An International Food and Drink Company
After implementing a more detailed costing system, food producer Mostlé SA Chief Executive Ada Schmidt made an unexpected and alarming discovery: her company was producing 130,000 variations of its various brands, and 30% weren’t making money. Excessive focus on variable costs and spare capacity led to the conclusion that many new products were “profitable” and long-term winners. Mostlé’s margins were lower than competitors, however, which strongly suggested that these seemingly “profitable” products were actually decreasing firm profit. For Mostlé, which produces a wide range of food and snack products in different facilities and countries, product profitability helps guide product portfolio decisions. It had a new sophisticated ERP system but management was not sure how to leverage it to achieve better profitability analysis.
Mostlé , like many companies, had underinvested in its product costing system. Top management decided that if improvements in product cost accuracy would lead to different decision outcomes, then the cost of improving its cost system becomes a strategic investment. While managers knew they were relying on flawed cost information, it was challenging to identify the appropriate cost system. It seemed that different strategic decisions called for different product costs. Additionally, different operational settings call for different costing approaches. A system that is appropriate for a pet food factory making a few flavors of dog food would not be appropriate for a confectionary plant making dozens of different candies.
Mostlé decided to evaluate its current and potential costing systems on three criteria:
Convenience: convenient to get the cost information needed
Correctness: product costs are reasonably accurate
Costs of implementation: costs of implementing and maintaining the system are reasonable
In selecting a product cost system that meets these three criteria, Mostlé needed to answer four key questions:
Which costs to include in product cost?
At what level of detail to track direct product costs?
How to organize indirect product costs?
How to allocate indirect costs to products?
Which costs to include in product costs? Using full absorption costing is appropriate for external financial reporting, but it only includes manufacturing costs: direct materials, direct labor, and some allocation of variable and fixed overhead. Other direct costs are not included. For example, a 2% tariff on every candy bar sold is as much a cost of selling a product as are the ingredients that went into it. Mostlé decided to include other relevant nonmanufacturing costs--such as R&D, sales, support, and distribution--in product costs.
At what level of detail to track direct product costs? Mostlé decided to use a hybrid of resource consumption accounting (RCA) and batch costing. RCA was used to track typical costs at the individual resource cost center level for a large number of cost centers (i.e., work areas). Batch costing was used for those unique ingredients and processing costs that differed by batch.
How to organize indirect product costs? The question of how to handle indirect costs is a key challenge for product costing. By definition, these costs cannot be easily traced to the product. Although simple plant-wide or department-based cost pools had been used extensively, analysis showed that these approaches had distorted product costs by using only one cost driver. To address this issue, Mostlé used activity-based costing (ABC) to organize indirect costs into activity pools and assign those costs on the most appropriate activity driver, including batch and product level cost drivers. In factories with many cost centers, Mostlé used RCA to track indirect costs by individual cost center and, in some instances, broke out costs into various categories (e.g., variable vs. fixed, supplies, labor, etc.). These costs are “direct” to the cost center and then charged to the product using a variable cost rate.
How to allocate indirect costs to products? Depending on the cost triggers, Mostlé used transaction-based as well as duration-based cost drivers. For example, when setting up melting pots for different products takes about the same amount of time, simple transaction drivers like number of setups made sense. On the other hand, setting up for a batch of organic chocolate bars takes longer than for nonorganic bars due to stringent cleaning requirements. In this case, setup hours is more appropriate than number of setups.
A careful examination of product costing needs resulted in a major costing system overhaul. New information led to major changes in strategic direction. For instance, CEO Ada Schmidt was surprised to discover that it cost more to make flavored frozen treats in the U.S. than in Europe. In response, Mostlé retrained U.S. factory workers to feed the machines faster, leading to a 33% drop in the cost of ice pops the following year. The company also jettisoned weaker brands, consolidated product offerings, and made other significant adjustments in strategic direction. Mostlé discovered that good product management, aided by better cost systems, can pay major dividends.
For more information, see “Product Costing Systems: Finding the Right Approach,” The Journal of Corporate Accounting & Finance,” May/June 2015.