely efficient bulk transportation and communications around the globe, makes it obvious that the cost accounting system required by today's firms must be different from the earlier systems.

An accounting system designed for establishing the cost of a product should be supported by practical theory. In addition, a well defined concept of relevant information is required. Several problems come into play in this determination and must be addressed individually.

Relevance of Direct Labor

Hours

It was previously stated that companies favor the use of direct labor hours as the means by which costs are allocated to products. When labor was the primary factor associated with the conversion of raw materials into finished goods this was a theoretically sound approach. At the turn of the century it would have been typical to picture Mr. Smith hand carving chairs in his backyard furniture business. However, today's conditions are not the same.

Direct labor, which frequently accounted for up to 40% of production costs 25 years ago, may only represents 5% of the same costs today. In his article in Growth Strategies, Tom Sheridan points out that cost accounting systems are not keeping up with current trends. Sheridan feels that for many manufacturing units, direct labor may account for no more than 10% of total production costs, and that to relate everything to that type of component would be dangerous and misleading.

Labor costs are diminishing as advanced technology and newly developed machinery are integrated into the production process. The product diversity of today's companies also poses a problem because labor may be used on many products simultaneously, making it extremely difficult to assign costs with any degree of certainty. Reliance upon direct labor hours as the sole means of allocating production costs could result in unrealistic figures and also cause distortion of product costs and profitability.

Set-up Costs

While direct labor is becoming a smaller portion of allocable product costs, manufacturing overhead is continually increasing. One of the biggest components of overhead cost is the introduction of new product lines. Laying the groundwork for a new and unproven idea requires a tremendous amount of time and research. The manufacturing overhead costs that fall into this category may be best understood as set-up costs. Set-up costs will vary depending on the necessary functions of establishing the new product.

Accounting treatment difficulties arise when these set-up costs are viewed as being fixed in nature (i.e., a marketing expense). This is a misclassification due simply to the fact that the only reason these set-up costs have come into existence is because the firm chooses to carry a diverse range of products or product lines. If these set-up costs are viewed as fixed costs, then the entire range of products throughout the company will need to absorb part of the costs.

The traditional cost systems failed to recognize that increasing product diversity would substantially increase overhead costs. Costs that would traditionally be aggregated and averaged across all of the firm's products need to be pinpointed and traced to the individual product that generated the need for large overhead and support departments. Thus, the introduction of a new product line appears to cost less than what it actually does.

Reliance on Volume: Errors

and Consequences

Costs associated with set-up will clearly vary according to the extent of product diversity. Even though this may be the typical case, high volume products often are unjustly burdened with additional costs. While direct labor hours or machine hours are the most common basis for cost allocation, these methods may charge a greater proportion of costs to high volume products as a result of their standardization.

Actual production processes are relatively similar when a firm produces homogeneous products. The equipment involved in this type of scenario may produce many similar, yet totally distinct products. In addition, the actual production process (line) may be in constant motion as the type of product being produced changes. Because more standardized (high volume) items can be produced during the same period over which less standardized (customized, low volume) items are produced, it is only logical to assume that these high volume products will absorb the majority of the overhead costs. This line of thinking is where many managers have traditionally been mistaken.

Low volume (customized) products create the need for frequent set-ups. Through the introduction of new products, many departments within the company will have to expand, and this expansion will cause an escalation of overhead costs. By aggregating these additional overhead costs and allocating them among all of the company's products, high volume products are being forced to absorb costs which came into existence only because of these new, low volume products.

The misallocation of set-up costs associated with low volume products will result in a distortion of the profitability figures for high volume and low volume products. Since most companies rely upon data generated by their costs system, the firm may diversify into new product areas under the assumption that their low volume products are extremely profitable, when in reality some of the low volume product costs are being passed on to the high volume items.

The most obvious example of a country which concentrated only on the high volume (few product lines) approach was Japan. By concentrating on just a few product lines, the Japanese have been able to maintain a competitive edge in world markets and to recover virtually all of their true manufacturing costs.

As firms shift their production emphasis away from the apparently less profitable low volume products, they may discover later that the profits perceived to exist within high volume item production do not actually exist. The switch from low volume to high volume products may be compounded by a cruel irony: once any type of product is removed from the product mix, those products which remain must support a greater share of manufacturing overhead. As any product absorbs additional overhead cost, it becomes less profitable and less competitive in the market.

What then is the production strategy which maximizes profitability? While no solution works in every case, a firm may consider improving its competitive position by becoming a "focused competitor." This type of competitor (company) has much simpler informational needs and can become more efficient by utilizing one detailed plan of action, rather than dispersing its resources in a great variety of directions. Again, this is not a solution for all firms, but it is a viable alternative which many firms should consider.

External Forces on the Cost

System

Another typical problem faced by most cost systems is establishing the true time frame for most manufacturing costs. What is the lifetime of a particular manufacturing overhead cost? It is necessary for costs to be correctly identified as short term or long term, and, while this is a problem to be dealt with by the managers and not the system itself, the problem is still worthy of consideration since the outcome of the short/long term decision will be part of the input into the cost accounting system.

An example of this time frame problem may be seen with regard to the development of a new product. New product development will impact firm income over a long period of time. If a manager is attempting to introduce a new product, the time period used to absorb certain overhead costs may be established so that the product "looks good" in the short run but in reality will not absorb all of its costs over the long term. Managers may attempt to maximize short term interim reporting by sacrificing long term profits, thereby causing further inaccuracies to exist within the cost system.

External factors play a definite role in the distortion of company costs and profits. Top management personnel in many firms fear the need to maximize short term operations. Companies are forced to concentrate on how they appear to the consumer, since the consumer ultimately represents the hope of what is for many firms illusive profit. Since this appearance is foremost in the minds of many firms, external reporting becomes the basis for managerial decisions.

Many firms develop only one cost system, and this system concentrates on financial reporting requirements. These firms chose to concentrate their energies on producing a single system that provides reliable, objective and auditable information for their external constituencies, and thereby sacrifice internal reporting needs. This type of system, while simplified in nature, will continue the distortion of profit and loss information of individual products.

Considerations for the

Future

In order for today's managers to achieve a true and accurate "bottom line," they must step away from their cost accounting system and analyze it objectively. Since all firms must never lose sight of their primary existence, every firm should realize that it has unique informational needs. These unique needs require each firm to place different demands on its cost accounting system. Therefore, it is impossible to design a standardized system that would satisfy every company in an efficient manner. A successful cost accounting system is one that is designed to account for all of a particular firm's inputs and can be adapted to comply with the ever changing needs of that particular firm.

In the future, managers may still use direct labor hours to allocate overhead costs, but they may want to consider using more than one allocation base simultaneously. Machine hours, floor space or direct labor dollars may prove to be a more relevant cost contributor and therefore should be used in conjunction with the traditional allocation bases in order to achieve more accurate results.

Moreover, the realization must be made that the volume of a product does not necessarily reflect its cost. The concept of transaction costing can provide insight on how some manufacturing overhead costs behave. Overhead costs such as set-up costs vary with several transactions: ordering, receiving, shipping, moving and counting inventory, installing machinery, inspecting, and implementing engineering orders. These transactional costs are largely independent of the actual size of the orders place; they vary more with the need for the transaction. Low volume and high volume products must be critically analyzed to determine the actual costs involved.

The typical trap to which many designers of cost accounting systems fall victim is the tendency to get caught up in the numbers. All of the relative factors that determine profitability are not in the form of monetary amounts. If this were the case, there would be no such thing as goodwill.

The cost accounting system cannot account for everything. A firm needs to have accurate information concerning factors such as product defects and customer satisfaction. The profitability of a particular product may depend upon more than the reduction of cost. Managerial accounting policies need to distinguish between those products that compete based on cost from those products that compete because of their unique properties in the eyes of the customers. Such a distinction will affect costing and pricing, and the performance indicators will give management a better feel for the business.

Clearly, some variances are necessary for the future. The Japanese, for example, are now evaluating their factories based upon throughput time rather than upon costs. Some authors feel that future cost accounting systems should distinguish between strategic profitability information and process control information, rather than relying on information generated by only one system.

Hewlett Packard, General Electric and Motorola are among the companies taking innovative steps forward in their cost accounting systems. At some IBM plants workers are responsible for their own maintenance and quality control. This allows for an easier allocation of manufacturing overhead. Caterpillar has established approximately 1,300 overhead "budgets." Larger machines will have larger budgets so that they receive a more correct portion of overhead costs. Zenith includes some non-production costs in its product cost determination in order to obtain more accurate figures. Hopefully, a greater number of companies will continue along these innovative lines in order to achieve the individualized cost accounting data required to make company-specific decisions.

Conclusion

As the business world makes gradual strides forward, cost accounting systems must be ready to handle various changes without distorting a company's costs or profits. With today's advanced computing technology, the designing of an effective, efficient cost accounting system will not be as difficult as it would have been 20 years ago.

Managerial accountants should look to outsiders for help in the final design of their cost accounting system. Engineers, operating personnel and marketing individuals can offer useful information that could not be derived from a strictly financial analysis. Companies must be willing to look to the future in order to explore the realm of possibilities that lie ahead for their cost accounting systems.

James M. Emig, PhD, CPA, is an assistant professor of accountancy at Villanova University. He received his BA from Catawba College and his MBA from the University of North Carolina at Greensboro before completing his doctoral degree at Texas A&M University. He is a member of the American Accounting Association and the National Association of Accountants. He has published in the area of managerial accounting, accounting education and microcomputers.

Matthew Mazeffa is a 1989 graduate of Villanova University, earning a Bachelor of Science in Accountancy degree. He is currently employed by Coopers and Lybrand as a staff accountant in their Philadelphia office.
COPYRIGHT 1990 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Author:Emig, James M.; Mazeffa, Matthew
Publication:The National Public Accountant
Date:Apr 1, 1990
Words:3018
Previous Article:Business meal deductions; the bite stops here.
Next Article:Calculating deferred tax assets.
Topics:


Related Articles
As tenants tighten belts, RE must give more.
Domestic violence: a bottom-line issue; The annual price tag could be as much as $5 billion.

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters