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© 2015 Wiley Periodicals, Inc. Published online in Wiley Online Library (wileyonlinelibrary.com). DOI 10.1002/jcaf.22045 This article was originally published in Volume 23, Number 3 of The Journal of Corporate Accounting and Finance.

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Joseph G. Fisher and Kip Krumwiede

M any firms use product cost- ing informa-

tion to value inven- tory for financial reporting purposes. However, having timely, relevant cost information is essen- tial for profitability analysis and strategic planning. Consider the following story. A few years ago, after implementing a more detailed costing sys- tem, Nestlé SA Chief Executive Peter Brabeck made an unex- pected and alarming discovery: His company was produc- ing 130,000 variations of its various brands, and 30 percent weren’t making money.1 Exces- sive focus on variable costs and spare capacity led to the con- clusion that many new products were “profitable” and long- term winners. Nestlé’s margins were lower than competitors, however, which strongly sug- gested that these seemingly “profitable” products were actually decreasing firm profit. Careful consideration of the cost and profitability analysis

provided by its new sophis- ticated Enterprise Resource Planning (ERP) system led Nestlé to jettison weaker brands, consolidate product offerings, and make significant adjustments in strategic direc- tion. As Nestlé discovered, selecting the correct product costing system for strategic decisions can be challenging but is essential in guiding firm strategy. The wrong system can lead to faulty strategic deci- sions with disastrous results.

We have found that many firms underinvest in their product costing systems. But if improvements in product cost accuracy would lead to

different decision out- comes, then the cost of improving the cost system becomes a stra- tegic investment rather than an unfavorable spending variance. While managers realize the problems caused by relying on flawed cost information, it is challenging to identify the appropriate cost system. Complicating the task is the fact that different strategic deci-

sions call for different product costs. The purpose of this article is to help companies determine the right product cost system approach. First, we discuss why choosing the right costing approach is important. Second, we discuss four key questions that must be answered when selecting a costing approach and the associated options. Lastly, we describe actions to take to achieve a proper fit.

WHY PRODUCT COST SYSTEMS MATTER

So why do companies need a costing system? First, generally

Product Costing Systems: Finding the Right Approach

Many product costing methods and systems exist, but having the right costing system for a given situation can be difficult. This article identifies four key questions to answer and points out the advan- tages and disadvantages of various cost systems to find the right balance of convenience, correct- ness, and implementation costs in a product cost- ing system. Nestlé, for example, discovered that good product management, aided by better cost systems, can pay major dividends. © 2015 Wiley Periodicals, Inc.

14 The Journal of Corporate Accounting & Finance / May/June 2015

ing and maintaining the current system reasonable?

There are some “red flags” to look for when assessing your system. Do competitors’ prices appear to be unrealistically low? Does it take weeks to do a spe- cial cost study to get the infor- mation needed for a strategic decision? Do marketing manag- ers want to continue products that show high profits in the accounting reports but are com- plex to produce? Do operational managers use their own cost systems for product decisions? If the current system shows any of these warning signs, or falls short on one or more of

the dimensions, then a new cost system may be appropriate. When select- ing a new product cost approach, there are four key questions that must be addressed. Answering these questions will guide the selection process.

FOUR KEY QUESTIONS IN PRODUCT COST DESIGN

Unfortunately, the myriad approaches to product costing and choices available can inhibit a systematic design approach. In selecting a product cost system, a firm needs to answer four key questions:

1. Which costs should be included in product cost?

2. At what level of detail should we track direct product costs?

3. How do we organize indirect product costs?

4. How do we allocate indirect costs to products?

Addressing these ques- tions will help guide system selection. Understanding the

desire more accurate product costing systems but have trouble justifying the cost. We have also found, however, the cost infor- mation philosophy to be quite different in Europe. One Ger- man controller of a company with a very detailed costing system expressed a commonly held view when he said, “How can you not have this level of detail?” The benefits of a supe- rior costing system are real but hard to quantify in return on investment (ROI) calculations, and implementation costs can seem onerous. In general, it is difficult to quantify all benefits prior to system implementation. Improving a cost system should

be approached as a strategic investment.

ASSESSING YOUR CURRENT SYSTEM

So how do you know if you have a satisfactory system? We recommend assessing your cur- rent system against three dimen- sions:

• Convenience: how conve- nient is it to get the cost information needed?

• Correctness: are the current product costs reasonably accurate?

• Costs of implementation: are the costs of implement-

accepted accounting principles (GAAP) and International Accounting Standards (IAS) require the determination of the cost of goods sold or ser- vices performed for financial reporting. Financial accounting, however, does not require a high level of accuracy or relevance for product costing—the method simply needs to be systematic and reasonable. Second, prof- itability assessment is a key component of strategic analysis. Many important strategic deci- sions are made at the product- line level. For almost any firm producing a large and diverse set of products in different facili- ties and countries (e.g., Nestlé), product profitability helps guide product portfolio decisions. Third, product costing systems can help in cost and operational control.

Unfortunately, given diverse demands on cost information, there is no single system that meets every reporting and stra- tegic need. Additionally, different operational settings call for different costing approaches. A system that is appropriate for a Nestlé Purina pet food factory making a few flavors of dog food would not be appropriate for a Nestlé confectionery plant making doz- ens of different candies. While this fact may be unsettling for managers who desire certainty, it also relieves the pressure to find the one and only cost number or system. Quite simply, the single best product cost system for all possible purposes does not exist. Selecting a costing system and philosophy requires a care- ful consideration of costs and benefits.

In our experience, we have found that most companies

Quite simply, the single best product cost system for all possible purposes does not exist. Selecting a costing system and philosophy requires a careful consideration of costs and benefits.

The Journal of Corporate Accounting & Finance / May/June 2015 15

Four Major Costing Continuums

1. Which costs should be included in product cost?

hgiHwoL

Throughput Costing

Variable Costing

Full Absorption Costing

Life-Cycle Costing

2. At what level of detail should we track direct product costs?

ecruoseRboJ

Job Costing

Operation Costing

Value Stream Costing

Process Costing

Resource Consumption Accounting

3. How do we organize indirect product costs?

xelpmoCSimple

Plantwide Cost Pool

Department Cost Pools

Time-Driven ABC

Activity-Based Cost Pools

Detailed Cost Centers

4. How do we allocate indirect costs to products?

xelpmoCSimple

Volume- Based

Drivers

Transaction-Based Drivers

Duration-Based Drivers

Intensity- Based

Drivers

Exhibit 1

Which Costs Should Be Included in Product Costs?

The first question relates to product cost definition. As a starting point, full absorption costing includes all manufactur- ing costs as product costs; it is most commonly used in practice, and it is mandated by GAAP for financial reporting. However, it may be insufficient since it only includes certain costs: direct materials, direct labor, and some reasonable allocation of vari- able and fixed overhead. Other direct costs are not included. For example, a 2 percent tariff on every candy bar sold is as much a cost of selling a product as the ingredients that went into it. Yet this cost would not be included in full absorption cost. Nor would absorption costing include other relevant nonmanu- facturing costs—such as R&D, sales, support, and distribu- tion—in product costs. Includ- ing full manufacturing costs can lead to unnecessary inventory buildup since fixed overhead (i.e., capacity) costs are capital- ized in inventory and not imme- diately expensed on the income statement. In addition, this cost- ing approach mixes variable and fixed costs, which makes it dif- ficult to determine cost behavior when making product decisions.

The question of what to include in product cost is chal- lenging, since there are many dif- ferent cost categories that may be considered. Exhibit 2 presents several cost models along with typical cost inclusions. Any com- bination of costs, however, may be included in product costs. Throughput costing includes only direct materials in product costs. This model (which dis- courages inventory buildup since fixed costs cannot be capitalized into the inventory account) is

Levels of Product Costing Completeness

Types of Cost Direct materials Direct labor Variable factory overhead Fixed factory overhead Nonfactory costs (sales, admin, distribution) R&D, design, customer service, disposal

Throughput Costing Variable

Costing Full Absorption Costing Life-Cycle

Costing

Exhibit 2

various options available can help identify and address the most critical needs. Exhibit 1 illustrates some of the more

common options available for each of the four key questions. Next, we discuss each question and options in more detail.

16 The Journal of Corporate Accounting & Finance / May/June 2015

commonly used in just-in-time production environments. On the other hand, this methodol- ogy does not measure full costs and would be inappropriate for making many strategic decisions (e.g., cost-based pricing).

Variable costing includes all variable manufacturing costs. This methodology is more appropriate when variable costs are significant and a key com- ponent of total cost. Although not allowed for GAAP due to immediate expensing of fixed overhead, the use of variable costing can discourage buildup of inventories since fixed pro- duction costs are expensed instead of being included in inventory. The separation of fixed and variable costs permits construction of a “contribution margin” income statement. Con- tribution margin equals sales minus all variable costs. Focusing on the contribution margin may be relevant for short-term strategic decision making since fixed overhead does not change significantly with changes in short- term production volume.

More inclusive methods include full absorption costing discussed earlier and life-cycle costing. Life-cycle costing includes all production-related costs as well as nonproduction costs such as sales, administra- tion, R&D, customer service, and disposal costs. These “upstream” and “downstream” costs are part of the overall value chain and are increasingly being recognized as costs that need to be taken into account when making strategic deci- sions. In fact, in many firms, these costs are more signifi- cant than manufacturing cost. Ignoring these costs can result

in understated product costs for strategic decision analysis.

It is important to empha- size that one product cost defi- nition cannot meet all costing needs. For example, for inven- tory control purposes, a firm may select throughput costing, while for pricing decisions the firm may use a more inclusive definition. Exhibit 3 provides a list of typical product cost defi- nitions along with associated pros and cons.

Another issue relating to product cost is how to address idle capacity cost. Idle capacity in one period may be a necessary investment in another period to meet demand. Including these costs as part of product costs,

however, leads to the risk of a “downward demand spiral.” This term refers to decreasing demand leading to allocating these costs to fewer products, which leads to higher cost allocations and prices, which in turn leads to further decreased demand, and so forth. Many firms attempt to report these idle capacity costs separately in order to minimize the impact of short-run capacity issues on product cost.2

At What Level of Detail Should We Track Direct Product Costs?

The second important question to answer is how to

track direct product costs. As Exhibit 1 illustrates, one end of the spectrum tracks costs by job (or product). Job costing is most appropriate when each job or product is unique, but it can lead to unnecessary recordkeeping for costs that are common to all jobs.

At the other end of the spec- trum is resource consumption accounting (RCA), where costs are tracked at the individual resource cost center level for a large number of cost centers (i.e., work areas).3 RCA requires tracking several cost categories for each cost center, separating fixed and variable costs, and developing a cost rate for the variable costs that can be used to charge costs to the output. A

flexible budget is devel- oped for each cost center based on the actual activ- ity volume. Fixed and variable costs continue to be separated as costs are rolled up to the final product cost. This level of detail allows firms using RCA to achieve a high level of cost accuracy and control. This approach is appropriate for batch processing and when cost

assignment drivers are quantifi- able, but it can be expensive to implement. Other methods between the two extremes include process cost- ing, operation costing, and value stream costing. Process costing tracks costs at the process or department level and assumes product uniformity. When products have certain unique costs (e.g., different materials) but essentially go through the same process, then a hybrid approach, called operation costing, is appropriate.4 Value stream costing is often associ- ated with the Lean Accounting philosophy and tends to be used

Focusing on the contribution mar- gin may be relevant for short-term strategic decision making since fixed overhead does not change signifi- cantly with changes in short-term production volume.

The Journal of Corporate Accounting & Finance / May/June 2015 17

with throughput costing. Value stream costing tracks revenues and costs by value stream (i.e., major flows of value-added activities that go into delivering specific products and services to customers). Sustaining costs are separated from value stream costs to minimize arbitrary allocations. Value stream cost-

ing works well in tandem with a Lean manufacturing strategy and simplifies the accounting process by not tracking costs for individual jobs or processes. On the down side, it is more chal- lenging to apply in situations where common resources are used to support multiple value streams.

Exhibit 4 provides a brief description and list of pros and cons for different approaches to tracking direct product costs.

How Do We Organize Indirect Product Costs?

The question of how to handle indirect costs is a key

Product Cost Definitions

Definition snoCsorP

Throughput costing

Includes only direct materials as product costs

Treats all other costs as period costs

Consistent with just- in-time and discourages inventory buildup

Relatively simple

May lead to strategic errors (e.g., underpricing products)

Not allowed under GAAP

Variable costing

Classifies cost by behavior (e.g., variable or fixed)

Treats variable manufacturing costs as product costs

Treats all other costs as period costs

Allows cost-volume- profit (break-even) analysis

Consistent with a contribution margin approach

Relatively simple

May lead to strategic errors (e.g., underpricing products)

Not allowed under GAAP

May require extra training

Full absorption costing

Includes all materials, labor, and manufacturing overhead as product costs

Treats all other nonmanufacturing costs as period costs

Required for GAAP and IAS

Commonly used and understood

Does not include nonmanufacturing costs

Can motivate unnecessary inventory buildup

May treat fixed production costs as variable

Life-cycle costing

Includes all production-related costs plus upstream and downstream costs as product costs (e.g., R&D, customer service, and disposal costs)

Recognizes overall value-chain costs

Best fit for long-term product decisions

Downstream costs often not known

May treat all value stream costs as variable

Exhibit 3

18 The Journal of Corporate Accounting & Finance / May/June 2015

Costing Approaches Relating to Direct Cost Detail

Cost Approach snoCsorP

Job costing (JC)

Each order is separately costed

Requires separate record keeping for each job or product

Best captures the unique aspects of each job

Generally most accurate costing system

May lead to unnecessary tracking for costs that are common

Expensive

Process costing (PC)

Tracks costs by department and computes average cost for all units for a time period

Typically the easiest and least costly method

Works well in environments where individual units are indistinguishable

Does not capture unique costs

Operation costing (OC)

Tracks unique costs by order (e.g., materials) like JC

Tracks common costs by department and computes average cost across all units

Captures the unique costs of each job

Cost-effective for costs that are common for each job or unit

Less accurate than JC for costs that differ by job

More effort required than PC

Value stream costing

Tracks revenues and costs by value stream

Shows sustaining costs separate from value stream costs (minimizes arbitrary allocations)

Supports Lean manufacturing philosophy

Simplifies the accounting process

Saves time by not having to track costs for individual jobs or processes

Less cost control over individual processes

Not as effective when company uses common resources

Resource consumption accounting (RCA)

Models how resources are used by outputs

Separates costs into variable and fixed elements for a large number of cost centers

Uses flexible budgeting at the cost center level

Responsibility for costs lies with cost center managers (strong cost control)

Highly accurate product cost information for short- term decisions

Typically requires expensive ERP system

Very detailed—can be difficult to understand

Typically most complex method

Exhibit 4

The Journal of Corporate Accounting & Finance / May/June 2015 19

cause-and-effect linkage between the costs and the product. As Exhibit 1 shows, the simplest bases are related to volume (e.g., units produced)—typically used with plantwide and department- based cost pools. Unfortunately, many cost categories are not cor- related with production volume. In these cases, transaction-based cost drivers are more appropri- ate. Examples of transaction cost drivers include number of setups, purchase orders, and design changes, which are com- monly used with ABC.

In other situations, dura- tion or intensity cost drivers are appropriate drivers. TDABC uses duration drivers that mea- sure the time required for a

transaction. For example, assume it takes longer to set up the melting pots for a batch of organic chocolate bars than for nonorganic bars. The chocolate factory may want to use setup hours rather than the number of setups to allocate setup costs. Intensity drivers are more complex since they seek to measure the actual resources used by

an activity.6 For instance, some products may be particularly difficult to set up because they require specially trained workers and quality control personnel. Instead of treating all setup hours alike, hours requiring dif- ferent human resources would be tracked separately. Use of intensity drivers typically results in more accurate product costs but is expensive to implement.

TAKING ACTION

Developing the right prod- uct costing system is not an easy or trivial process. In order to find the right fit, first assess your

the capacity cost rate, TDABC allows the firm to compute the cost of unused capacity. One downside of TDABC is the need to estimate the time to carry out each type of transac- tion and the assumption of constant time requirements. In addition, resource costs that are not correlated with time (e.g., level of complexity, space, etc.) may be handled more easily by conventional ABC methods.

The most complex method to organize indirect costs is to use detailed cost centers. Often used with RCA, this method tracks costs at the individual cost center (i.e., work area) level by various categories (e.g., vari- able vs. fixed, supplies, labor,

etc.). These costs are “direct” to the cost center and then charged to the product using the variable cost rate. Tracking these costs at this disaggregated level allows for greater accuracy but at the expense of higher implementa- tion and maintenance costs.

How Do We Allocate Indirect Costs to Products?

Closely related to deciding how to track indirect costs is choosing the most appropriate basis for allocating these costs to the product. The goal is to find the best “cost driver” for each cost pool that approximates the

challenge for product cost- ing. By definition, these costs cannot be easily traced to the product (or cost object). Exhibit 1 illustrates a continuum of methods to track indirect costs from simple to more complex methods (see Exhibit 5 for a list of pros and cons for each method). Historically, most businesses have chosen plant- wide or department-based accu- mulation approaches in which overhead costs are accumulated into either a single cost pool or department-based cost pools. Departmental cost pools are commonly used with operation and process costing methods.

Although simple plantwide or department-based cost pools are used extensively, prior research suggests that these approaches can lead to highly distorted product costs due to the inclusion of only one cost driver. To address this issue, activity- based costing (ABC) organizes indirect costs by activity and can result in more accurate prod- uct costs. ABC, however, has been criticized due to inherent complexity. Chal- lenges include the difficulty in collecting activity data, alloca- tion challenges, and high imple- mentation costs. Time-driven ABC (TDABC) has been devel- oped in response to these issues.5 TDABC attempts to simplify the ABC process by using time as the cost driver and thus skip- ping the activity definition stage and surveying task. Instead, just two parameters need to be estimated: (1) a capacity cost rate for each department and (2) the typical capacity usage for each type of transaction. By using a department’s total productive time available as the denominator when computing

20 The Journal of Corporate Accounting & Finance / May/June 2015

Costing Approaches Relating to Organizing Indirect Costs

Cost Approach snoCsorP

Plantwide cost pool

All indirect costs are accumulated into a single cost pool

Simplest method

Works well if all products consume indirect costs at the same rate

Generally least accurate assignment

Can lead to highly distorted costs since all indirect costs assumed to be driven by one driver

Departmental cost pools

Indirect costs are accumulated into a separate cost pool for each department

Simple method

Recognizes differences in overhead costs among departments

Generally more accurate than plantwide method

Often not very accurate assignment of overhead costs to products

Activity-based costing (ABC)

Assigns indirect (overhead) costs to activity cost pools

Next assigns activity costs to cost objects using appropriate cost drivers and rates

Generally most accurate assignment of overhead costs to products

Can use cost drivers and activity cost rates to help manage business

Needs to use JC, PC, or OC to account for direct costs

Complex to set up and maintain

Time-driven ABC

Indirect costs are accumulated into a separate cost pool for each department

Uses time as the cost driver for all resources within a given department

Multiplies single cost rate by the time

Takes less time and effort than ABC (does not require accumulating costs by activity or tracking various cost driver data)

Allows the firm to compute the cost of unused capacity

Must estimate time to carry out each type of transaction

Not as accurate for resource costs that are not driven by time (e.g., complexity, space)

required for each type of transaction

Detailed cost centers

Indirect costs tracked at the individual cost center (work area) level

Costs tracked by category (e.g., variable vs. fixed, supplies, labor, etc.)

Costs are charged to the output using a variable cost rate for each cost center

Cost center manager has responsibility for indirect costs

Higher granularity and accuracy than other cost approaches

Typically requires expensive ERP system

Very detailed—can be difficult to understand

Requires most effort to set up and maintain

Exhibit 5

The Journal of Corporate Accounting & Finance / May/June 2015 21

NOTES

1. Ball, D. (2007, July 23). After buying binge, Nestle goes on a diet. Wall Street Journal, p. A1.

2. See Kaplan, R., & Anderson, S. (2007, March/April). The innovation of time-driven activity-based costing. Cost Management, 21(2), 5–15. See also Kren, L. (2008). Using activity-based manage- ment for cost control. Journal of Perfor- mance Management, 21(2), 18–28.

3. See White, L. (2009, May/June). Resource consumption account- ing: Manager-focused management accounting. The Journal of Corporate Accounting & Finance, 20(4), 63–77; Krumwiede, K., & Suessmair, A. (2007). Getting down to specifics on RCA. Strategic Finance, 88(12), 50–55; and Mackie, B. (2006). Merging GPK and ABC on the road to RCA. Strate- gic Finance, 88(5), 33–39.

4. See Pryor, T. (2010, January/February). A financial thermometer for lean oper- ations. Journal of Corporate Accounting & Finance, 21(2), 81–91; and Kennedy, F., & Brewer, P. (2005). Lean account- ing: What’s it all about? Strategic Finance, 87(5), 27–34.

5. Kaplan, R., & Anderson, S. (2007). The innovation of time-driven activity- based costing. Cost Management, pp. 5–15. See also Öker, F., & Adigü- zel, H. (2010). Time-driven activity- based costing: An implementation in a manufacturing company. Journal of Corporate Accounting & Finance, 22(1), 75–92.

6. For a more complete discussion of dif- ferent types of cost drivers, see Kaplan, R., & Cooper, R. (1998). Cost and effect: Using integrated cost systems to drive profitability and performance. Boston, MA: Harvard Business School Press; pp. 95–98.

information was used to help make the decision. Show how more accurate or complete information might have altered the outcome of the decision. It is hard to quantify the benefits of improvements to a costing system, but a firm can often quantify the benefits for spe- cific decisions and use them as examples. In addition, employ- ees whose measured perfor- mance is negatively affected by the new product cost system may be wary of system change. Being cognizant of potential behavioral issues is key in sys- tem implementation.

Back to Nestlé’s situation, a careful examination of prod- uct costing systems resulted in a major system overhaul. New information led to major changes in strategic direc- tion. For instance, CEO Peter Brabeck was surprised to dis- cover that it cost more to make flavored frozen treats in the United States than in Europe. In response, Nestlé retrained US factory workers to feed the machines faster, leading to a 33 percent drop in the cost of ice pops the following year. Nestlé discovered that good product management, aided by better cost systems, can pay major dividends.

current system based on conve- nience, correctness, and costs of implementation. Also look for warning signs that your current product cost system is flawed. If the current system seems to be consistently falling short, consider the four key ques- tions and different approaches available discussed in this article. Many of the approaches included in this article fit well as a costing package. For exam- ple, typical pairings include: throughput costing and value stream costing; department- based cost pools with process or operation costing; plantwide cost pools with volume-based drivers; ABC with transaction drivers; TDABC with duration drivers; and RCA with detailed cost centers.

Beyond the issues dis- cussed in this article, product costing system change can result in challenging behav- ioral and political issues. Even if improvements to the cost systems are in order, there is often resistance due to financial and time con- straints. To help “sell” a cost system improvement initia- tive to upper management, try identifying some recent specific strategic or opera- tional decisions in which cost

Joseph G. Fisher is the Harry C. Sauvain Chair of the Department of Accounting in the Kelley School of Business at Indiana University in Bloomington, Indiana. Kip Krumwiede is an associate professor in the Department of Accounting in the Robins School of Business at the University of Richmond in Richmond, Virginia.

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