Traps to avoid in product costing

In today's hotly competitive business environment, accurate product costing has become critically important to a business's survival. John A. Lessner is a senior manager in Ernst & Ernst's cost and finance consulting practice in Minneapolis. This article grows out of his experience in implementing activity-based cost-accounting systems for clients. Fifty years ago, when manufacturing was far less automated than it is today, the costs of materials, labor and overhead were just about evenly divided. Now, production of a product's various components is often so synchronized on highly automated production lines that there is little or no need to maintain component inventories; thus, the old costing formulas, still used by many industries, are no longer applicable. For example, overhead and labor now eat up much less of the production cost, while materials costs have climbed to an average of 55% of a product's total cost. Also, overhead costs are relatively more fixed because of advances in automation and production data management, while the difference between direct and indirect labor is vanishing. Further complicating the costing equation is the trend in manufacturing to focus more attention on quality, flexibility and responsiveness, to meet customer needs. This makes production-line cost analysis more difficult because each line requires small, but significant, changes in production techniques. All this is of more than academic interest. As national and global competition increase, even tiny costing disparities can have an overwhelming impact on whether a product-or an entire company, for that matter survives. Here are two typical traps managers in charge of product costing fall into-and ways to avoid them. THE SCRAP TRAP In most cases, accounting for scrap generated in the production process is straightforward. If scrap is an insignificant component in a product's production, managers generally ignore it as a cost factor. Obviously, if it weighs in heavily, attention is given to controlling it and factoring its cost into product pricing. Things get more complicated, however, when producing many lines of a similar product. For example, a manufacturer may have a custom product line that requires frequent production line stops, adjustments and start-ups; such a line often has high scrap costs. The company also may have a stock product line that runs nearly nonstop; as a result, its scrap costs are relatively low. …