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.