Refining a Costing System
A refined costing system reduces the use of broad averages for assigning the cost of
resources to cost objects (such as jobs, products, and services) and provides better measurement
of the costs of indirect resources used by different cost objects—no matter how
differently various cost objects use indirect resources.
Reasons for Refining a Costing System
There are three principal reasons that have accelerated the demand for such refinements.
A refined costing system reduces the use of broad averages for assigning the cost of
resources to cost objects (such as jobs, products, and services) and provides better measurement
of the costs of indirect resources used by different cost objects—no matter how
differently various cost objects use indirect resources.
Reasons for Refining a Costing System
There are three principal reasons that have accelerated the demand for such refinements.
1. Increase in product diversity. The growing demand for customized products has led companies to increase the variety of products and services they offer. Kanthal, the Swedish manufacturer of heating elements, for example, produces more than 10,000 different types of electrical heating wires and thermostats. Banks, such as the Cooperative Bank in the United Kingdom, offer many different types of accounts and services: special passbook accounts, ATMs, credit cards, and electronic banking. These products differ in the demands they place on the resources needed to produce them, because of differences in volume, process, and complexity. The use of broad averages is likely to lead to distorted and inaccurate cost information.
2. Increase in indirect costs. The use of product and process technology such as computer-integrated manufacturing (CIM) and flexible manufacturing systems (FMS), has led to an increase in indirect costs and a decrease in direct costs, particularly direct manufacturing labor costs. In CIM and FMS, computers on the manufacturing floor give instructions to set up and run equipment quickly and automatically. The computers accurately measure hundreds of production parameters and directly control the manufacturing processes to achieve high-quality output. Managing more complex technology and producing very diverse products also requires committing an increasing amount of resources for various support functions, such as production scheduling, product and process design, and engineering. Because direct manufacturing labor is not a cost driver of these costs, allocating indirect costs on the basis of direct manufacturing labor (which was the common practice) does not accurately measure how resources are being used by different products.
3. Competition in product markets. As markets have become more competitive, managers have felt the need to obtain more accurate cost information to help them make important strategic decisions, such as how to price products and which products to sell. Making correct pricing and product mix decisions is critical in competitive markets because competitors quickly capitalize on a company’s mistakes. Whereas the preceding factors point to reasons for the increase in demand for refined cost systems, advances in information technology have enabled companies to implement these refinements. Costing system refinements require more data gathering and more analysis, and improvements in information technology have drastically reduced the costs to gather, validate, store, and analyze vast quantities of data.
Guidelines for Refining a Costing System
There are three main guidelines for refining a costing system. In the following sections, we delve more deeply into each in the context of the Plastim example.
2. Increase in indirect costs. The use of product and process technology such as computer-integrated manufacturing (CIM) and flexible manufacturing systems (FMS), has led to an increase in indirect costs and a decrease in direct costs, particularly direct manufacturing labor costs. In CIM and FMS, computers on the manufacturing floor give instructions to set up and run equipment quickly and automatically. The computers accurately measure hundreds of production parameters and directly control the manufacturing processes to achieve high-quality output. Managing more complex technology and producing very diverse products also requires committing an increasing amount of resources for various support functions, such as production scheduling, product and process design, and engineering. Because direct manufacturing labor is not a cost driver of these costs, allocating indirect costs on the basis of direct manufacturing labor (which was the common practice) does not accurately measure how resources are being used by different products.
3. Competition in product markets. As markets have become more competitive, managers have felt the need to obtain more accurate cost information to help them make important strategic decisions, such as how to price products and which products to sell. Making correct pricing and product mix decisions is critical in competitive markets because competitors quickly capitalize on a company’s mistakes. Whereas the preceding factors point to reasons for the increase in demand for refined cost systems, advances in information technology have enabled companies to implement these refinements. Costing system refinements require more data gathering and more analysis, and improvements in information technology have drastically reduced the costs to gather, validate, store, and analyze vast quantities of data.
Guidelines for Refining a Costing System
There are three main guidelines for refining a costing system. In the following sections, we delve more deeply into each in the context of the Plastim example.
- Direct-cost tracing. Identify as many direct costs as is economically feasible. This guideline aims to reduce the amount of costs classified as indirect, thereby minimizing the extent to which costs have to be allocated, rather than traced.
- Indirect-cost pools. Expand the number of indirect-cost pools until each pool is more homogeneous. All costs in a homogeneous cost pool have the same or a similar causeand- effect (or benefits-received) relationship with a single cost driver that is used as the cost-allocation base. Consider, for example, a single indirect-cost pool containing both indirect machining costs and indirect distribution costs that are allocated to products using machine-hours. This pool is not homogeneous because machine-hours are a cost driver of machining costs but not of distribution costs, which has a different cost driver, number of shipments. If, instead, machining costs and distribution costs are separated into two indirect-cost pools (with machine-hours as the cost-allocation base for the machining cost pool and number of shipments as the cost-allocation base for the distribution cost pool), each indirect-cost pool would become homogeneous.
- Cost-allocation bases. As we describe later in the chapter, whenever possible, use the cost driver (the cause of indirect costs) as the cost-allocation base for each homogenous indirect-cost pool (the effect).
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