Many cost accounting systems accumulate product costs incorrectly and therefore lead to inappropriate decisions. Let's look at the following two products.
Product 1, manufactured from material purchased in a nearby city, requires two hours of direct labor time, very little machine time and is scheduled through the shop regularly. Its manufacturing lead time is only three days, so very little finished goods inventory is required to meet customer demand.
Product 2 is manufactured from material that costs the same as product 1 but the material is purchased in Korea. Product 2 also requires two hours of direct labor but six hours of machine time on a new million-dollar piece of equipment, which needs constant maintenance; parts for the equipment are available only from the original manufacturer in France. The demand for product 2 is erratic, resulting in constant schedule changes. Because of these conditions--the erratic demand, the equipment's unreliability, a four-week manufacturing lead time and the excessive material lead time--10 weeks' worth of product 2 finished goods are kept on hand at all times.
Which product costs more? Although the answer is obvious, most cost accounting systems in use today would tell management these two products cost exactly the same! Since raw material costs and direct labor for both products are the same, most of today's cost accounting systems would assign the same overhead to these products, leading management to have a distorted perception of the product cost. What should financial managers do when they can make product profitability decisions better without cost accounting data?
They get back to basics. They must understand the manufacturing process to understand the costs. The process, as shown in the product 2 example, is often not simple and assuredly is not the same for all products. Many companies, realizing their diverse products are probably cross-subsidizing each other by sharing costs that are unique to an individual product, are investigating or attempting to upgrade their costing systems. One way to do this effectively is to implement an activity based costing (ABC) system.
WHAT IS ACTIVITY BASED
ABC recognizes that costs originate from and are driven up or down by factors other than volume and direct labor. These factors or activities have proven to be better indicators of product costs than figures based on volume or direct labor. ABC systems assign costs to products based on their consumption of activities, such as order preparation, storage time, wait time, engineering changes and internal product movement. As a result of its more sophisticated approach to product costing, ABC provides companies with better product costs and a better understanding of product pricing and product mix decisions on their profitability.
To use ABC and other new costing tools effectively, it is necessary to understand how costs are incurred. This requires asking the materials handler why one part is moved seven times before it is plated and asking the materials manager why a year-and-a-half supply of packaging materials is in stock. It also requires working simultaneously with the marketing organization to understand the true product cost and with the plant engineers to reduce that product's cost while ensuring that product quality and customer service are maintained or improved.
PROCESS VALUE ANALYSIS
When applied with common sense and a basic understanding of the business, process value analysis (PVA) is the foundation for other cost analysis tools, including activity based product costing. PVA is the most powerful analysis method financial managers can use to analyze a company's cost structure. This method allows them to get back to basics and understand the manufacturing and costing system.
By using the following step-by-step approach, financial managers can understand their companies' detailed manufacturing and costing procedures. …