(FORTUNE Magazine) – A LARGE, highly regarded consumer goods manufacturer offers more than a dozen versions of one of its leading products. The numbers cranked out by the company's accounting system suggest that each version costs about the same to produce. Because the products are priced similarly, they apparently earn equivalent profit margins. But the company's top manufacturing executive knows otherwise. His gut tells him that some low-volume products are money losers. Says he: ''We've been hiding the real picture from ourselves.'' Another big diversified company used to be in the business of rebuilding locomotives. The managers of the division that included the locomotive operation thought they were making money until a consulting firm figured out that costs had been seriously underestimated. The company bailed out of the business, and not a moment too soon. Says Dale Marco, the consultant who advised the company: ''The more contracts it won, the more money it lost.'' These two companies and hundreds of others suffer from the same insidious problem: The methods they use to allocate costs among their many products are hopelessly obsolete. As a result, companies are pricing some products too high and others too low. They are making some products they ought not to be selling at all and are buying others, often from overseas suppliers, that they could more profitably make themselves. ''Many U.S. companies don't know where they are making money and where they are losing,'' says Robert S. Kaplan, a Harvard accounting professor who is one of the harshest critics of prevailing cost systems. The blurred numbers also lead companies to misallocate capital, and stymie efforts by plant managers to improve efficiency. How could the crew in the green eyeshades have allowed the numbers to run amok? And what about the shop floor supervisors and corporate executives managing the business? Are their goggles opaque too? ''People have simply not been paying attention to cost accounting,'' answers Bob Kaplan. ''It's a boring subject. A manager would rather devise new products and new sales strategies. He hasn't wanted to hear that his cost system was broken.'' Even when the message has been delivered, few managers consider it a high priority. While conceding the weaknesses in his cost system, James Lewis, who heads a division of Continental Can, asks: ''Does it hinder our ability to compete? Probably not, because we're no dumber than our competition.'' That is a dangerous attitude given the threat from foreign manufacturers. Before the 1970s, U.S. companies so dominated their markets that they were destined to do well in spite of faulty cost-accounting systems. In those days, says Kaplan, ''the premium for having an excellent cost system, or the penalty for having a poor one, was not very high.'' Just when the competition was getting tougher, the deficiencies in cost systems increased. Over the past two decades most corporations have thoroughly revamped their manufacturing processes, notably by replacing people with machines. Yet the typical accounting system still focuses on labor costs, so the magnitude of the errors in cost estimates has gotten worse. Companies also are pouring huge sums into research and development, and they offer customers not just model A of a product, but variations B through Z. Each of these changes has fundamentally altered the costs of manufacturing, says Steve Hronec, who heads Arthur Andersen & Co.'s manufacturing consulting practice. ''But cost-accounting systems have not changed. They are literally 60 or 70 years behind the times.'' Managers have long operated under the delusion that their procedures for determining product costs were reasonably sound. The typical system, however, was designed not as a tool to measure the costs associated with individual products, but as a means of valuing the inventory reported on a company's balance sheet. Outside auditors needed a reliable way to determine how much inventory was on hand at the end of a period. As long as the company's total inventory was valued correctly, auditors rarely lost sleep over the possibility that the pile of semiconductor chips over in the corner might have been overvalued, while the stack of typewriters was undervalued. In valuing inventories, accountants include three types of costs: materials, overhead, and the labor that goes directly into making products. Allocating materials and labor costs to specific products is fairly straightforward. But accountants have big trouble dealing with overhead, a black hole that swallows up everything from the equipment used to fashion a product to the security guard who watches over the plant at night. How much of the purchasing agent's salary is attributable to the semiconductor chip, how much to the typewriter, how much to the hundred other products made in the same plant? What about the grease that keeps the machines humming, or the computers that make sure paychecks come out on time? Boiled down to its simplest form, the question becomes: Which products cause which costs? WHILE COMPANIES use many different schemes to allocate overhead, the most common goes something like this. First, managers spread common costs like purchasing, maintenance, and rent among a plant's major production departments. The departments include such areas as fabrication, assembly, and packaging. Many companies perform this step reasonably well. Purchasing costs, for example, might be allocated according to the number of purchase orders filled on behalf of each department. Next, the costs in each department are assigned to the individual products that pass through it. That is where most accounting systems break down. In this step, the allocation of costs usually is based on just one factor, commonly the proportion of the production department's direct labor hours that go into making each product. Allocating overhead on the basis of direct labor hours was passable when plants made just a handful of products and labor was the biggest expense. But today some plants turn out thousands of products that require vastly different production processes. As companies have replaced people with machinery, overhead -- which includes depreciation of the equipment -- has soared. At many companies it now accounts for half of total production costs. Direct labor, which frequently accounted for 40% of production costs 25 years ago, often represents no more than 5% today. Consider what goes on every day at a Continental Can factory in West Chicago. The plant produces thousands of parts for canmaking machines, including the small, doughnut-shaped components that help attach lids to beer cans. Some versions of these so-called seaming rolls are high-volume parts the company has been making for 20 years. The operators who run the drill presses and lathes have the older models down to a science. It shows. The most popular seaming rolls generate little scrap and rarely need any reworking after they are completed. In contrast, before a brand-new model can be made, designers must encode specifications onto computer tapes that control the sophisticated (and expensive-to-maintain) machine tools used to fabricate the part. AS IT HAPPENS, all seaming rolls require the same amount of labor and have roughly the same material costs. You know which ones ought to have the higher cost (the new models), and so does Jim Lewis, whose division turns them out. But the plant's cost system, which allocates overhead on the basis of direct labor hours, says that the costs of making the older, high-volume models and the newer, low-volume ones are the same. Says Lewis: ''We have to find a way to better identify our costs.'' This perverse way of assigning costs can make high-volume products look much more expensive than they really are. In one case, Rockwell International realized that its line of heavy-duty truck axles was selling erratically. One of its best-selling axles had begun losing market share. To find out why, the division managers conducted a special study. They found that the practice of essentially allocating overhead in proportion to direct labor costs had created serious distortions. Jack Schubert, corporate cost-accounting director for Rockwell, says the division had been ''overcosting'' its highest-volume axle by roughly 20%, while underestimating the cost of other axles by as much as 40%. Because the company had priced its products in relation to their estimated costs, it had been overpricing the high-volume product. That lured competitors into the market. ''Competitors don't want your cats and dogs,'' says Schubert, who is redesigning Rockwell's cost systems. ''They want the volume business.'' The imaginary profits -- and losses -- that arise from flawed cost systems can lead to very expensive blunders. Consultant Robert A. Howell says he knows of many companies that have given up high-volume -- but apparently low-margin -- products to foreign competitors, leaving themselves with low-volume products whose true costs are actually much higher than thought. Says Howell, who teaches accounting at New York University: ''We may be giving away the best business to foreign companies.'' SUCH MISTAKES are compounded by a cruel irony: Once the high-volume products disappear, those that remain must carry a greater share of overhead and thus become even less profitable. Says Robert McIlhattan, a partner in Ernst & Whinney's Chicago office: ''I've had clients that have dropped whole product lines. Then the products they kept couldn't support the remaining costs, so they dropped them too.'' Misallocation of overhead is only one of the flaws in cost accounting. Even in this era of just-in-time inventories, many companies ignore the cost of carrying inventories when evaluating the profitability of individual products. If a product routinely accounts for the lion's share of total inventories, it ought to be charged with both the costs of financing the inventory and the costs of such things as extra storage space and record keeping. Robert Howell recalls a food-processing company that churned out so much inventory it had to lease container cars on a rail siding just to hold the stuff. The seemingly profitable product was a loser if the costs associated with the excess inventory were charged against it. Many systems focus almost exclusively on the costs incurred within the walls of the plant, ignoring up-front outlays for research and development and postproduction expenses for distribution and marketing. According to Harvard professor Robin Cooper, these nonproduction expenses can easily make up 25% of the cost of some products and less than 10% for others. Managers may know intuitively that one product is really cheaper and another more expensive than the reports tell them. ''They know the direction of the bias,'' says Harvard's Kaplan. ''But I don't think their intuition gives them any notion of what the magnitude can be. The distortions can be very large -- 50%, 100%, even 200%.'' Costs also can vary considerably from customer to customer. Some buyers create headaches for the producer by insisting that they be served first or by paying late. Others are more costly to serve simply because they are so far from the plant. Like many companies, Campbell Soup has always charged all customers the same prices, although it costs far more to ship soup to Alaska than to grocery stores in Philadelphia, a short hop from the company's original kitchen. But how much more? Campbell doesn't know, and some of its executives are pushing for accounting changes that would provide the answer. Companies that do not understand their costs are apt to misallocate capital. Managers say they don't rely solely on the figures produced by their regular cost system when making large investments. But most companies do use the routine numbers to make the first cut of investment opportunities that merit more study. Says Lee Steele, a cost-accounting expert at Touche Ross: ''Suppose you think you're making an 8% margin on a product. Even though you could probably gain market share if you added capacity, you probably won't invest in that area because of the low margin. But what if your margin is really 15%?'' Steele is now working with a large electronics company whose fuzzy cost system, he believes, has obscured countless investment opportunities. Managers also use this flawed cost-tracking apparatus as a tool to manage the day-to-day operations on the shop floor. Yet the most readily available cost information often is expressed in too little detail. Suppose a product engineer introduces a big change in the way a product is made. As Mark Coran, vice president of finance for Pratt & Whitney, puts it: ''Analytically, you know your costs should change. But if they are spread around among many products according to a formula, you can't see the impact of what you did. So you can't tell whether you accomplished anything or not.'' IN THE FACE OF so many maddening problems, a small but growing number of companies are retooling their cost-accounting systems. Some 30 manufacturers, including Rockwell, Eastman Kodak, and General Electric, are part of an organization called Computer Aided Manufacturing International, which has been at work for two years developing a conceptual framework to update cost management systems. Because each company is different, there is no single cookbook solution to the problem. But some general principles make sense for all companies. First, don't scrap the existing cost system. Since it probably does a good job determining inventory costs, let it continue to perform that role. Second, the new cost management system doesn't need to be precise to the penny. Mike Gearhardt, an assistant controller at Day International, an industrial plastics company, says he knows accountants who boast of calculating the cost of $10 products down to the fourth decimal place. What they really ought to worry about is whether the product costs $10 or $6. Finally, think of costs in terms of the products and customers that cause them. Three years ago IBM set up what it calls a corporate cost competency center, a group that encourages operating divisions to charge overhead costs directly to specific products rather than spreading them around like peanut butter. At many IBM facilities, the company's ''cost competency'' has benefited from new plant layouts in which equipment is arranged in discrete units dedicated to making a group of similar products. At its Lexington, Kentucky, plant, for example, typewriters and computer keyboards move not from one common functional department (fabrication, say) to another (assembly), but flow through their own tightly arranged production lines. These production lines should be as self-contained as practical. At some IBM plants, the workers on the lines are even responsible for doing their own maintenance, quality control, and other jobs that were formerly handled by central departments serving the whole plant. While the new layouts were motivated by the company's desire to speed the production cycle and reduce work-in-process inventory, the arrangement gives accountants a clearer picture of which costs are associated with which products. Robert Kelder, IBM's cost competency program manager, says that in the past a typical plant had to allocate about 75% of its overhead according to an arbitrary formula, leading to significant distortions in the estimated costs of some products. In the plants that have made the change to direct charging, only 25% of overhead has to be allocated; the rest is clearly identified with specific products. Caterpillar, whose immense plants are laid out more traditionally, takes a different approach. Rather than homogenizing the costs generated by its many fabrication departments, it regards each major piece of production machinery as an individual cost center. Each machine is like a small bucket that contains its share of overhead costs. At Caterpillar's heavy-equipment plant in Decatur, Illinois, the company breaks down costs into more than 1,300 overhead buckets. A machine that takes up a lot of floor space is allocated a larger proportion of rent than a smaller machine. If the smaller machine is harder to maintain or uses a lot of electricity, it gets proportionately more of those costs. In most cases, Caterpillar assigns these buckets of overhead costs to specific products according to how much time each one spends passing through each machine. Says Lou Jones, controller at the Decatur plant: ''We have the ability to look at our costs all the way from the total product cost down to an individual part within that product, and then down to an individual operation within that part.'' Zenith is another stickler for matching production costs with products. The last surviving U.S.-owned producer of television sets also pays close attention to nonproduction expenses and includes them in its calculations of % product costs. For instance, the company is more rigorous than most in breaking down its sales and marketing outlays on a product-by-product basis, so that it has an unusually close fix on its true profit margins. MOST LARGE COMPANIES seem to recognize that their cost systems are not responsive to today's competitive environment. ''We have their awareness and we've overcome denial,'' says Kaplan. But few companies have seized the opportunity that awaits those that modernize their accounting practices. Quite simply, accurate cost information can give a company a competitive advantage. Steve Hronec of Arthur Andersen says one of his clients is overhauling its cost system for precisely that reason. ''Their goal is to blow away the competition,'' says Hronec. ''They don't have any foreign competitors in the U.S., and they plan to keep it that way.''