4
A TAXONOMY OF ACCOUNTING AND COSTING METHODS
Organisations possess a growing desire to understand their costs and the behaviour of what drives their costs. An organisation’s managerial accounting system design can help or hinder its organisation’s journey toward completing the full vision of enterprise performance management as I have defined it. It is understandable that people with nonfinancial backgrounds and training have difficulties understanding accounting. For many of them, accounting is outside their comfort zone.
However there is a gathering storm in the community of management accountants in which a need for so-called ‘advanced’ accounting techniques (eg, activity-based costing management, resource consumption accounting, lean accounting and time-driven activity-based costing) is confusing even the trained accountants, as well as the seasoned practitioners. The result is that managers and employees receive mixed messages about what costs are the correct costs. Upon closer inspection, various costing methods do not necessarily compete. They can co-exist and be reconciled and combined. They all do the same thing. They measure the consumption of economic resources.
CONFUSION ABOUT ACCOUNTING METHODS
The fields of law and medicine advance each decade because their body of knowledge is codified. Attorneys and physicians build upon their predecessor’s captured learning over the centuries. In a sense, the generally accepted accounting principles (GAAP) published by the USA’s Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) organisations have also codified rules and principles. Financial accounting standards support external reporting for government regulatory agencies, bankers and the investment community.
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 typically are the methods and treatments at their organisation that they inherit from prior accountants who they succeeded. Accountants work long hours, with lots of daily problems to solve, so getting around to improving (or reforming) their organisation’s management accounting practices and information to benefit their managers and employees is not a frequent occurrence. The escalation of compliance reporting, such as the USA’s Sarbanes-Oxley Act of 2002 or India’s Clause 49, is a major distraction from investing time to evaluate improvements to the organisation’s managerial accounting system.
In the field of accounting, although rules are many, principles are few. Sadly, many accountants apparently are not aware that the purpose of managerial accounting is to provide data that generates questions and influences peoples’ behaviour 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 for delivering one additional customer order? To start, that 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 for 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 something is determined (ie, calculated) based on assumptions that an organisation has latitude to make. For example, should we include or exclude a sunk cost, such as 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 amongst accountants. If we step back, we can see that an organisation can refine its managerial accounting system over time through various stages of maturity. Changes to managerial accounting methods and treatments typically are not continuous, and they occur as infrequent and sizably punctuated reforms.
To assure we are oriented, let me be clear that the topic we are discussing in this book 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 enterprise performance management. The purpose of management accounting information should be viewed as having two broad uses:
• A cost autopsy (historical, descriptive). This information uses cost accounting information for analysis of what already happened in past time periods. My reference to costs as an ‘autopsy’ is quite morbid. However, the money was spent, and cost information reports where it went. Types of analysis include actual versus budgeted spending for cost variance analysis, activity cost analysis, product profitability, benchmarking and performance measure monitoring.
• Decision support (future, predictive). This planning and control information serves as 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 behaviour and rates for its calculations. Types of analysis include price and profit margin analysis, capital expenditures, outsourcing decisions, make-or-buy, project evaluation, incremental (or marginal) expense analysis, and rationalisation of products, channels and customers.
To be clear, the relatively higher value-add for performance improvement comes from decision support compared to cost autopsy reporting. The good news is the administrative effort of costing for decision support is relatively less because the source information is typically used as needed and for infrequent decisions, such as when setting catalogue or list prices, rather than for daily operations. However, some organisations must quote prices daily for custom orders to a wide variety of customers, so it is important that their cost modelling supports profit margin analysis—whether they are on an incremental or fully-absorbed cost basis.
A HISTORICAL EVOLUTION OF MANAGERIAL ACCOUNTING
If we travel back through time and re-visit the weeks in which an organisation’s initial managerial accounting system was initially constructed, we first realise that it is a spin-off or variant of the ongoing financial accounting system already in place. The nature of the organisation’s purpose and the economic conditions it faces govern the initial financial accounting system design. So, for example, if the organisation’s output is non-recurring with relatively short product or service life cycles, 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 organisation 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 (eg, a bank loan) are recurring, consequently, the associated employee work activities will also be recurring. As a result, the initial financial accounting method may likely take on a standard costing approach (of which activity-based costing is simply a variant). In this case the repeating material requirements and time requirements for task labour are first measured. Then, the equivalent costs for both direct material and labour 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 slightly differ from these averaged costs that were calculated ‘at standard.’ So there are various methods of cost variance analysis (eg, volume variance, labour rate or price variance, etc) to report what actually happened relative to what was planned and expected.
The overarching point here is that an organisation’s initial condition—the types of products and services it makes and delivers as well as its expense structure—governs its initial managerial accounting methodology.
AN ACCOUNTING FRAMEWORK AND TAXONOMY
A need exists for an overarching framework to describe how expenses are measured as costs and to be used in decision making. An understandable framework is not difficult to construct and articulate. A framework I created for the International Federation of Accountants (www.ifac.org) is described here.
Figure 4-1 illustrates the large domain of accounting with three components: tax accounting, financial accounting and managerial accounting. The figure is similar to taxonomies that biologists use to understand plant and animal kingdoms. A taxonomy defines the components that make up of a body of knowledge. In the figure, two types of data sources are displayed at the upper right. The upper source is from financial transactions and bookkeeping, such as purchases and payroll. The lower source is non-financial measures, such as payroll hours worked, retail items sold or gallons of liquid produced.
Figure 4-1: Domain of Accounting
Source: Cokins, Gary. ‘A Costing Levels Continuum Maturity Model.’ International Federation of Accountants, 2012, www.ifac.org/publications-resources/evaluating-costing-iourney-costing-levels-continuum-maturity-model.
As earlier mentioned, the financial accounting component is intended for external reporting, such as for regulatory agencies, banks, shareholders and the investment community. This information is compulsory. Financial accounting is governed by laws and rules established by regulatory agencies. In most nations, financial accounting follows GAAP. Some people jokingly refer to this as the ‘GAAP trap’ because focusing on these numbers may distract the organisation from more relevant accounting data or prevent it from finding more appropriate ways to calculate costs and profit margins. Financial accounting’s purpose is for economic valuation. As such, it is typically not adequate or sufficient for internal decision making.
The tax accounting component in the figure has its own world of legislated rules.
Our area of concern is the management accounting component. It is used internally by managers and employee teams for insights and decision making. If you violate the financial accounting laws, you may go to jail. However you don’t risk going to jail if you have poor managerial accounting, but your organisation runs the risk of making bad decisions. This is relevant because the margin of error is getting slimmer as the pressure grows for better organisational performance.
To oversimplify a distinction between financial and managerial accounting, financial accounting is about valuation, and managerial accounting is about value creation through good decision making.
The managerial accounting component in Figure 4-1 comprises three parts that are all recipients of inputs from the ‘Cost Measurement’ procedure of transforming incurred expenses (or their obligations) into calculated costs:
• Cost accounting represents the assignment of expenses into outputs, such as the cost of goods sold and the value of inventories. This box primarily provides external reporting to comply with regulatory agencies.
• Cost reporting and analysis represents the insights, inferences and analysis of what has already taken place in the business, that is, historical information, in order to understand and monitor performance.
• Decision support with cost planning involves decision making. It represents using the historical cost reporting information and its rates in combination with other economic information, including forecasts and planned changes (eg, processes, products, services, channels) in order to test, validate and make the types of decisions that lead to a financially successful and sustained future.
It will be apparent that the key differentiator between cost accounting and the other two uses of cost measurement is that cost accounting is deeply constrained by regulatory practices and describing the past in accordance with rules of financial accounting. The other two categories offer diagnostic support to interpret and draw inferences from what has already taken place and for what can happen in the future. Cost reporting and analysis is about explanation. Decision support with cost planning is about possibilities and probabilities.
Asking What? So What? Then What?
An important message at the bottom of Figure 4-1 is that the value, utility and usefulness of the information increases, arguably at an exponential rate, moving from the left side to the right side of the diagram.
In Figure 4-1 the cost accounting data establishes a foundation; it is of low value for decision making. The cost reporting for analysis information converts cost measurement data into a context. It is useful for managers and employee teams to clearly observe outcomes with transparency that may have never been seen before or is dramatically different from their existing beliefs derived from their firm’s less mature cost measurement method. Cost reporting displays the reality of what has happened and provides answers to the ‘What?’ question. That is, for example, what did things cost last period?
However, an obvious follow-up question should be ‘So what?’ That is, based on any questionable or bothersome observations, is there merit to making changes and interventions? How relevant to improving performance is the outcome we are seeing? This leads to the more critical and relatively higher value-added need to propose actions—to make and take decisions—surfaced from cost planning . This is the ‘Then what?’ question. For example, what change can be made or action taken (such as a distributor altering its truck and rail distribution routes), and what is the ultimate impact? Of course, changes will lead to multiple effects on service levels, quality and delivery times, but the economic effect on profits and costs should also be considered. This gets to the heart of the widening gap between accountants and decision makers that use accounting data. To close the gap, accountants must change their mindset from managerial accounting to managerial economics, sometimes referred to as decision-based costing.
There is a catch. When the ‘Cost Reporting and Analysis’ component shifts right toward the ‘Decision Support With Cost Planning’ box in Figure 4-1, then analysis shifts to the realm of decision support via economic analysis. For example, one needs to understand the impact that changes will have on future expenses. Therefore, the focus now shifts to resources and their capacities, which require expenses. This involves classifying the behaviour of resource expenses as sunk, fixed, semi-fixed or variable with changes in service offerings, volumes, mix, processes and the like. This can be tricky. A key concept for these classifications is that the ‘adjustability of capacity’ of any individual resource expense depends on both the planning time horizon and the ease or difficulty of adjusting the individual resource’s capacity (ie, its stickability). This wanders into the messy area of marginal expense analysis that textbooks oversimplify but is complicated to accurately calculate in the real world.
Predictive Versus Descriptive Accounting
Figure 4-2 illustrates how a firm’s view of its profit and expense structure changes as analysis shifts from the historical cost reporting view to a predictive cost planning view. The latter is the context from which decisions are considered and evaluated.
Figure 4-2: Descriptive Versus Predictive Accounting
Source: Copyright Gary Cokins. Used with permission.
On the left-hand side of the figure, during the historical time period, the expenses were incurred. The capacity these expenses were incurred for were supplied, and then they were either (1) unused as idle or protective capacity, or (2) used to make products, deliver customer services or to internally sustain the organisation. This is the cost reporting and analysis component from Figure 4-1 that calculates output costs. The money was spent, and costing answers where it was used. This is the descriptive view of costs. Accountants refer to this as full absorption costing, when all the expenses for a past time period are totally traced to outputs. It traces expenses (and hopefully does not allocate expenses on causal insensitive broad averages) to measure which outputs (eg, products) uniquely consumed the resources. Full absorption costing uses direct costing methods, which are relatively easy to apply, and ideally supplements the reporting with activity-based costing techniques for the indirect and shared expenses, which are trickier to model, calculate and report.
In contrast, Figure 4-2’s right-hand side is the predictive view of costs—the decision support with cost planning component from Figure 4-1. In the future, the capacity levels and types of resources can be adjusted. Capacity only exists as a resource, not as a process or work activity. The classification of an expense as sunk, fixed, semi-fixed or variable depends on the planning time horizon. The diagonal line reveals that in the very short term, most expenses are not easily changed; hence, they are classified as fixed. As the time horizon extends into the future, capacity becomes adjustable. For example, assets can be leased, not purchased. Future workers can be contracted from a temporary employment agency, not hired as full-time employees. Therefore, these expenses are classified as variable.
In the predictive view of Figure 4-2, changes in demand, such as the forecasted volume and mix of products and services ordered from customers, will drive the consumption of processes (and the work activities that belong to them). In turn, this will determine what level of both fixed and variable resource expenses are needed to supply capacity for future use. For purchased assets, such as retail store display shelves or expensive equipment, these costs are classified as sunk costs. Their full capacity and associated expense were acquired when an executive authorised and signed his or her name to the purchase order for the vendor or contractor. Some idle capacity (such as staffing a customer call centre) is typically planned for. This deliberately planned idle capacity is intended to meet temporary demand surges or as an insurance buffer for the uncertainty of the demand forecast accuracy. Its cost is justified by offsetting potential lost revenues from unacceptable, low service levels to customers.
Because decisions only affect the future, the predictive view is the basis for analysis and evaluation. The predictive view applies techniques such as what-if analysis and simulations. These projections are based on forecasts and consumption rates. However, consumption rates are ideally derived as calibrated rates from the historical, descriptive view, when the rate of operational work typically remains constant until productivity and process improvements affect them. These rates are for both direct expenses and rates that can be calibrated from an activity-based costing model for the indirect and shared expenses. When improvements or process changes occur, the calibrated historical consumption rates can be adjusted up or down from the valid baseline measure that is already being experienced. Accountants refer to these projections as marginal expense analysis. For example, as future incremental demands change from the existing, near-term baseline operations, how is the supply for needed capacity affected?
This topic of marginal expense analysis will be later covered in Part 4 on planning, budgeting and forecasting.
CO-EXISTING COST ACCOUNTING METHODS
Confusion can arise because some costing methods calculate and report different costs that are not just variations in cost accuracy but are also different reported costs altogether. This raises the question, ‘Should there be two or more different, co-existing cost reporting methods that report dissimilar numbers?’ For example, one tactical costing method is used for operations (eg, lean accounting) and making short-term decisions. Another strategic costing method (for planning, marketing, pricing and sales analysts to evaluate profit margins) is used for longer-term decisions.
There will be debates, but, eventually, some form of consensus will triumph within an organisation. The underlying arguments may be due to the inappropriate usage of standard costing information—and potential inappropriate decisions and actions that may result. However there may be a deeper problem. Cost accounting system data is not the same thing as cost information that should be used for decision making. As described in Figure 4-2, the majority of value from cost information for decision making is not in historical reports—the descriptive view. Its primary value comes from planning the future (such as product and customer rationalisation), marginal expense analysis for one-off decisions or trade-off analysis between two or more alternatives.
The good news is that organisations are challenging traditional managerial accounting practices. So in the end, any accounting treatments that yield better decision making should prevail. The co-existence of two or more costing approaches may cause confusion over which one reports the correct cost. But that is a different problem. What matters is that organisations are seeking better ways to apply managerial accounting techniques to make better decisions.