Measure Costs Right: Make the Right Decisions
Robin Cooper and Robert S. Kaplan
Harvard Business Review September-October 1988
HBR Executive Summary
Managers in companies selling multiple products are making strategic decisions about pricing and product mix with distorted cost information. What's worse, most companies detect the problem only after their competitiveness and profitability have deteriorated.
Two prominent critics of existing cost-accounting practices describe an alternative system they refer to as activity-based costing. The theory behind their approach is simple. Virtually all of a company's activities exist to support the production and delivery of today's goods and services. They should therefore all be considered product costs. Moreover, nearly all organizational costs are divisible or separable: all factory and support costs-for functions such as logistics, marketing and sales, financial administration, and data processing-can be split apart and traced to individual products or product families.
Most companies currently trace these and other overhead costs-if they trace them at all-using simplistic allocation bases like direct labor or materials usage. Adopting the more sophisticated activity-based approach can produce striking changes in reported product costs and profitability. For example, a large manufacturer of hydraulic valves implemented activity-based costing and discovered that 75% of its products were losing money.
Companies need not scrap their official costs systems to use activity-based methods. The two can exist simultaneously. Indeed, activity-based costing is as much a tool of corporate strategy as it is a formal accounting system. Decisions about pricing, marketing, product design, and mix are among the most important decisions managers are paid to make. None of them can be made effectively without accurate knowledge of product costs.
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