A Three Part Managerial Cost Accounting Lecture
For many accountants there is confusion and a lack of consensus with how to allocate costs to products and service lines. I refer to this as “a mystery in a box to accountants”. To solve this mystery here are three lectures to accounting professionals and students from a skilled and experienced accountant – me – that explains the problem and how to solve it. Even if you believe you have already ‘graduated’ from a “Cost Accounting” course in college or have a CPA, I encourage you to sit in the back of our virtual lecture hall and audit these three lectures.
Management Accounting 101
Welcome, accounting fanatics, to Management Accounting 101. No need to take your seats. All you need to know is this:
Do not allocate indirect expenses to products and service lines using cost allocation factors like spreading butter across bread.
Examples of cost allocation factors include the amount of sales, number of units produced, number of employees, number of labor hours, or square feet or meters. None of those comply with costing’s causality principle. The causality principle requires valid costing methods be based on cause-and-effect relationships.
The appropriate cost accounting method is to trace and assign indirect expenses into calculated costs using driver quantities so that they are similar to direct costs. By definition the drivers you choose must have a cause-and-effect relationship with the indirect costs being calculated. Line managers and executives will also appreciate this method because it makes indirect cost calculations more visible and substantially more accurate. This will enable you and your colleagues to gain insights and make better decisions. Class 101 dismissed.
Management Accounting 102
Welcome back, accounting zealots. Join us for Management Accounting 102. This brief lecture is intended to inspire you. It ends with a pop quiz.
Let’s reflect on the giants of the scientific revolution from past centuries.
- Copernicus shocked the world by placing the Sun rather than the Earth at the center of the universe.
- Galileo Galilei was the father of the scientific method and applied the telescope to test theories.
- Johannes Kepler then described planetary motion with our planets, including the Earth, orbiting around the Sun. His work helped …
- … Isaac Newton develop his theory about gravity that every particle attracts every other particle in the universe with a force that is directly proportional to the multiplicative product of their masses and inversely proportional to the square of the distance between their centers.
- Albert Einstein then refined Newton’s work with his general theory of relativity describing gravity as a geometric property of space and time - spacetime.
All of these advances replaced misconceptions with reality. Wisdom is knowledge tempered with judgement.
Pop Quiz – Have you replaced distorting and misleading cost allocation factors with reality based on cost accounting’s causality principle? If you aren’t sure, see the example list of cost allocation factors in 101 above.
Since this is rarely a straightforward answer, I encourage you to attend my next and final class lecture.
Management Accounting 103
Welcome back, accounting enthusiasts. You are entering Management Accounting 103. This is my final lecture. It will explain how to resolve the “cost allocation” problem I described in my 101 class. One solution to this problem can be found in activity-based costing (ABC). It has the power to move managerial accounting from the 1960s into the 21st century.
I refer to ABC with this: “Break the GAAP rules to find the jewels”.
Before I explain this quote, here is some background. There has been a slow adoption by accountants to apply ABC as a replacement for the flawed and misleading traditional “cost allocation” methods for indirect expenses (commonly referred to as “overhead”) from standard cost accounting systems. As I mentioned in my 101 lecture, allocating indirect expenses using non-causal, broadly averaged cost allocation factors is like spreading butter across bread. None of those traditional cost allocation factors reflect the true consumption of expenses that unique and diverse products and service lines consume of the end-to-end processes and the work activities that belong to the processes.
After ABC decomposes the single and typically large indirect cost pool into multiple cost pools – the work activities – and traces and assigns them based on a cause-and-effect relationship there is no surprise to those managers who have always been suspicious. What is discovered, compared to the traditional costing, is that some of the products and service lines are being over-costed and the others must be under-costed because cost allocations have zero-sum error. It is true that traditional costing does exactly reconcile the indirect expenses in total into the product and service line costs. That satisfies the auditors for most external, financial, regulatory and statutory reporting, but the costs are wrong in the parts. This means that CFOs and accountants are providing their managers and executives flawed and misleading costs, which indicates the profit margins are also wrong.
The benefits from applying ABC in comparison to traditional cost allocation methods that violate “costing’s causality principle” are numerous. They include:
(1) extremely more accurate profit and cost reporting of outputs, products, services, channels and customers;
(2) transparency and visibility of the “drivers” for work activities and their magnitude; and
(3) past period calibrated unit-level cost consumption rates that are essential to multiply against future forecasted demand volume and mix that determine resource capacity requirements – workforce headcounts and spending amounts. These rates are needed for what-if scenario analysis, make-versus-buy decisions, and capacity-sensitive driver-based rolling financial forecasts and budgets.
Causality is at the heart of ABC. For example, if the quantity of an activity driver increases 20% then its activity cost should also increase 20%. If this correlation is not present, then the activity driver is not a correct one. The work activities are what consume the resource capacity – the expenses. Any CFO, financial controller, or FP&A analyst who are using traditional “butter spreading” cost allocation methods and are not using ABC where it is applicable (which is for most organizations) are being irresponsible in their duty to provide valid information to managers and employees. The information they are providing is faulty, distorted and deceiving. Line managers deserve better from their CFO to support their decisions.
Are CFOs and accountants being irresponsible or, worse yet, unethical when they misallocate costs? Statutory and regulatory compliance for external financial reports is defined as requiring adherence to the letter of the law. CFOs do that. But ethics is about practicing honesty and treating people fairly. With this definition, a case can be made that CFOs who fail to use progressive management accounting techniques, including ABC, are being unethical.
Solidify your learning from my lectures writing down your response to these Questions.
- What drivers do we use in our cost allocation systems?
- Do these drivers have a cause and effect impact on the consumption of resources they are being applied to?
- If the answer to 2 above is “No.” or “I don’t know.”, then it’s time to take a deep dive with your team to develop a causality-based costing system.
Thank you for participating my three Managerial Cost Accounting Lectures. I wish you success in your quest to grow your team from “bean counters” to “bean growers”; providing insight and better decision-making tools by replacing arcane cost allocation methods with modern ones.
Class is dismissed.
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