I was recently criticized by some august members of the cost & management accounting community. I had made a comment that I felt product costing was largely unhelpful for lean companies. It seems I hit a nerve with my comments because these criticisms were harsh and personally insulting both to myself and our customers. In this posting I would like to give a recent example illustrating some of my concerns about product costing. My conclusion is that ABC Product Costing is unhelpful and harmful to lean organizations. Let me know what your conclusions are.
I visited a company in the last few weeks that makes daily consumer products that we all buy. The company has a strategic imperative to become a lean organization, and has engaged my company to assist them with Lean Accounting. When I visited one of the primary plants, I was given a presentation of their current standard cost accounting system.
ACTIVITY-BASED STANDARD PRODUCT COSTING. The plant controller showed us an example of the standard cost calculation for one of the plant’s primary products. The company has a well implemented ABC costing system that makes sensible, pragmatic use of cost drivers. But the product demonstrated requires around 150 lines of calculations to establish cost. During the discussion one of the corporate people stated that these product costs did not take a lot of work to develop because the data was all accurately available within the ERP system. The controller heatedly begged to differ. He explained that he spends a great deal of his time maintaining this system, and this leads to him having to do a lot of overtime, especially at month-end. No one was able to tell us on the spot how many transactions are required to maintain and run this system. It is clearly a very time-consuming and onerous amount of work using thousand or millions of transactions.
VARIANCE ANALYSIS. The controller also showed us the variance analysis reports. These show the detailed, line-by-line variances for each cost driver. The corporate person explained that these reports are very helpful for identifying issues and problems with the production and leads to substantial process improvements. This time the plant manager begged to differ. He stated that the information was too complicated, too late, and mostly irrelevant to the process. He has to spend a lot of time “explaining” the variances to various managers each month. He also stated that the newly introduced daily cell & process measures and the daily 10 minute, stand-up meetings were much more helpful to identify the issues and problems. And – more to the point – his shop floor and other people use these daily measurements to create on-going problem solving and improvement.
DECISION MAKING. At another meeting it was explained that the product costs are used to provide a series of reports that show the profitability of the products by region, by product family, by channel, and other useful analysis. The purpose of these margin reports is so that the product managers, regional manager, and other senior people can rationalize their product offings and sales promotions and maximize profitability. Once again, the people that receive these reports were adamant that they would not use these reports to make this kind of decision. They stated that they always use some kind of ad-hoc material contribution margin or incremental cost method because that shows the true situation. There was also wide agreement that almost nobody in the plants or the offices really understands how the product costs are calculated. This can lead to bad decisions when the information is not well understood.
INVENTORY VALUATION. The company does not use the standard product costs to value inventory. The standard product costs are retained throughout the year but they are also recalculated each month-end to provide the so-called actual costs. One of the people working in the IT shared services department told us that this variance analysis and application process is so transaction heavy that it takes around 20 full hours to just run the program. This often delays month-end by 2 days.
ACCURACY. When we began to discuss the effectiveness of the ABC product costs we looked at an example of a newly designed “lean” product flow. This flow has four separate work stations comprising machines and manual operations. We saw that two products took the same time to flow through the bottleneck operation, and therefore the production cost is the same for both products because they flow through the cell at the same rate. When we looked at the standard cost for these items they were different because their total labor and machine times were different.
CONCLUSION. After careful discussion of these two products, everyone recognized that not only was the standard costing a huge amount of work to maintain, uses vast numbers of transactions, does not provide useful information for decsision-making or improvement, does not even value inventory, delays the month-end, and is so complicated almost nobody understands it. But also the calculations gives the wrong costs.
These kinds of examples lead me to conclude that product costing is not helpful for companies aspiring to lean transformation.
Doug: Thanks for your message and thoughtful comments. This blog is anecdotal and I was not trying to give a detailed explanation. The blog was also in response to some rather offensive criticism I received because of my lack of enthusiasm for ABC. As I mentioned in the blog, I am speaking here about companies that are aspiring to create a lean culture within their organizations. I am sure there are many valuable uses of activity-based methods, but lean companies is not one.
I apologize if my descriptions are sloppy. It has been 15 or more years since I have used ABC/M and I may be out of touch. But, I have worked with many companies that have a similar profile to the one described in the blog. These companies do use ABC method to calculate their product costs and they go into the Standard Cost field in the ERP system. This particular company is a fine organization and very much respected through out the world for more than 100 years. If their accounting systems were audited using one if the ABC/M assessments, they would achieve a high score. They would not told they had poorly implemented the methods. These approaches to ABC are very harmful to lean organization. They are deeply anti-lean.
But, having said all this, you are right. Forgive me. I was writing a populist blog, not an academic treatise. I was trying to get my point across by using some mockery and irony.
All the best, brian
You use an anecdotal reference to ABC product costing–an implementation that appears on its surface to be poorly implemented from a business needs perspective–to then generalize about ABC and product costing as an entire methodology. Moreover, your discussion confuses ABC with standard costing. These are totally separate concepts, as I imagine you know. Certainly ABC can be used to develop standard costs and variances, and there are arguments pro and con for doing so. However, this particular case offers no information to generalize to the conclusion that product costing is of no value. Moreover, your third paragraph is titled “ACTIVITY-BASED STANDARD PRODUCT COSTING”, as if this were some particular well recognized method. You may not realize, however, that a Google search shows your comments above as the ONLY reference on the entire web to those 5 words in that order. This makes my case that while there is product costing and standard costing, either of which can apply ABC, there is no standard approach, as you seem to imply, to Activity-based standard product costing.
Each of your paragraphs would require much more discussion to get into details, and contrast the example from which you are trying to generalize to that which would typically be understood to be ABC best practices. Perhaps the most telling part of this superficial analysis is the conclusion. You started off trying to justify why product costing was unhelpful, and conclude it is because because this company implemented standard costing in a manner that was burdensom? Really? That is the basis of your conclusion? I suggest you review the difference between standard costing and product costing, and choose one or the other (or both independently) to refute. Using a poor example of one to refute the other makes no sense at all.