ABC at CM Tech
Chapter 21
Confusion with Managerial Accounting
An organization’s managerial accounting system design can help or hinder its journey toward completing the full vision of performance management as I have been defining it. It is understandable that people without financial background and training have difficulty understanding accounting—for many, accounting is outside their comfort zone. But there is a gathering storm in the community of management accountants where the need for advanced accounting techniques (e.g., activity-based costing [ABC], resource consumption accounting, lean accounting, time-driven activity-based accounting) is confusing even the trained accountants and the seasoned practitioners. What is the problem?
The fields of law and medicine advance each decade because their body of knowledge is codified. Attorneys and physicians stand on the shoulders of their predecessors’ captured learning. In a sense, the generally accepted accounting principles (GAAP) published by the Financial Accounting Standards Board and the International Financial Reporting Standards (IFRS) organization have also codified rules and principles (though with lots of loopholes). Accounting standards support external reporting for government regulatory agencies and bankers. Unfortunately, unlike financial accounting, with its codification, managerial accounting has no such framework or set of universal standards. Accountants are left to their own devices, which are typically the methods and treatments at their organization that they inherit from their predecessors. Accountants burn the midnight oil with lots of daily problems to solve, so getting around to improving (or reforming) their organization’s management accounting information to benefit their managers and employees is not a frequent routine. The escalation of global compliance reporting, such as with Sarbanes-Oxley, is a major distraction from investing time to evaluate improvements to the organization’s managerial accounting system.
But in managerial accounting, although rules are many, principles are few. Sadly, many accountants were apparently absent from school the day the teacher defined the purpose of managerial accounting as to provide data that influences people’s behavior and supports good planning, control, and decision making. Of course, how to apply cost information for decision support can lead to heated debates. For example, what is the incremental cost of taking and delivering one additional customer order? For starters, the answer depends on several assumptions; but if the debaters agree on them, then the robustness of the costing system and the resulting accuracy requirement to make the correct decision to answer that question might justify an advanced costing methodology.
Another accounting principle is “precision is a myth”—there is no such thing as a correct cost because the cost of a thing is determined (i.e., calculated) based on assumptions that an organization has latitude to make. For example, should we include or exclude a sunk cost like equipment depreciation in a product’s cost? The answer depends on the type of decision being made. It is this latitude that is causing increasing confusion among accountants. If we step back for a better view, we can see that an organization can refine its managerial accounting system over time through various stages of maturity. Changes to managerial accounting methods and treatments are typically not continuous, but occur as infrequent and sizably punctuated reforms.
Let me be clear that the topic we are discussing is managerial accounting. Under the big umbrella of accounting there is also bookkeeping, financial accounting for external reporting, and tax accounting. Those are peripheral to performance management. Management accounting information should be viewed as having two broad purposes:
1. Cost autopsy (historical, descriptive). This information uses cost accounting information for analysis of what already happened in past time periods. Types of analysis include actual versus budgeted spending for cost variance analysis, activity cost analysis, benchmarking, and performance measure monitoring.
2. Decision support (future, predictive). This planning and control information serves for economic analysis to support decisions to drive improvement. It involves numerous assumptions such as what-if volume and mix based on projections, and draws on prior economic cost behavior for its calculations. Types of analysis include price and profit margin analysis, capital expenditures, outsourcing and make-or-buy decisions, project evaluation, incremental (or marginal) cost analysis, and rationalization of products, channels, and customers.
To be clear, the relatively higher value-add for performance improvement comes from decision support as compared to cost autopsy reporting. The good news is that the administrative effort for decision support is relatively less because the source information is typically used as needed and for infrequent decisions, such as when setting catalog or list prices, rather than for daily operations. However, some organizations must daily quote prices for custom orders to a wide variety of customers, so it is important their cost modeling supports profit margins—whether they are on an incremental or fully absorbed cost basis.
HISTORICAL EVOLUTION OF MANAGERIAL ACCOUNTING
If we travel back through time and revisit the weeks in which an organization’s managerial accounting system was initially architected, we first realize that it is a spinoff or variant of the ongoing financial accounting system already in place. The nature of the organization’s purpose and economic conditions it faces governed the initial financial accounting system design. So, for example, if the organization’s output is nonrecurring with a relatively short life cycle, like constructing a building or executing a consulting engagement, then project accounting is the more appropriate method—a very high form of direct costing. Similarly, if the organization is a manufacturer of unique one-time engineer-to-order products, then they will likely begin with a job-order cost accounting scheme.
In contrast, if the products made or standard service lines delivered (e.g., a bank loan) are continuously recurring, as consequently will be the associated employee work activities, then the initial financial accounting method would likely take on a standard costing approach (of which ABC is simply a variant), where the repeating material requirements and labor time/effort of work tasks is first measured and then the equivalent costs for both direct material and labor are assumed as a constant average and applied in total based on the quantity and volume of output—products made or services delivered. Of course, the actual expenses paid each accounting period to third parties and employees will always differ slightly from these averaged costs that were calculated “at standard,” so there are various methods of cost variance analysis (e.g., volume variance, labor rate or price variance, etc.) to report what actually happened relative to what was planned and expected.
The overarching point here is that an organization’s initial condition—the types of products and services it makes and delivers as well as its expense structure—governs its initial costing methodology.
SHARED AND INDIRECT EXPENSES
An organization that was founded with recurring products and work, typically with longer product life cycles, cannot last long as a one-trick pony. Inevitably, proliferation of different types of products (e.g., more colors, sizes, and ranges) occurs, or standard service lines evolve, in order for it to remain a viable organization. Innovation is key to any organization’s survival. Increases in the diversity and variation (i.e., heterogeneity) of outputs quickly result in complexity, which in turn causes the need to add support people and system resources to manage the increasing complexity. Gradually, these support-related expenses are no longer insignificant or immaterial. Exhibit 21.1 illustrates how over the decades, indirect expenses have been displacing direct expenses for this reason.
As a result of this accelerating relative growth of indirect to direct costs, organizational managers begin requesting visibility of these costs, too, not only as part of the organization’s monthly expenses (i.e., inputs) but also as they are associated with each product or standard service line—the calculated costs of outputs.
This need by managers to view output costs consumed, not just input expenses incurred and money spent, ultimately leads an organization to experience one of those punctuated reform changes along the accounting system’s stages of maturity—full absorption costing with overhead cost allocations of the indirect and shared expenses.
Exhibit 21.1 Need for Tracing, Not Allocating, Costs
Source: © Gary Cokins. Used with permission.
This stage of maturity is where concepts such as support department-to-support department stepdown overhead expense allocation evolved, and in the 1980s, its more granular allocation method—ABC. Many organizations now realize that their predecessor accountants’ past method of choice was a single convenient cost allocation factor that simplistically relies on broad-based averages (such as number of output units produced or labor input hours) as the factor or basis for the overhead cost allocation to products or service lines. Hence, using that method, the true cost of each product or standard service line does not reflect the true consumption of the portion of the indirect resources that each product or service is uniquely consuming.
What are the consequences of misallocating costs? First, we must acknowledge that the descriptive view of expenses incurred (i.e., money spent in a historical past period) is a permanent irreversible event; any error in allocating that spending into calculated costs is a zero-sum-error game. As a result, some products will be over-cost and, therefore, all of the other products must be under-cost. Hence, the cost data being used by managers and employee teams for decisions or profit margin-validated pricing is somewhat (in many cases, grotesquely) flawed and misleading. ABC resolves this problem with its rational cause-and-effect cost tracing logic. It complies with accounting’s causality principle. Exhibit 21.2 illustrates the basic concept of ABC transforming a department’s expenses as captured in the general ledger accounting system into its calculated costs of work activities (that belong to business processes) and ultimately into its products, service lines, channels, and customers.
Exhibit 21.3 illustrates an organization’s enterprise-wide expense structure flowing into the ultimate final costs of its end customers and its organizational sustaining cost (i.e., those expenses transformed into work activity costs that are not caused by or traceable to products or customers).
Exhibit 21.2 Each Activity Has Its Activity Cost Driver
Source: © Gary Cokins. Used with permission.
Exhibit 21.3 Activity-Based Cost/Management Cost Assignment Network
Source: © Gary Cokins. Used with permission.
Equipped with a costing methodology that correctly models the consumption of resources based on accounting’s causality principle, one can depend on its information to be valid for reliable analysis, control, planning, and decision support.
TIME-DRIVEN ACTIVITY-BASED COSTING
Before describing what one learns from better managerial accounting information, I want to briefly discuss time-driven activity-based costing (TDABC) because it has recently received attention as yet another advanced managerial accounting technique. When the condition exists that a substantial amount of resource expenses are in a highly repeatable process, such as for a credit card processing facility, the ABC model may replace the activity driver quantities with an average (i.e., standard) time required for each activity event. This method is referred to as time -driven activity-based costing.1 As in what an atom is to an element, like carbon, in chemistry, time is the ultimate decomposed measurement for any activity driver. For example, an activity driver might be the number of automobile driver licenses processed daily for license bureau staff, say 200 per day. But 15 minutes per each processing event would be the time duration. A new license registration might take 25 minutes. A different number of atoms combine to make up the fundamental elements in chemistry. In costing, a different number of minutes are consumed for a single activity driver quantity of one.
One difference between TDABC and ABC as earlier described is that TDABC is capacity-sensitive and computes a standard activity cost using standard rates. That is, activity driver rates remain constant. In contrast, ABC is capacity-insensitive (but can be capacity-aware if known unused capacity in the resource is isolated and assigned to a business-sustaining final cost object). ABC computes the activity cost each period as “actual,” and therefore the final cost object’s unit cost fluctuates each period. TDABC requires an up-front investment to measure event times and to continuously maintain them. ABC simply requires activity quantities typically imported from operational systems.
Some argue that the magnitude of any organization’s unused capacity rarely becomes substantial because of management by sight—managers can detect when employees have run out of work or have slowed down. Hence, quantifying unused capacity as a cost may not be a burning platform concern. If the extra incremental administrative effort to collect and maintain the detailed time data for TDABC does not exceed the incrementally more useful information (e.g., measuring unused capacity cost), then TDABC may not be justified. Applying activity driver quantities may be adequate.
WHAT DO PROPERLY TRACED COSTS REVEAL?
With valid cost modeling, Exhibit 21.4 displays a graph line at the top—referred to as the “profit cliff” of the true cumulative buildup of each product’s profit, rank ordered from the most profitable to the least (often products at a financial loss where their costs exceed their revenues). The graph illustrates how unrealized profits can be hidden due to inadequate costing methods. The accountants are not properly assigning the expenditures based on the causality principle of accounting. The graph is of each product’s cost, net of sales, to reveal each product’s and service line’s profit.
The products are rank sorted left to right from the largest to the smallest profit margin rate. The very last data point equals the firm’s total net profit, as reported in its profit and loss statement. For this organization, total revenues were $20 million, with total expenses of $18 million, to net a $2 million profit, but the graph reveals the distribution of the mix of that $2 million net profit. Although not empirically tested, experiences with these measures show that the total amount of the profits, excluding any losses, usually exceeds 200% of the resulting reported net profit; greater than 1000% has even been measured.
The last data point in Exhibit 21.4 exactly equals the total reported profit, but that single point gives no visibility to the parts. Think of the last data point as being on a vertical metal track; it can slide only up or down. Looking at the graph this way reveals that products and service lines to the left of the peak, where an item’s sales exactly offset its costs, are also fair game for increasing profits. Many people focus only on the losers to the right.
Exhibit 21.4 Cumulative Profit Distribution by Product Source: © Gary Cokins. Used with permission.
Exhibit 21.5 Each Product’s Activity Costs Pile Up
Source: © Gary Cokins. Used with permission.
ABC information is typically shocking to executives and managers since their prior belief from their traditional broadly averaged costing method is the flat graph line at the bottom with the small decline where each product’s cost was distorted. This graph line has its accuracy removed by the broad-brush averaging of traditional cost allocations rather than tracing and assigning each activity cost using its proportionate activity cost driver.
Exhibit 21.5 clarifies the “profit cliff” exhibit. This exhibit provides visibility of each product’s stack of consumed activity costs, which were not only hidden as a single lump-sum cost, but also distorted from the broadly averaged cost allocation method just described. It reveals the information that constitutes a single data point on the right down-sloping side of the graph. The exhibit illustrates that each product’s, service line’s, or customer’s final cost object’s activity costs have piled up in a stack.
Each product is in effect looking up and asking each work activity how much of that activity cost it consumed in the past period, and it stacks these costs like pancakes, where the thickness of the pancake reflects the quantity of the activity driver multiplied by the unit activity cost driver rate. This not only provides visibility into the indirect costs that were previously hidden and rendered inaccurate by the single broad-brushed average, but it also focuses workers on the driver of the cost. If the organization could reduce the quantity or frequency of the driver (or eliminate it altogether), then the height of the stacked cost will go down. To reduce costs, one must attack what causes them. The term cost management is an oxymoron. You do not really manage your costs, but rather you manage what causes your costs to occur. The assignment of activity costs to their cost objects comes from the ABM cost assignment network, where each activity driver and rate apportions the proper amount of activity costs consumed.
ACCOUNTING FOR LEAN MANAGEMENT: AN ALTERNATIVE OR COEXISTING COSTING METHOD?
Lean management can be described as a systematic approach to identifying and eliminating waste, including non-value-adding activities, through continuous improvement by flowing product or services at the pull of a customer, in pursuit of perfection. Lean management techniques increasingly are merging with Six Sigma quality initiatives to accelerate throughput via end-to-end processes. Productivity increases as throughput accelerates without adding resources or incurring errors.
Nonmonetary process data is foundational to continuous improvement projects. Employees are trained to use tools such as process flowcharts, checksheets, fishbone charts, Pareto diagrams, process control charts, histograms, and scattergrams. In addition, they measure movement of products or transactions, such as flow times and distances, as well as unplanned events such as product rework and errors.
A popular method to visualize and measure processes is value stream mapping. It removes the barriers of functional or departmental silos to aid improvement teams with better communications and decision making. Value stream maps support a lean management guideline to reveal visibility of the processes before moving forward with lean actions for improvement.
Exhibit 21.6 Processes: Six Sigma, Lean Management, and Value Stream Mapping
Source: © Gary Cokins. Used with permission.
Exhibit 21.6 illustrates what activity costs look like as cost stacks in a value stream map. Each stack’s height reflects the amount of resource expenses consumed, such as wages, supplies, or energy. Each cost stack can also be scored and tagged in monetary terms with attributes. Attributes are like the color of money; they do not change the amount of a cost but add insights into aspects or characteristics of what comprises the cost. Examples of attributes are the degrees of economic value-adding along the continuum or of cost-of-quality categories: (1) error free; (2) costs of conformance (prevention or appraisal activities); and (3) costs of nonconformance (internal failure or external failure related activities).
Each value stream may have multiple measures, such as for safety, quality, time, delivery, and cost. The last metric, cost, has spawned a method referred to as lean accounting or, more appropriately, management accounting for a lean operations environment. The management accounting community is currently wrestling with controversy, conflicts, and ambiguities caused by competing forms of accounting for lean management environments.
After providing a basic explanation of accounting for lean and its differences from commonly accepted costing principles, we can go on to discuss the issues and controversies.
For the purpose of more accurately measuring output costs, such as for products and services, plus to provide visibility and transparency into indirect or shared costs hidden by traditional broadly averaging standard costing methods, ABC has been adopted by many organizations. With the value stream mapping technique, work activities that are traced and reassigned to final cost objects with the ABC methodology are, in contrast, sequenced in time as a process flowchart. Think of this as pivoting on the activities in the ABC cost-assignment model and time-sequencing the activities in a different direction—not tracing and reassigning the costs, but rather accumulating them.
Accounting for lean is based in part on the idea that time is money. For example, a night’s stay at a hotel might cost 11¢ per minute. Attending a music concert might be 63¢ per hour. An hour meeting with ten employees might be $6.50 per minute. Any value stream’s cost-per-minute rate can be calculated as a ratio of its annual expenses (e.g., wages, supplies, depreciation, etc.) divided by the total minutes that resources worked, excluding holidays and a percent factor for coffee breaks, illness, and so on.
The other idea on which accounting for lean is based is to quantify non-value-added costs. For any value stream, first the calculated time of work to make error-free products or deliver error-free services based on that product’s or service’s average unit processing time (e.g., a bank teller’s 4.26 minutes per customer), multiplied by the volume of units processed, is calculated. This cost is then subtracted from the total value stream expenses, and the difference can be classified as the non-value-added (NVA) costs. It is a total NVA cost amount with little visibility as to what it is made up of, and it assumes that no very diverse items were processed. That is, with accounting for lean, there would be no visibility of the cost stacks in Exhibit 21.6—only a single lump sum of the value stream expense and lump sum of the NVA. But at least it can calculate a financial figure that the traditional accounting spending or income statement cannot report.
My observation is that accounting for lean developed as a result of frustrations that managers and employee teams in operations had with traditional cost accounting’s inability to evaluate lean projects for their cost savings potential or to measure improvements after they are completed. Additional frustrations from operations personnel involved questioning whether their daily efforts to collect transactional data were worth it, given that many operations people have found little use for actual-to-standard cost variance reporting. This frustration is understandable in light of what is now generally understood about deficiencies in traditional standard costing.
There is usefulness to line operations employees and managers in more clearly viewing and understanding the costs of their processes plus the elimination of some transactional paperwork no longer deemed useful, such as standard cost variance reporting. Accounting for lean attempts to solve some of operations’ immediate financial measurement problems since as employees make improvements such as to eliminate NVA costs, reduce resources, and increase the rate of throughput in processes, they can measure productivity improvements that ultimately show up on the bottom line.
However, the previously mentioned conflict surfaces if the cost of outputs (not the resource expenses) of a value stream are calculated. This is because distortions from broad averages or the exclusion of applicable indirect expenses will be reported differently from the ABC tracing method. This conflict arises because ABC complies with a universal accounting principle—the principle of causality. The causality principle states that a cost should proportionately reflect the consumption of its inputs. In contrast, accounting for lean follows a flow principle as the guiding principle behind monetary management information.2
Accounting for lean’s violation of the accounting principle of causality raises this question: Is accounting for lean a viable replacement for, complement to, and/ or supplement for current and evolving management accounting approaches such as ABC? Does it have the capability to advance the main purposes of management accounting of decision support (i.e., discovery, ideas, and validation) and enterprise resource optimization?
Another way of asking this question is: Should there be two different coexisting costs for the same product—one cost for operations that is tactical and short term in nature and another cost for marketing and sales to analyze profit margins that is strategic in nature? Or should a single universal managerial accounting method prevail that complies with or knowingly violates accounting’s causality principle? There will be debates, but eventually some form of consensus will prevail.
My opinion is that the criticisms that lean management advocates have of standard costing, though valid, are misplaced. Their real argument is with the inappropriate ways that many companies use information generated by the standard costing systems and the inappropriate actions that result. Cost accounting system information and cost information that should be used for decision making are not the same thing.
Key tests for accounting for lean will be: How does it handle economic projections? Does it classify resource expenses as variable, semivariable, fixed, or unavoidable versus avoidable (allows for adjustability of capacity)? Does it isolate unused/idle capacity expenses?
The good news is that organizations are questioning and challenging archaic forms of accounting, so in the end any accounting treatments that yield better decision making should prevail. The concern will be where two or more costing approaches coexist, one that complies with the causality principle and one that violates it.
COSTING STAGES OF MATURITY
An organization’s executive management and employee teams need detailed output, product, channel, and customer cost information to make specific decisions regarding product pricing, mix, service levels, or dedication of resources. Exhibit 21.7 illustrates the progressive stages of maturity ranging from the primitive broad-average allocation method to the multistage cost assignment technique of activity-based management (ABM).
Exhibit 21.7 Stages of Maturity of Cost Accounting Methods