Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

16.4.1 Limits of Traditional Product Costing

Intended learning outcomes: Describe allocating fixed costs to products with conventional cost accounting using two cost types. Explain the potential for error in traditional product costing.

Often, job-order costing allocates fixed costs (overhead) by an extra charge, expressed as a percentage of the variable costs of labor and materials.

In the simplest case, this percentage is either a single percentage or multiplication factor of the variable manufacturing costs or two different percentages for material costs and labor costs, as shown in Figure This traditional overhead-cost-allocation process thus allocates overheads to products using direct material and labor costs (for example, labor hours or machine hours) as the basis for allocation.

Fig.       Allocating fixed costs to products with conventional cost accounting using two cost types.

There has been a rapid explosion of the value of these simple job-order costing factors over the past two decades, mainly because internal labor costs have moved rapidly in the direction of fixed internal labor costs (machines, tools, etc.). Today, there are some companies with a ratio of fixed to variable costs of 10 to 1, meaning that variable costs represent just 10% of the manufacturing costs for the entire organization. The remainder is made up of fixed costs of various types (see also Figure, specifically:

  • Material procurement and storage costs
  • The cost of managing subcontracted operations
  • Machinery, tool, production facility, and infrastructure costs
  • The costs of R&D, licensing, product and process design, planning & control, etc.

Problems arise with conventional costing, for the focus remains on the variable costs. Often, the reduction in variable costs will merely increase the multiplication factor, since the same fixed costs are then simply distributed among fewer variable costs. If the organization has a broad product concept, such as mixed manufacturing with products ranging from products made to customer specification (which may change from one order to the next) to standard products with no variants, this results in the distortion shown in Figure

Fig.       Potential for error in traditional product costing.

As a result, too much overhead is attributed to products produced with high variable costs — often standard products — and too little overhead is attributed to products with low variable costs — often products according to (changing) customer specification. In the example, P1 — having high variable costs (the black portion) — is overcosted with fixed costs (the white portion), and P2 — having low variable costs, is undercosted with fixed costs. See here also [CoSt93].

Since the cost of goods manufactured is used as the basis for pricing, this misallocation of fixed costs would tend to result in less complex products (technically and logistically) being put on the market at too high a price, while too low a price would be charged for complex products. This would mean that a company could lose its competitive edge for series and mass-produced items — not because of the high cost of wages or other factors, but due to the costing system itself!

The problems with conventional costing came to light with respect to in­vestment in qualification of employees and machinery. These invest­ments raised the fixed costs and had a disproportionately large effect on the very product range for which the investments had targeted more efficient production. It is not surprising that the new production methods resulted in a demand for a new way of thinking about costs. The new type of costing system proposed and developed was activity-based costing (ABC).

Course section 16.4: Subsections and their intended learning outcomes