How Cost Accounting Distorts Product Costs

Cooper, Robin; Kaplan, Robert S.

Management Accounting; Apr 1988; 69, 10; ABI/INFORM Global
pg. 20

BI3TRRT3
The traditional cost system that defines variable
costs as vai ying in the short term mith production
u›ill misclassify these costs as fixed.
BY ROBS COOPER er scale production.
The cum ulative effect of deci-
ALL‘ ROBERT S. sions on product design, introduc- Similarly, a di If’e re n t i a ted
KAPLAM tion, support, discontinuance, and pro- ducer achieves competitive ad

I
pricing helps define a firm’s strate- an- tage by meeting specialized
n order to make sensible deci- gy. If the product cost information custr›m - ers’ needs with prod ucts
sions concerning the products they is distorted, the firm can follow an wh ose costs of differentiation are lo
market, manager › need to know inappropriate and unprofitable ver than the price prem iums char
what their products cost. Product strategy. For example, the low-cost ged for special features and
design, new product intro- duction producer often achieves competi- service.:-. II the cost system fails to
decisions, and thc amount of effort tive advantage by servicing a broad measure diI- fere nti ati on costs
expended on tryin ¿ to mar- ket a range of customers. This strategy prope rl y, t he n the firm might
given product or product line will will be successful if the economies choose to com pete in se g m e nts
be influenced by the ‹anticipat- of scale exceed the additional t h at a re a ct u ‹i11 y unprofitable.
ed cost a nd p rofi tab i lit y of the costs, the diseconomies of scope,
produ ct . Co n ve rse 1y , if product caused by producing and servicing
profitability appears to c!rop, the a more diverse product line. If the FULL VS. VARIABLE COST
question of discontinuanc e will be cost sys- tem does not correctly espite the importance of roost
raised. Product costs also can play attribute the additional costs to the information, d is ag ree m e nt
an important role in settiiig prices, products that cause them, then the sti 11 e x ists abou t w het h e r
particularly f or customiz ed prod- firm might end up competing in product costs should be measured
ucts with low sales volu mes and seg- ments where the scope-re1ated by full or by variable cost. In a I ull-
without readily available market costs exceed the benefits from larg- cost system, fixed production c‹ists
prices. are allocated to products so t ha I re-
ported product costs measure t‹ital
manufacturing costs. In a varie‹ble-
cost system, the fixed costs are not
allocated and product costs reflect
o n I y t h e m a r g i n a1 co st o1’
manufacturing.
Academic accountants, supt›ort-
ed by ec onom is t s, have arg ued
strongly that variable costs are the
relevant ones for product decisions.
They have demonstrated, usint* in-
creasingl y complex models, .hat
setting marginal reven ues eqn.il to
marginal costs will produce t he
highest profit. In contrast, acc ou n-
tants in practice continue to report
full costs in their cost accounting
systems.
The definition of variable cost
used by academic accou ntants as-
sumes that product decisions have
Robin Cooper and Bob Kaplan ore taking research out of the academic setting. a short-time horizon, ty pical1 y a

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 month or a quarter. Costs are vari-
seemed to be prospering at these
able only if they vary directly with
monthly or quarterly changes in
Management prices.
At Schrader Bellows, production
production volume. Such a defini-
tion is appropriate if the volume of
accounting managers believed that certain
products were not earning their
production of all products can be
changed at will and there is no way
thinhing because keep because they were so difficult
to produce. But the cost system re-
to change simultaneously the level
of fixed costs.
of its focus on ported that these products were
among the most profitable in the
In practice, managers reject this
short-term perspective because the
short-term costing line. The managers also were con-
vinced that they could make cer-
decision to offer a product creates a
long-term commitment to
has missed the tain products as efficiently as any-
body else. Yet competitors were
manufac- ture, market, and support
that product. Given this
most important consistently pricing comparable
products considerably lower. Man-
perspective, short-term variable
cost is an inad- equate measure of
aspect of product agement suspected that the cost
system contributed to this problem.
product cost.
While full cost is meant to be a
decision matting. At Mayers Tap, the financial ac-
counting profits were always much
surrogate for long-run manufactur-
lower than those predicted by the
ing costs, in nearly all of the com-
cost system, but no one could ex-
panies we visited, management was
also was responsible for setting plain the discrepancy. Also, the se-
not convinced that their full-cost
prices. Cost-plus pricing to achieve nior managers were concerned by
systems were adequate for its prod-
a desired level of gross margin pre- their failure to predict which bids
uct-related decisions. In particular,
dominantly was used for the spe- they would win or lose. Mayers Tap
management did not believe their
cial products, though substantial often won bids that had been over-
systems accurately reflected the
modifications to the resulting esti- priced because it did not really
costs of resources consumed to
mated prices occurred when direct want the business, and lost bids it
manufacture products. But they
competition existed. Such competi- had deliberately underpriced in or-
were also unwilling to adopt a vari-
tion was common for high-volume der to get the business.
able-cost approach.
products but rarely occurred for
Of the more than 20 firms we vis-
the low-volume items. Frequently,
ited and documented, Mayers Tap,
Rockford, and Schrader Bellows
no obvious market prices existed TWO-STAGE COST
provided particularly useful in-
for low-volume products because ALLOCATION SYSTEM
they had been designed to meet a
sights on how product costs were
particular customer’s needs. he cost systems of all compa-
systematiea lly distorted. i These
nies we visited had many com-
companies had several significant
common characteristics. b mon characteristics. Most im-
They all produced a large num- portant was the use of a two-stage
ber of distinct products in a single cost allocation system: in the first
anagers in all three firms stage, costs were assigned to cost
facility. The products formed sever- expressed serious concerns
al distinct product lines and were pools (often called cost centersJ, and
about the accuracy of their in the second stage, costs were allo-
sold thro ugh diverse marketing product-costing systems.
channels. The range in demand vol- cated from the cost pools to the
For example, Roekford attempt- products.
ume for products within a product ed to obtain much higher margins
line was high, with sales of high- The companies used many differ-
for its low-volume products to ent allocation bases in the first
volume products between 100 and com- pensate, on an ad hoc basis,
1,000 times greater than sales of stage to allocate costs from plant
for the gross underestimates of overhead accounts to cost centers.
low-volume products. As a conse- costs that it believed the cost
quence, products were man ufac- Despite the variation in allocation
system pro- duced for these bases in the first stage, however, all
tured and shipped in highly varied products. But man- agement was
lot sizes. While our findings are companies used direct labor hours in
not able to justify its decisions on the second stage to allocate over-
based upon these three companies, cutoff points to identi- fy low-
the same effects were observed at head from the cost pools to the
volume products or the mag- nitude products. Direct labor hours was
several other sites. of the ad hoc margin in- cre ases.
In all three companies, product used in the second allocation stage
Further, Roekford’s management even when the production process
costs played an important role in believed that its faulty cost system
the decisions that surrounded the was highly automated so that bur-
explained the ability of small firms den rates exceeded 1,000%. Figure
introduction, pricing, and discon- to compete ef- fectively against it
tin ua nce of products. Reported 1 illustrates a typical two-stage al-
for high-volume business. These location process.
product costs also appeared to play small firms, with no apparent
a significant role in determining Of the three companies we
economic or technolog- ical exam- ined in detail, only one had
how much effort should be assigned advantage, were winning high-
to marketing and selling products. a cost accounting system capable
volume business with prices that of re- porting variable product
Typically, the individual respon- were at or below Rockford’s
sible for introducing new products costs. Variable cost was identified
report- ed costs. A nd the s mall at the
firms

MANACiEMENT ACCOU NTING / APRIL 1988

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 budgeting stage in one other site,
but this in l’ormation was not subse- FIGURE J I TNE TWO-STAGE PROGRESS
quently used for product ‹hosting.
The inability of the cost system to
report variable cost was a c’ommon Power Indirect Factory Plant
feature of many of the systems we COstS LObOr 2OstS
Su pp1ies
observed. Reporting variab fe prod-
uct costs was the exception, not the
rule.
Firms used only one cost system
even though costs were c allected
and allocated f'or several purposes,
incl uding product costing. opera- Cost Center Cost Center Cost Cost Cente
tional control, and inventory valua- Center
tion. The cost systems seemed to be
designed primarily to perform the
inventory valuation function for fi-
nancial reporting because they had Direct labor Hours Direct Labor Direct Labor Hours Direct fob‹or
HOUFS OUFS
serious deficiencies for operational
control (too delayed and too aggre-
gate) and for product cost ing (too
aggregate J. Proouct

THE FAILURE OF
maasixat cosrixs

T
recommendation to management, mac hines and to act as t ro uL. Ie-
he extensive use of fixed-cost
direct costing, even if correctly im- shooters. Labor freq uent ly works
allocations in all the com pa- pleme nte d, is not li kely a solu- on several dift‘erent products at the
nies we investigated contrasts tion—and may perhaps be a major same time so that it becomes m-
sharply with a 65-year history of problem—for product costing in the possible to assign labor hours in tel-
academics advocating m a rg i n al co n te m po r a r y m a n u fa c t u r ligently to products. Some of’ the
costing for product decisions. If the i n g environment. companies we visited had respond-
ma rgi na1-cost co n cept h.id been ed to this situation by beginning ex-
ad o pted by com pan ies’ ra an age- periments using machine hours in-
ment, then we would have ‹expected 7HE FAILURE OF stead of labor hours to a11 oc:1te
to see product-costing systems that
exp licitly reported variable -cost in- FIXEB-COST ALLOCATIONS costs from cost pools to produ cts
(for the second stage of the allrica-

W
form ation . Instead, we o bser ved
cost systems that reported variable
hile we consistently ob- tio n process ). Other com pa n i es,
served managers avoiding particularly those adopting just-in-
as well as full costs in only a small time or contin uous-flow product ion
the use of variable or mar-
minority of companies. processes, were mov’ing to mate via I
ginal costs for their product-related
The traditional academi: recom- dollars as the basis for distributing
decisions, we observed also their
men d ation fo r m arg i na1 costing costs from pools to products. M‹ite-
discomfort with the full-cost alloca-
may have made sense when vari- rial dollars provide a less expen*›
tions produced by their existing
able costs ( labo r, m a ter Tal, a nd ive method for cost allocation than
cost systems. We believe that we
some overhead) were a ri•lative ly ma- chine hours because, as with
h ave ide nt i fie d t he tw o m aj or
high proportion of‘ total manufac- labor hours, material dollars are coll
sources for the discomfort.
tured cost and when product diver- act- ed by the ex isting cost system,
The first problem arises from the
s ity was suf fic i e nt ly sma 11 that A move to a m a c h i n e -h on r
use of direct labor hours in the sec-
there was not wide variati‹in in the be.s i s would require the collection
ond allocation stage to assign costs
demands made by dif‘fere nt prod- of new data for many of these cc›m
from cost centers to products. This
ucts on the firm’s production and pan i es.
procedure may have been adequate
m ar ket in g re so u r ces. But these Shifting f’rom labor hours to ma-
many decades ago when direct la-
conditions are no longer typical of chine hours or materi a1 dol lars Jiro-
bor was the principal value-adding
many of today’s organizal ions. In- vides some relief f’rom the prob fern
acts vity in the material conversion
c re as i ngly, overhead ( m‹ast of it of using unrealistic bases for attrib-
process. But as firms introduce
considered ”fixed”1 is becoming a uting costs to prod ucts. I n t.ict,
more automated machinery, direct
larger share of total man ul acturing some companies have been experi-
labor is increasingly engaged in set-
costs. In addition, the pl ants we ex- menting with using all three .i llo-
up and supervisory functions (rath-
amined are being asked to produce cation bases sim ultaneousl y: la bor
er than actually performing the
an increasing variety of products hours for those costs that vary v/ it h
work on the product) and no longer
that make quite different demands the n umber of labor ht›urs worked
represents a reasonable surrogate
on equipment and support depart- (e.g., supervision—if the am ount oi
for resource demands by product.
ments. Thus, even if‘ direct or mar- 1abor i n a prod uct is hig h, t he
In many of the plants we visited,
ginal costing were once a useful labor’s main tasks are to load the amount ot“ supervision relatecl to
that product also is 1i ke 1 y tc be

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 high I, mac hine hours for those
The other plant presents a much tionship between the range of prod-
costs that vary with the number of
more complex production-manage- ucts produced and the size of the
hours the machine is running (e.g.,
ment environment. Its 200 prod- support departments. First, the
power—the longer the machine is
ucts have to be scheduled through costs of most support departments
running the more power that is
the plant, requiring frequent set- are classified as fixed, making it
consumed by that product), and
ups, inventory movements, pur- difficult to realize that these costs
material dollars for those costs that
chases, receipts, and inspections. are systematically varying. Second,
vary with the value of material in
To handle this complexity, the sup- the use of volume-related alloca-
the product (e.g., material han-
port departments must be larger tion bases makes it difficult to rec-
dling—the higher the value of the
and more sophisticated. ognize how these support-depart-
material in the product, the greater
The traditional cost accounting ment costs vary.
the material-handling costs associ-
system plays an important role in Support-department costs must
ated with those products are likely
obfuscating the underlying rela- vary with something because they
to be.)
have been among the fastest grow-
Using multiple allocation bases
ing in the overall cost structure of
allows a finer attribution of costs to
§ manufactured products. As the ex-
the products responsible for the in-
e ample demonstrates, support-de-
currence of those costs. In particu-
l partment costs vary not with the
lar, it allows for product diversity
°• volume of product items manufac-
where the direct labor, machine
tured, rather they vary with the
hours, and material dollars con-
range of items produced (i.e., the
sumed in the manufacture of differ-
complexity of the production pro-
ent products are not directly pro-
cess). The traditional definition of
portional to each other.
variable cost, with its monthly or
For reported product costs to be
quarterly perspective, views such
correct, however, the allocation
costs as fixed because complexity-
bases used must be capable of ac-
related costs do not vary signifi-
counting for all aspects of product
cantly in such a short time frame.
diversity. Such an accounting is not
Across an extended period of time,
always possible even using all
however, the increasing complexity
three volume-related allocation
of the production process places
bases we described. As the number
ad- ditional demands on su pport
of prod- uct items manufactured
de- partments, and their costs
increases, so does the number of
eventu- ally and inevitably rise.
direct labor hours, machine hours,
The output of a support depart-
and materi- al dollars consumed.
The strategic importance of product ment consists of the activities its
The designer of the cost system, in
costing is the focus of Professor personnel perform. These include
adopting these bases, assumes that
Cooper’s research efforts. such activities as setups, inspec-
all allo- cated costs have the same
t ion s , m ate r ia 1 h a n dli ng , a
behavior; namely that they increase
n d scheduling. The output of the de-
in direct relationship to the volume
of prod- uct items manufactured.
But there are many costs that vary
At the companies partments can be represented by
the number of distinct activities
with the diversity and complexity
of prod- ucts, not by the number of
visited and that are performed or the number
of transactions handled. Because
units produced. studied, we most of the output of these depart-
ments consists of human activities,

THE COST OF COMPLEXITY

found however, output can increase quite
significantly before an immediate

he complexity costs of a full-

and deterioration in the quality of ser-
vice is detected. Eventually, the
y line producer can be illustrat-
e ed as follows. Consider two
growing proportion maximum outpu t of the de part-
ment is reached and additional per-
identical plants. One plant pro- sonnel are requested. The request
duces 1,000,000 units of product A. typically comes some time after the
The second plant produces 100,000
u nits of product A and 900,000
manu initial increase in diversity and
output. Thus, support departments,
units of 199 similar products. (The
similar products have sales vol-
costs is considered while varying with the diversity of
the demanded output, grow inter-
umes that vary from 100 to 100,000
units.
ixed.”In reality, mittently. The practice of annually
budgeting the size of the depart-
The first plant has a simple pro-
duction environment and requires
they are the most ments further hides the underlying
relationship between the mix and
limited manufacturing-support fa-
cilities. Few setups, expediting,
variable and volume of demand and the size of
the department. The support de-
and scheduling activities are
required.
rapidly increasing partments often are constrained to
grow only when budgeted to do so.

MANAGEMENT ACCOUNTING /APRIL 1988

costs for t‘he firm. 23

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 TABLE \ I COMPARISON OF REPORTED PRODUCT COSTS AT SCHRADER BELLOWS
Transaction-Based
Existing Cost System System Percent of Change
Soles Unit Unit Gross Unit Unit Gross Unit Unit Gross
Product Volume Cosf" Morg!n Cost" Morpin Cost Margin
1 43,562 7.85 5.II 7.17 6.19 (8.7) 12.3
2 500 8.74 3.76 15.45 (2.95) 76.8 (178.5)
3 53 12.15 10.89 82.49 (59.45) 578.9 (645.9)
4 2,079 I3.63 4.91 24.ST |5.97| 79.8 (22T .6)
S S,6Z0 T 2.40 7.95 19.99 0.36 61.3 (93.4)
6 11,169 8.04 5.49 7.96 5.57 (1.0) 1.5
7 423 8.47 3.74 6.93 5.28 {18.2) 41.2
”‘The sum of total cost (sales volume x unit cost) for all seven products is diherent under the two systems because the seven products only
represent a small fraction of total production.

Sup port-de part ment costs are

expand to cope with the additional transactions-based a pproac h re in-
perhaps best described as ”discre-
complexity of more products, lead- forces the effect oi’ the setu p-re lat-
tionary” because they are budgeted
ing to increased overhead charges. ed costs because the low—sales— Vol —
a n d a ut h or ize d e ac h yea r . The
The reported product cost of all ume items tend to t rigge r m ore
questions we m ust address are:
products consequently increases. s m a 11 i n c o m i n g a n d o u t go i
What determines the level of these
The high-volume products appear n g shipments.
discretionary fixed costs? Why, if
more expensive to produce than Sc hrader Be llows had recen t ly
these costs are not afFecteil by the
previously, even though they are performed a ”strategic cost an‹ily- sis”
quantity of production, are there
not responsible for the additional that significant 1 y increased I he nu
eight people in a support depart-
costs. The costs triggered by the in- mber of bases used to a1loc rite costs
ment and not one? What generates
tro duct io n of new, 1o w-volu me to the products; many secoid- stage
the work, if not physical quantities
products are systematically shifted allocations used transacti runs costs to
of inputs or outputs, that requires
to high-volume products that may assign su pport-department costs to
large sup port-depart ment staffs?
be placing relatively few demands products. In particular, t he number of’
We believe the answers to these
on the p1a nt’s su p po r setups allocated a size- able percentage
questions on the origins of discre-
t departments. of support-dep:Art- ment costs to
tionary overhead costs (i.e., what
Many of the transactions that products.
drives these costs) can be found by
generate work for production-sup- The effect of’ changing these !sec-
analyzing the activities or transac-
port departments can be proxied by ond-stage allocations t'rom a dii ect
tions demanded when pro‹1ucing a
the number of setups. For example, labor to a tra nsaction basis ›v as
full and diverse line of products.
the movement of material in the dramatic. While t he su p port de-
p1ant often occ urs at the com- partment costs accounted for about
mencement or completion of a pro- 50Wr of’ overhead (or about 25 of’
TRABSACTIOB COSTING duction run. Similarly, the major- total costs1, the chs me in the re-
i ty of t he t i me spe nt on par ts ported product costs ranged ft ‹um
ow -v o1u me pro d ucts c re ate
inspection occurs just after a setup about min us 10Ur to plus 1,00()"/‹ .
mo re t ra nsa c ti on s per u nit
or changeover. Thus, while the sup- The significant chhinge in the re-
manufactured than their high-
port departments are engaged in a ported product costs IN r the I ow-
volume counterparts. The per unit
broad array of activities, a consid- vol- ume items was due to the subsJ
share of these costs should, there-
erable portion of their costs may be on- tial cost of’ the support depart
fore, be higher for the low-volume
attributed to the number of setups. mt'nts and the low batch size over w
products. But when vol ume-related
Not all of the support-depart- ment h ich the transaction cost was
bases are used exclusively to allo-
costs are related (or relatable) to spread.
cate sup port-de p art men t costs,
the number of setups. The cost of' Table 1 shows the magnitude of’
high-volume and low-volume prod-
setup personnel relates more to the the shift in reported product coasts
ucts receive similar transaction-re-
quantity of setup hours than to the for seven representati ve products.
lated costs. When only volume-re-
actual number of setups. The num- The existing cost system repoi ted
l a te d ba se s a re u se d fo r
ber of inspections of incoming ma- gross margins t h at va ried I’i o ni
second-stage allocations, high-vol-
terial can be directly related to the 26% to 47*/c , w hile t he strata gi c
ume products receive an excessive-
n umber of mate rial rece ipts, as analysis showed gross margin t hat
ly high f’raction of support-depart-
would be the time spent moving the ranged from 25S Wc to 1 46"Z‹ .
ment costs and, therefore, subsidize
received material into inventory. 'the trends in the two sets o1’ repoi
the low-volume products.
The number of outgoing shipments ted product profitabilities were
As the range between low-vol-
can be used to predict the activity cl‹•ar: the existing direct-labor-based
ume and high-vol ume products in-
level of the finished-goods and sys- tem had identified thro low-vol u
creases, the degree of cross-subsidi-
ship- ping departments. The rue products as the m ost p rof’i ta bl
zation rises. Support departments
assignment of all these support e, while the strategic cost analysis,
costs with a in- dicated exactly the reverse.

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Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
 There ‹i re th ree important mes- tion-lot size for the other six prod- volume products. In recognition o1'
s.ides in tne table and in the compa- ucts. A more detailed analysis of this phenomenon, more companies
n; s tind i rite in general. t h e s e v e n p r od u ct s , h o w e v are experimenting with assign ing
e r , sh owed that product seven was material-related overhead on t he
Ti ad it io nal systems that assign as- sembled with components also basis of’ the total number of difl'er-
costs to prod ucts using a single used to produce two high-volume ent parts used, and not on the phys-
v‹ 1 u ni e- re1at ed base serious ly prod- ucts, (n u mbers one and six ical or dollar volume of’ materials
d retort product costs. and that it was the production-lot used.
Th e d i st o rt i o n is system a t ie. size of the com ponen ts that was the
Low-yr›1 ume pt oducts are under- dominant cost d river, not the as-
c‘osted. ‹ind high-vol u me prod- sembly-lot size, or the shipping-lot LOBG-TERM VARIABLE COST
ucts ‹me overcosted. size.

T
\ccu nite product costs cannot, In a traditional cost system, the he volume-unrelated support-
i ii gene ral, be achieved by cost va1 ue of commonality of parts is department costs, unlike trod i-
svstena s t hat rely on ly on vol- hidden. Low-vol ume com ponents tional variable costs, do not
u me-rel:tted bases i even m ulti- appear to cost only slightly more vary with short-term changes in ac-
p1 e bases such as machine hours than their high-vol ume cou nter- tivity levels. Traditional variable
ri n d ia4 ‹iteu ia1 quantities) for sec- parts. There is no incentive to de- costs vary in the short ru n w ith
o n d-st rid e .i11 r›cat ion s. A differ- sign products with common parts. production fluct uat ions beda use
sn I ty Jae of ‹allocation base must The shift to tra nsact ion-rel a ted they represent cost elements that
br used for os erhead costs that costing identifies the much lower reQuire no managerial actions to
s a ry wit h t he number of’ trans- costs that derive from design ing change the level of expenditure.
actions | erf or med, as opposed to products with common (or fewer) In contrast, any amou nt of de-
t lie s o lume of product produced. parts and the much higher costs crease in overhead costs associated
generated when large numbers of with reducing diversity and com- plc
"l’lie sh il t to t ransaction -related unique parts are specified for low- x ity i n the facto ry wi11 ta ke many
‹i1 I next ion bases is a more t‘unda- months to realize and will re- quire
me n tal c hange to the philosophy of specif’ic managerial actio ns. The
cost -syst ems design than is at first i r
a1 ized. In a t raditional cost sys- t Direct costing, number of personnel in sup- port
departments will have to be reduced,
eNJ t h.it uses vol ume-related bases, t
he cost ink element is always t he a even if eorrectly machines may have to be sold off, and
some supervisors will become
roduct It is the product that con- suHat
s di rect labor hours, machine h t›u implemented, is redundant. Actions to ‹ic- com plish
these overhead cost re- ductions will
re. or material dollars. There- l i› re,
it i s t he p rod uct t h at gets cost r d. not a solution and lag, by months, t he complexity-
reducing actions in the product li ne
lii a t i .insact ion-related system,
costs are assigned to the units that is perhaps a major and in the process technology. But
this long-term cost response mirrors
c‹iused the transaction to be origi-
n‹it r d. For exam Male, iI’ the transac-
problem for the way overhead costs were first built
up in the l'ac- tory—as more products
t it a is ri setup, then the costing cle-
rn c ii t w i1 l be t he production 1ot product costing. with spe- cialized designs were added
to the product line, the organ ization si
bed a use e tic h p i od uct io n 1ot re- m- ply muddled through with exist ing
qui i es ‹i st ngle setu p. The same is personnel. It was on ly over t ime
t i ue f or purchasing act iv ities, in- that overworked su pport depa rt-
sps c‘tions, scheduling, and materia1 ments requested and received addi-
move ments. The costing element is tional personnel to handle the in-
no longer the product but those ele- c re ase d n u mber of t ra n sa c t i o
ments the t rans:tction affects. ns that had been thrust upon them.
I ia t he t re nsact ion-related costing The personnel in the support de-
sx’st em, t he unit cost of’ a product is part ments are often highly skil led
detei n4 in ed by dividing the cost of’ a and possess a high degree of firm-
t i ‹i nsaction by the number of‘ units specific knowledge. Management is
in t lie cost ing element. For exam- 1 oa t h e t o 1a y t h e m o ff w h e n
ple, when the costing element is a changes in market conditions tem-
p i od uc t ion lot, the un it cost of‘ a porarily reduce the level of prod uc-
Ja rod uct is deter niined by dividing ti o n com p le x ity. Co nseq uen t1 y
t he Jaroduction lot cost by the num- , when the workload of these depart-
the i tel un it s in t he production lot. m e nts d r o ps, s u r p1 u s ca pa c i t
T la is c h ‹i nge i ii the cost in g ele- y exists.
rna n t is ia ot triv in1. In the Sch rader The long-term perspective man-
Be I I ow's st i'ateg ie cost analysis I see agement had adopted toward its
T.im1 e 1 i, pi oduct seve n appears products often made it difficult to
to riot.itt t he st rout inverse use the surplus capacity. When it
relation- s la i Ja bet eve en p i of its and was used, it was not to make prod-
produc-

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
 ucts never to be produced. again, publication of this article, is help-
but rather to produce inve atory of
products that were known to dis-
rupt production (typically I he very
The accompanying article, co-auth-
low-vol ume items) or to t›roduce,
ored with Robin Cooper, is
under short-term contract, prod-
excerpt- ed from Acco unt in g &
ucts for other companies. We did
Ma nage- me n t: Fie Id Stud y
not observe or hear about a situa-
Perspec I i ver (Boston, Mass.,
tion in whic h this ca pac ity was
Harvard Business School Press,
used to introduce a product that
1987) Wi lli am J. Bruns, Jr. and
had only a short life expi•ctancy.
Robert S. Kaplan (eds.). The book
Some companies justified the ac-
contains 13 field studies on
ceptance of special orders ‹›r incre-
management accounting
me n t a 1 b u s i ness because t
innovations presented at a colloqui-
hey ”knew” that the income ft om
um at the Harvard Business School
this business more than cover‹*d
in June 1986 by leading academic
their variable or incremental costs.
researchers from the U.S. and
They failed to realize that the lc ng-
Western Europe. The colloquium
term consequence from accepti rig
represents the largest single collec-
such incremental business was i
tion of field research studies on
steady rise in the costs of their
management accounting practices
support departments.
in organizations.
The HBS colloquium had two
principal objectives. First, the au-
WHEB PROBUCT COSTS thors were to understand and
ARE B0T KBOWIt docu- ment the management
accounting practices of actual
he magnitude of the errors in
organizations. Some of the
reported product costs and the
organizations would be captured in
nature of their bias make it difficult
a process of transition: attempting,
for full-line prod ucers to enact
and occasionally suc- ceeding to
sensible strategies. The exist- ing
modify their systems to measure,
cost systems clearly identify the
motivate and evaluate op- erating
low-vol ume product'› as the most
performance. Other organi- zations
profitable and the high-vol- ume
were studied just to under- stand
ones as the least profitable. Focused
the system of measurement and
competitors, on t ae other hand, will
control that had evolved in their
not suffer from I he same handicap.
particular environment.
Their cost syster is, while equally
A second, and even more
poorly designed, wi11 report more
impor- tant, objective of the
accurate product c osts be- cause
colloquium was to begin the
they are not distorted as
much by lot-size diversity. process by which field research
methods in manage- ment
With access to more r cc u rate
accounting could be estab- lished
product cost data, a focu'.ed com-
as a legitimate method of in-
pet itor can sell the high -volume
quiry. Academic researchers in
products at a lower price. The full-
accounting have extensive experi-
line producer is then ap parently
ence with deductive, model-build-
faced with very low ma -gins on
ing, analytic research with the de-
these prod u cts and is n at u rail y
sign and ana lysis of controlled
tempted to deemphasize t his busi-
experiments, usually in a labora-
ness and concentrate on ap parently
tory setting; and with the
higher-profit, low-vol ume ,pecialty
empirical analysis of large data
business. This shift from high-vol-
baBes. This experience has
ume to low-vol ume produ its, how-
yielded research guidance and
ever, does not produce tf e antici-
criteria that, while not always
pated higher p ro fit ab i1 .ty. The
explicit, nevertheless are widely
firm, believing in its cost system,
shared and permit re- se arch to
chases illusory profits.
be cond ucted and evaluated.
The firm has been victi mized by
At a time when so many organi-
diseconomies of scope. In trying to
zations are reexamining the ade-
obtain the benefits of ecu nomy of
quacy of their management ac-
scale by expanding its product of-
counting systems it is especially
ferings to better utilize it'› fixed or
important that university-based re-
capacity resources, the ft rm does
searchers spend more time working
not see the high diseconomies it has
directly with innovating organiza-
tions. We are pleased that MAN-
AGEMENT ACCOUNTING, through
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
 finally prescribe about the new
opportunities for manage- ment
accounting.
Robert SI. Kaplan
ing to publicize the existence of the
field studies performed to date. MANAGEMENT ACCOUNTING,'AP€.IL
The experiences described in 1988
the accompanying article, as well
as in the other papers in the
colloquium volume, indicate a
very different role for
management accounting systems
in organizations than is currently
taught in most of our business
schools and accounting de-
partments. We believe that present
and future field research and case-
writing will lead to major changes
in ma n age m e nt acc ou nt i
n g courses. To facilitate the
needed changes in curricu I u m
and re- search, however, requires
extensive cooperation between
university fac- ulty and practicing
management accountants. As
noted by observers at the Harvard
colloquium:
There is a tremendous store
of knowledge about manage-
ment accounting practices
and ideas out there in real
companies. Academicians as
a whole are far too ignorant
of that knowledge. When
aca- demics begin to see the
rele- vance of this data base,
per- haps generations of
students will become more
aware of its ric h ness. Such
awareness must precede any
real pro- gress on p rescrib
ing good management
accounting for any given
situation.
To observe is also to
discov- er. The authors have
observed interesting
phenomena. We do not
know how prevalent these
phenomena are or un- der
what conditions they exist or
do not exist. But the stud-
ies suggest possible
relation- ships, ea uses,
effects, and even dynamic
process in the sense that
Yogi Berra must have had in
mind when he said,
”Sometimes you can ob-
serve a lot just by
watching.”
With the research support
and cooperation of the members
of the National Association of Ac-
countants, many university
profes- sors are looking forward
to watch- ing and also describing
the changes now under way so
that academics can begin to
develop theories, teach, and
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
 into oduced by creating a far more will misclassify these costs as fixed. SUMMARY

P
coma plex production environment. The misclassification also arises
The cost accounting system fails to from an inadequate understanding roduct costs are almost all
reveal this diseconomy of’ scope. of the actual cost drivers for most variable costs. Some o1 t he sources
overhead costs. Ma ny overhead of variability relate to physical
costs vary with transactions: trans- volume of items produced. These
A COMPREHENSIVE COST SYSTEM actions to order, schedule, receive, costs will vary with u n its produced,
inspect, and pay for shipments; to or in a varied, multipro- duct
ne message comes thro ugh move, track, and count inventory; environment, with surrogate
overwhelmingly in our expe- to schedule production work; to set measures such as labor hours, ma-
riences with the three firms, up machines; to perform quality as- chine hours, material doll ars and
a n d w it h t h e ni a n y ot h e r s we surance; to implement engineering Quantities, or elapsed time of pro-
tal ked and worked with. Almost all change orders; and to expedite and duction. Other costs, however, p‹ir-
product-re 1 ated dec is ions—i ntro- ship orders. The cost of these trans- ticularly those arising from over-
d net ion. pr ici ng, and discont inn- actions is largely independent of h e a d s u p po r t a n d m a r k ct i
ance —are long-term. Management the size of the order being handled; n g departments, vary with the
account ing thinking I and teaching) the cost does not vary with the diversi- ty and complexity in the
d ur in g t he past half-century has amount of inputs or outputs. It does product line. The variability of
co n ce nt rated o n in t’or mation for vary, however, with the need for these costs is best explained by the
na‹ik ing short-run incremental deci- the transaction itself. If the firm in- incidence of’ transactions to initiate
sions based on variable, incremen- the next stage in the production,
ts 1, or relevant costs. It has missed logistics, or
the most important aspect of prod- distribution process.
uct decisions. Invariably, the time A com pre he ns ive product cos t
period l’or measuring ”variable,” syste m, in co rpo rat in g the 1o n g-
"incremental,” or ”relevant” costs term variable costs of manuf’actur-
has been about a month (the time ing and marketing each product or
period corresponding to the cycle of pr od u ct 1 i ne, s ho u 1 d pr ov
the firm’s internal financial report- ide a much better basis for
ing system J. While academics ad- managerial decisions on pricing,
mon is h that notions of’ f’ixed and introducing, discontinuing, and
variable are meaningful only with reengineeri n g product lines. The
respect to a particular time period, cost system may even become
t h e \ i m m ed i at e1y d is ca rd t h strategically i m por- tant for running
is w‹i r n ing an d teach f rom the the business and creating sustainable
per- s Ja ect i ve o f o n e - m o n t h d com pet it ive advantages for the
ec is i o n hori zons. firm. ■
This short-term locus for product
cost ing has led a11 the com panies fiohin Cooper is or associate
we visited to view a large and grow- pro[essor of business
ing proportion of’ their total manu- administration at the Harvctrd
I act uring costs as ”fixed.” In fact, Bust ness S!chool and a fe Holt r›/
how'ever, what they call ”I ixed” the Institute o/ Chci rtered Acco un
costs have been the most variable ter nfs in England and Wales. He
and rapidly increasing costs. This tart tee a column, ”Cost Manajemen
paradox has seemingly eluded most t
iiccounting practitioners and schol- Pri nci ples and Concepts, in th‹•
ars. Two fundamental changes in Journal of Cost Management cnr/
our thin king about cost behavior has produced reseorch on actii it› -
must be introduced. based costing for the CAM-I Cos I
First, the allocation of’ costs f‘rom Management S!ystem ProJect.
I h e cost p oo1s to t h e pr od u cts Robert S. Ka plan is the Arth ui
should be achieved using bases that Lo wee Dich i uson Professor o/
reflect cost drivers. Because many Accou nttng at the Ha rva rd
ove rhead costs are driven by the Business lschool and a prof‘ess‹›r of
complexity of production, not the i nd Itstria1 adm mrs mutton at
vol ume o1 production, nonvolume- Carnegie-Mellon Uni versi I›.
Pneumatic products ore manufactured
related bases are required. Second, Cu rren t1y, Pro/essor Ka pla n .Bert
by one of the companies in the study.
many of‘ these overhead costs are es on the Execu ti ve Cont mi ttee of
so m ew h a t d isc ret io na r y. W th‹• CAM-I Cost Management
hi le t hey very with changes in the troduces more products, if it needs System Project, the Manu[acturi nd !
com- pl ex ity of the production to expedite more orders, or if it Studies Board of the to/iown/ Resea
process, these changes are needs to inspect more components, re.h Coit nci 1, and the Fina ucta 1
intermittent. A t raditional cost then it will need larger overhead Accounting Standards Ad seem'
svstem that defines va i iabl e costs departments to perform these addi- Committee.
as varying in th e sho rt term with tional transactions.
production volume 'Mayers Tap I disguised name 1 is desc ribed i n
Harvard Busin ess School, case se rios 9-18ñ- 1 I I
Sc h rader-Be1lows is described in HBS t’iis‹
Series 9-156 272.

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