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Traps to avoid in product costing.

In today's hotly competitive business environment, accurate product costing has become critically important to a business's survival. John A. Lessner is a senior manager in Ernst & Ernst's cost and finance consulting practice in Minneapolis. This article grows out of his experience in implementing activity-based cost-accounting systems for clients. Fifty years ago, when manufacturing was far less automated than it is today, the costs of materials, labor and overhead were just about evenly divided. Now, production of a product's various components is often so synchronized on highly automated production lines that there is little or no need to maintain component inventories; thus, the old costing formulas, still used by many industries, are no longer applicable.

For example, overhead and labor now eat up much less of the production cost, while materials costs have climbed to an average of 55% of a product's total cost. Also, overhead costs are relatively more fixed because of advances in automation and production data management, while the difference between direct and indirect labor is vanishing.

Further complicating the costing equation is the trend in manufacturing to focus more attention on quality, flexibility and responsiveness, to meet customer needs. This makes production-line cost analysis more difficult because each line requires small, but significant, changes in production techniques.

All this is of more than academic interest. As national and global competition increase, even tiny costing disparities can have an overwhelming impact on whether a product-or an entire company, for that matter survives.

Here are two typical traps managers in charge of product costing fall into-and ways to avoid them. THE SCRAP TRAP In most cases, accounting for scrap generated in the production process is straightforward. If scrap is an insignificant component in a product's production, managers generally ignore it as a cost factor. Obviously, if it weighs in heavily, attention is given to controlling it and factoring its cost into product pricing.

Things get more complicated, however, when producing many lines of a similar product. For example, a manufacturer may have a custom product line that requires frequent production line stops, adjustments and start-ups; such a line often has high scrap costs. The company also may have a stock product line that runs nearly nonstop; as a result, its scrap costs are relatively low.

Manufacturers still using the traditional cost-accounting approach typically collect scrap costs as overhead expenses and charge them to a single cost center. Cost center overhead, including scrap, is then applied to all product lines on the basis of direct labor costs. The result is scrap costs are charged to all products consuming direct labor, regardless of the scrap they actually generate.

Assume a further, and typical, complication: Through design improvements, the company is able to reduce scrap costs significantly. These savings, according to the traditional system, also impact the overhead costs and are applied to all products. The result is the savings are averaged into both stock and custom product costs. Since the custom line has the highest labor costs, it also absorbs the largest share of recent savings. So, in effect, the stock products subsidize the production costs of custom products.

Over the short term, these savings are realized in the "bottom line." Over the long term, product profitability analyses that use these distorted costs cause management to erroneously assume custom products generate better margins than they actually do.

As a result, the company can mistakenly push sales of lower-profit custom products rather than higher profit stock products.

Once the error is identified, the solution is obvious: Don't allocate either costs or savings simply by linking them to direct labor; instead, isolate each line's real production costs and assign them accordingly. THE PACKAGING TRAP Another typical trap is miscellaneous vendor charges: for example, special packaging, painting and inspection of the manufacturer's products. In traditional cost-accounting systems, these charges are expensed as miscellaneous overhead costs and proportionally absorbed into all products, based on their labor content.

As a result, product lines not even subject to these charges subsidize the others, producing distorted product costs.

The solution, again, is to target the charges to the correct products.

Product costing is surely one of the most important pieces of management information accountants provide. It affects the success of contract bidding and product pricing. As such, it ultimately determines the success of a company. n
COPYRIGHT 1991 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Lessner, John A.
Publication:Journal of Accountancy
Date:Jul 1, 1991
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