5

MANAGERIAL ACCOUNTING DESIGN COMPLYING WITH THE CAUSALITY PRINCIPLE

Up to this point in the book, concepts and principles have been covered, including references to activity-based cost management (ABC/M) principles. In this chapter, the design of a managerial accounting system is discussed. Because ABC/M principles are essential, this chapter begins with it as a topic.

REMOVING THE BLINDFOLD WITH ABC/M

Imagine that you and three friends go to a restaurant. You order a small salad, and they each order an expensive prime rib and a glass of wine. When the waiter brings the bill, your three friends say, ‘Let’s split the bill evenly.’ How would you feel?

This is how many products and service lines also feel when the accountants take a large amount of indirect and support overhead expenses and allocate them as costs without any logic. There is minimal or no causal link that reflects a true relative consumption of the expenses by the individual products, service lines or end-users. This is unfair. ABC/M more fairly ‘splits the bill’ based on what was individually ordered. Many ABC/M practitioners wish the word allocation never existed. It implies inequity to managers and employees based on past abuses in their organisation’s accounting practices. The word allocation effectively means ‘misallocation’ because that is usually the result. ABC/M practitioners will often say that they do not allocate expenses. Instead they trace and assign them to costs based on cause and effect relationships.

ABC/M can do much more than simply trace expenses and costs. It provides a tremendous amount of visibility and transparency of costs for people to draw insights from and also use for predicting and validating the possible outcomes of decisions. Many operations people cynically believe that accountants count what is easily counted, but not what counts. Outdated, traditional accounting—broadly averaged cost allocations—blocks managers and employees from seeing the more relevant costs.

As a caution, it is a mistake for ABC/M project teams to refer to ABC/M as an improvement, project, programme or change initiative. ABC/M merely creates information. The ABC/M information is simply used as a means to an end. If ABC/M is described as an improvement programme, it might be regarded by managers and employees as a fad, fashion or ‘project of the month.’ ABC/M information makes visible the economics of the organisation and its consumption of resource expenses. Money is continuously being spent on organisational resources regardless of whether ABC/M measuring is present.

ABC/M is not just about supporting other initiatives but about driving some of those initiatives. An organisation is continuously using up its resources through its work activities and into its outputs regardless of whether ABC/M is monitoring these events. ABC/M is simply like a mirror, displaying expenses transformed into costs. When one realises that ABC/M is fundamentally good information to be used for understanding, discovery and decision making, then it is better positioned for longer-term use and wider acceptance. ABC/M’s information can be a great enabler for providing answers. The key word here is enabler. One controller I met referred to ABC/M as the ultimate question generator. He observed that, equipped with the ABC/M information, employees and managers frequently had reactions like, ‘What would explain or account for that?’

OVERHEAD EXPENSES ARE DISPLACING DIRECT EXPENSES

So why has ABC/M become popular? A primary reason has been a significant shift in most organisations’ expense structures. What do I mean by a shift? The direct labourers in organisations are the employees who perform the frontline, repeating work that is closest to the products and customers. However, numerous other employees behind the frontline also do recurring support work on a daily or weekly basis. The support work done by these employees is highly repeatable at some level. Figure 5-1 is a chart that includes this type of indirect expense plus the other two major expense components of any organisation’s cost structure, its purchased materials and its direct expenses.

Figure 5-1: Overhead Expenses Are Displacing Direct Expenses

Source: Copyright Gary Cokins. Used with permission.

Most organisations are experienced at monitoring and measuring the work of the labourers who do recurring work (direct expenses). For these expenses, cost rates and standard costs are reported. The bottom layer of the figure contains cost information that also reveals performance-related costs other than the period’s spending, such as labour cost variance reporting. It is in this area of the figure, for example, that manufacturers use labour routings and process sheets to measure efficiency. These costs are well known by the name standard costs. Service organisations also measure this type of output-related information. For example, many banks know their standard cost for each type of deposit, each type of wire transfer and so forth.

Problems occur in the indirect expense area appearing at the top portion of Figure 5-1. The figure reveals that over the last few decades, the support overhead¹ expenses have been displacing the recurring direct costs. The organisation already has substantial visibility of its recurring costs, but it does not have much insight for understanding its overhead or what is causing the level of spending of its overhead. ABC/M helps provide visibility for insights and learning.

In a bank, for example, managers and employee teams do not get the same strong financial information about the vice presidents and other higher-ups as they do about bank clerks performing the recurring work. The only financial information available to analyse the expenses of the vice presidents and other support overhead is the annual financial budget data. These levels of expenses are annually negotiated. The focus is on spending levels, not on the various cost rates to perform work. The expense spending is monitored after the budget is published. Spending is only monitored for each department or function for each period to see if the managers’ spending performance is under or over their budget or plan.

ABC/M merely extends to the indirect and shared expenses the same type of understanding and visibility of spending that is already applied to the recurring direct workers. It is not complicated. Basically ABC/M becomes an organisation-wide method of understanding work activity costs as well as the standard costs of outputs.

IMPACT OF DIVERSITY IN PRODUCTS, SERVICE LINES, CHANNELS AND CUSTOMERS

When you ask people why they believe indirect and overhead expenses are displacing direct expenses, most answer that it is because of technology, equipment, automation or computers. In other words, organisations are automating what previously were manual jobs. However this is only a secondary factor for explaining the shift in organisational expense components.

The primary cause for the shift is the gradual proliferation in types of products and service lines. Over the last few decades organisations have been increasingly offering a greater variety of products and services, as well as using more types of distribution and sales channels. For example, with products more colours, sizes and ranges have been offered. In addition, organisations have been servicing more and different types of customers. Introducing greater variation and diversity (ie, heterogeneity) into an organisation creates complexity, and this increasing complexity results in more indirect expenses to manage it. So the fact that the overhead component of expense is displacing the recurring direct labour expense does not automatically mean that an organisation is becoming inefficient or bureaucratic. It simply means that the company is offering more variety to different types of customers.

In summary, the shift of indirect expenses displacing direct labour reveals the cost of complexity, which is mainly customer-driven. ABC/M does not fix or simplify complexity. The complexity is a result of other things. However what ABC/M does do is point out where the complexity is and where it comes from.

How long can organisations go on making decisions with the misinformation reported by their accounting systems? In the 1980s many organisations, reacting to the pressures from high-quality Japanese products, confessed that they had a ‘quality crisis.’ In the 21st century, organisations may realise that they have a ‘management accounting crisis.’

GROWING DISCONTENT WITH TRADITIONAL CALCULATION OF COSTS

Why do managers shake their heads in disbelief when they think about their company’s cost accounting system? I once heard an operations manager complain, ‘You know what we think of our cost accounting system? It is a bunch of fictitious lies—but we all agree to them.’ It is a sad thing to see the users of the accounting data resign themselves to lack of hope. Unfortunately, some accountants are comfortable when the numbers all foot and tie and could care less if the parts making up the total are incorrect. The total is all that matters to them, and any arbitrary cost allocation can tie out to the total. It is just math.

The sad truth is that when employees and managers are provided with reports that have flawed and misleading accounting data in them, they have little choice but to use that information regardless of its validity or their scepticism of its integrity. Mind you, they are using the data to draw conclusions and make decisions, which is risky.

How can traditional accounting, which has been around for so many years, suddenly be considered so bad? The answer is that the existing data are not necessarily bad as it is quite distorted, incomplete and unprocessed. Figure 5-2 shows the first hint of the problem. The left side shows the classic monthly responsibility-centre expense statement report that managers receive. Note that the example used is the back office of an insurance company. It is quite like a factory, which demonstrates that, despite misconceptions, indirect white collar workers produce outputs no differently than do factory workers.

If you ask managers who routinely receive this report questions such as, ‘How much of these expenses can you control or influence? How much insight do you get into the content of work of your employees?’ they will likely answer both questions with, ‘Not much!’ This is because the salary and fringe benefit expenses usually make up the most sizeable portion of controllable expenses, and all that the manager sees are those expenses reported as lump-sum amounts. In short, they see what was spent but not what caused varying levels of spending or to what (ie, products) or whom (ie, customers) it is traced.

Figure 5-2: The Language of ABC/M

Source: Copyright Gary Cokins. Used with permission.

When you translate those ‘Chart of Account’ expenses into the work activities that consume the financial general ledger’s expenses, a manager’s insights from viewing the activity costs begin to increase. The right side of Figure 5-2 is the ABC/M view of the left side that is used for analysis and as the starting point for calculating the costs for both processes (and the work activities that belong to them) and their diverse outputs. In effect, the ABC/M view resolves the deficiencies of traditional financial accounting by focusing on work activities. ABC/M is work-centric, whereas the general ledger is transaction-centric. To be clear, the left side general ledger cost centre report is not bad, but the format of the data is structurally deficient to trace and assign those expenses into process and output costs. ABC/M reformats that data.

Here is a critical concept. Expenses are not the same thing as costs. What are the differences? Expenses are defined as an organisation exchanging money with third parties, such as paying suppliers or paying its employees’ salaries. (Expenses may also be near-cash balance sheet liabilities that reflect the obligation to pay cash in the near future.) In short, currency exits the treasury. In contrast, costs are always calculated costs. Costs reflect the use of the spending of the expenses. That is, from the expenses, all costs follow. Costs are calculated representations of how those expenses flow through work activities and into the outputs of work, that is, products, services, channels and customers.

ACTIVITIES ARE EXPRESSED WITH ACTION VERBS

A key difference between ABC/M and the general ledger and traditional techniques of cost allocation (ie, absorption costing) is that ABC/M describes activities using an ‘action verb-adjective-noun’ grammar convention, such as ‘inspect defective products,’ ‘open new customer accounts,’ or ‘process customer claims.’ This gives ABC/M its flexibility. Such wording is powerful because managers and employee teams can better relate to these phrases, and the wording implies that the work activities can be favourably affected, changed, improved or eliminated. The general ledger uses a chart of accounts, whereas ABC/M uses a chart of activities. In translating general ledger data to work activities and processes, ABC/M preserves the total reported turnovers and costs but allows the turnovers, budgeted funding and costs to be viewed differently—and better.

Notice how inadequate the data in the ‘Chart of Accounts’ view in the figure are for reporting business process costs that run cross-functionally, penetrating the vertical and artificial, silo-like boundaries of the organisation chart. The general ledger is organised around separate departments or cost centres. This presents a reporting problem. For example, with a manufacturer, what is the true total cost of processing engineering change notices (ECNs) that travel through so many hands in different departments? For a service organisation, what is the true cost of opening a new customer account?

Many organisations have been flattened and de-layered to the extent that employees from different departments or cost centres frequently perform similar activities and multi-task in two or more core business processes. Only by re-assembling and aligning the work activity costs across the business processes, such as ‘process ECNs’ or ‘open new customer accounts,’ can the end-to-end process costs be seen, measured and eventually managed. As a result of the general ledger’s structure of cost centre mapping to the hierarchical organisation chart, its information drives vertical behaviour, it does not process behaviour, which is much more functional and desirable.

Managing with a process view has created a growing need for better managerial and costing data. Managing processes and managing activities (ie, costs) go together. By defining a business process as comprising two or more logically related work activities intended to serve end customers, the need for integrating processes, outputs and measured costs becomes even more apparent as an important requirement for managers and teams. There are two ways to organise and analyse ABC/M work activity cost data: (1) the horizontal process view sequences and additively builds-up costs, whereas (2) the vertical cost assignment view transforms resource expenses into output costs by continuously re-assigning costs based on causal-based tracing (ie, cost allocations). I will further describe both views in a few pages. The primary focus in this book is this latter vertical view, popularly called absorption accounting. Activity-based costing is more associated with this latter view.

By using traditional cost systems, managers are usually denied visibility of many of the costs that belong to the end-to-end business processes. This is particularly apparent in the stocking, distribution, marketing and selling costs that traditional accounting ‘expenses to the month’s period.’ With traditional cost allocations, these sales, general, and administrative expenses are not proportionately traced to the costs of the unique products, containers, services, channels or customers that cause those costs to occur.

I am often asked to explain Figure 5-2 in the simplest terms. I humorously reply, ‘The right side is good because the left side is bad!’ Now I did not say the general ledger is a bad thing. In fact, it is just the opposite. The general ledger is a wonderful instrument for what it was designed to do—accumulate spending transactions into their accounts. Repeating my earlier point, the data in that format is structurally deficient for decision support other than the most primitive form of control, budget variances. Translating it into calculated costs corrects this deficiency.

DRIVERS TRIGGER THE WORKLOAD COSTS

Much more information can be gleaned from the right side view of Figure 5-2. Look at the second activity, ‘Analyse claims’ for $121,000, and ask what would make that activity cost significantly increase or decrease? The answer is the number of claims analysed, that is, that work’s activity driver. Figure 5-2 shows that each activity, on a stand-alone basis, has its own activity driver. At this stage, the costing is no longer recognising the organisational chart and its artificial boundaries. The focus is now on the work that the organisation performs and what affects the level of that workload.

Additionally, let’s assume there were 1,000 claims analysed during that period for the department shown in Figure 5-2. The unit cost per each analysed claim is $100 per claim. If a specific group of old-age pensioners over the age of 65 were responsible for half of those claims, we would know more about a specific customer or beneficiary of that work. The old-age pensioners would have caused $60,500 of that work (ie, 500 claims multiplied by $121 per claim). If married couples with small children required another fraction, married couples with grown children a different fraction, and so forth, ABC/M would trace all of the $121,000. If each of the other work activities were similarly traced using the unique activity driver for each activity, ABC/M would pile up the entire $914,500 into each group of beneficiary. This re-assignment of the resource expenses would be much more accurate than any general cost allocation applied in traditional costing procedures and their broad averages. ABC/M complies with cost accounting’s causality principle—a cause and effect relationship. Arbitrary cost allocations do not.

This cost assignment network is one of the major reasons that ABC/M calculates more accurate costs of outputs. As earlier mentioned, the terms tracing or assigning are preferable to the term cost allocation because many people associate the allocation with a re-distribution of costs that have little to no correlation between source and destinations. Hence, to some organisations, overhead cost allocations are rejected by users as arbitrary and are cynically viewed.

When managers receive the left side responsibility expense centre report in Figure 5-2, they are either happy or sad, but rarely any smarter. In summary, the general ledger view describes what was spent, whereas the activity-based view describes what it was spent for and what caused the cost. The ledger records the expenses, and the activity view calculates the costs of work activities, processes and all outputs, such as products. Intermediate output costs, such as the unit cost to process a transaction, are also calculated in the activity view. When employees have reliable and relevant information, managers can manage less and lead more.

The assignment of the resource expenses demonstrates that all costs actually originate with the customer or beneficiary of the work, not with the general ledger. This is the opposite of what accountants who perform cost allocations think about costs. Cost allocations are structured as a one source-to-many destinations redistribution of cost. However the destinations actually are the origin for the expenses. In Figure 5-2, the destinations, usually outputs or people, place demands on work, and the work activities draw on the resources and capacity. Then, in the opposite direction, the costs measure the effect by reflecting backward through an ABC/M cost assignment network. Costing is modelling, not bookkeeping.

This may sound ironic, but cost management can be considered an oxymoron (like controlled chaos). You do not really manage costs and financial results. That is like pushing a rope. You understand the causes (and drivers) of costs. Then you manage the causes. Cost management is accomplished by driver management. So, in effect, an organisation does not manage its costs. It manages what causes those costs to occur (ie, its cost drivers) and the effectiveness and efficiency of the organisations’ people and equipment to respond to those causal triggers.

Today’s competitive world will be dominated by learning organisations, not ones that are limited by spending restrictions, such as from a budget. The right side of Figure 5-2 re-states those same expenses in a much more useful format and structure for decision support. Cost accounting is outside many individuals’ comfort zones. ABC/M makes cost information understandable and logical. However when you have the wrong information coupled with the wrong measurements, it is not difficult to make wrong decisions.

STRATEGIC VERSUS OPERATIONAL ABC/M

A common misconception is that organisations use only a single, enterprise-wide ABC/M system. There can actually be multiple ABC/M systems constructed for a single organisation. There are two broad users and decision makers of ABC/M data: strategic versus operational. In fact, two types of ABC/M model designs serve each type of user, but they both follow the same cost assignment mechanics based on the causality principle. The difference between them is the scope of expenses included plus the inclusion or exclusion of pricing or turnover data for calculating profit margins.

Strategic ABC/M, also referred to here as enterprise-wide ABC/M, is about first doing the right things, that is, selling profitable products and services to customers that are also profitable. Strategic ABC/M is about enhancing turnovers and assuring higher profits based on the product’s or service’s value to draw good prices and the considering varying levels of demanding behaviour of different types of customers.

Operational ABC/M, also referred to here as local ABC/M, is not enterprise-wide but, rather, addresses individual functions, departments or business processes. Its intent is not about analysing profit contribution margins but, rather, focuses on improving process, more efficiently managing activity costs, taking out waste and optimising asset utilisation.

In short, the difference in ABC/M model design is as follows:

• Strategic ABC/M includes all of the enterprise expenses and then subtracts the traceable costs (to products, channels and customers) from sold line items (ie, pricing and turnovers) to compute the profit contribution margins.

• Operational ABC/M confines the expenses included to those mainly involved in the function, department or process. It focuses on analysing the work to remove waste, manage unused capacity, improve productivity and improve asset utilisation.

One of the values of commercial ABC/M software is that it can consolidate multiple operational ABC/M models into the parent, enterprise-wide strategic ABC/M model.

Endnotes

1 Organisations often refer to this support-related work as overhead. Overhead is also referred to as indirect and shared expenses. The term overhead can be misleading and often has a negative connotation. In many cases, overhead is a crucial and is a very positive thing to have. I will use indirect and overhead interchangeably or together to refer to this type of expense and cost. Regardless of which term is used, the objective of calculating costs is to properly trace them, not arbitrarily allocate them, to what is causing them—and in the proper proportions.