Evolvement of The
Traditional Cost System.

One of the most important benefits of exact cost information is the application for pricing purposes. Although in practice prices are affected by many forces over which the manufacturer has little or no control, still good cost information is the basis an estimating system uses for pricing purposes. A company that has an intimate and accurate knowledge of its costs can base its price estimates on a sound foundation that will bring few miscalculations. A proper costing system will, in the long run, improve the company's competitive position within the industry. This may help explain the fact that today trade associations are trying to promote good accounting practices among their members, rather than emphasizing monopolistic activities, such as price fixing, as a means to increase profits.

Costs for Facility Profits

The primary emphasis of a company's cost system should be to provide relevant and reliable information for management decision making rather than focusing only on financial reporting requirements. A company that does not have a proper cost system and cannot identify all of the cost of making its own products is like an unguided missile. So it is with a cost system in itself. It may take off but nobody knows where it will land. A company that cannot predict in advance the amount of profit it will earn, must wait until the periodic profit-and-loss statements are published — which may be too late.

Many companies operate on the basis of poor cost information. That doesn't mean that these companies have poor production methods. What it does mean is that regardless of their methods or the degree of streamlining in their plants and offices, the product costs are not an effective guide to their pricing or other decisions.

The Big Problem.

The primary key to the cost/estimating puzzle lies in the allocation of the overhead costs to the product. The apportioning of direct materials and direct labour costs to the product is fairly routine. That is, you can see the material that goes into a product and by tracing a product through its manufacturing process you can identify what labour it took to produce it. Simple records will give the materials and labour costs.

Overhead costs are not directly identifiable with specific products. This makes determining the exact dollar amount that should be added to a product's labour and material cost for exact overhead recovery a major problem. You cannot see the piece of the manager's salary in the product, nor the machine's depreciation expense, nor the cost of the material handlers who came in contact with the product.

Over the years many cost system formulas have cropped up to provide for overhead expenses. Each formula claiming an ability to allocate the proper distribution of overhead expenses. Accurate cost finding has been hampered by unnecessary complications and illogical theories. Shortcuts, formulas, magic numbers, factors and percentages confused the cost finding process and generated tons of paperwork. Often these methods arise out of a need for quick quotations, and management never does recognize product costing as a science.

Once the idea of the magic number becomes implanted, it is hard to pry loose. It becomes even more difficult to do when owners see a profit figure on an Income Statement as proof of their judgment in applying overhead. Unfortunately, the use of the magic number does not find costs, it forces them. Overhead gets spread with a bulldozer, filling in holes and levelling peaks. Management is victimized by the current shortcut formula and alternately rides the peaks of profit and loss as the overhead formula approaches or departs from actual costs.