Why Most Cost Accounting Systems Fail

Why Most Cost Accounting Systems Fail

Oftentimes, the first place to seek understanding of the financial well-being of the organization is to examine the organization’s financial statements. However, GAAP accounting, supported by General Ledger systems, is designed to capture costs at the functional/department level and although they can be structured for P&L data at a granular level (e.g., office or branch), they may not deal with indirect/overhead costs, overlap/duplication, value creation, or activity fragmentation. Therefore, GAAP accounting provides little, if any, managerial insights that can be used to identify improvement opportunities or divestiture targets. To support this strategy, more detailed managerial cost accounting systems are required. The most commonly applied cost-accounting systems include:

Conventional Absorption Cost Accounting (ACA)

Having its roots going back to over a century, conventional absorption costing remains the dominant method that is used for costing products and services. As the name implies, ACA is the method by which Overhead and Indirect (O&I) expenses are commonly “allocated” to the Lines of Business (LOB) or outputs of the organization. O&I costs are allocated to the LOBs typically using metrics associated with each LOB. Such metrics include direct labor costs, machine hours, number of employees, floor space, and more often by revenues. For example, LOBs having proportionately greater revenues often subsidize LOBs having lesser revenues but may carry greater O&I expenses – as typical of new and immature product and service offerings. O&I costs, sometimes exceeding 50% of all spending, are typically aggregated then allocated in this manner. The major drawback is thatresulting LOB costs may be grossly inaccurate as LOBs will be assigned costs unassociated with the creation, selling, and delivery of the specific product or service.

Cited in the January, 2017 McKinsey white paper “Who Should Pay for Support Functions” – “…one of the basic problems with allocation practices: they often result in business units [LOBs]paying for costs that they cannot control [costs not incurred by the LOBs]” and “…what [leaders] want most from an allocation system is actionable information.

Conventional Driver-Based Activity Based Costing (ABC)

ABC utilizes a two-stage process for costing LOBs. First, resource costs are allocated to activities, then subsequently, activitycosts are allocated to products and services which creates the potential for significant errors.

Stage 1, the first source of error. Resource costs are allocated to the activities using resource drivers. A commonly used resource driver is the distribution of total effort expressed as a percentage of time or Full-Time Equivalency (FTE) effort. As per the instructions given by a leading ABC software tool – “wages coming the GL system will be allocated to activities according to the distribution of total FTEs associated with those activities.” A critical assumption is that the distribution of costs within a department is thesame as the distribution of effort expended on the activities – this is most often not the case and as such, activity costs can become significantly distorted.
Stage 2, the second source of error. The manner in which activity costs are allocated to cost objects (e.g., LOBs, channels, customers, etc.). A single principal Activity CostDriver (ACD) is identified for each activity and an average cost per ACD is computedwhich is used to assign activity costs to objects based on the consumption of the number of drivers by each object. The three main issues associated with this approach are:

  1. The selection of a single driver that represents the cost behavior of the activitywhen, in actuality, the activity may be influenced by a multitude of drivers.
  2. ACD rates are derived from the activities to which they pertain. Activity costs (although error prone) contain fixed, variable, and semi-variable costs, yet ACD rates derived from activities are often treated as 100% variable which distort product/service costs – especially when volumes change.
  3. The use of an average ACD rate – the ACD rate may be comprised of a wide dispersion of costs for which the average rate often is not representative of any individual product or service. As a result, LOBs receiving the activity costs in this manner will be over- or under-costed and as such making it challenging to identity true low-margin targets for divestiture or improvement.

Time-Driven Activity Based Costing (TDABC)

Why Most Cost Accounting Systems Fail

TDABC is a costing method that uses the time required to complete each step in a process to produce a product or deliver a service. The cost of a product or service is determined by multiplying the total time required to complete a series of process steps by the capacity cost rate, whereas the capacity cost rate (expressed as a cost perunit of time) is determined by the total cost of capacity supplied (such costs include personnel; benefits; management; occupancy; utilities; equipment costs; and allocated indirect and overhead spending) divided by the practical capacity of resources (expressed using a unit of time) within a given time period. Similar to ACA, indirect and overhead costs are “allocated” (in many cases in an arbitrary manner) such that they represent an overhead cost to the department that is performing the prescribed process. Since managerial and O&I costs are blended into the total cost of capacity supplied, the activities associated with these O&I costs cannot be determined so the value resulting from such costs cannot be established. Since many tasks that, at best, can be identified as “knowledge work” or variable in time consumption, such activities cannot be described in terms of specific process-step time and therefore, they cannot be adequately costed and yet may represent a significant portion of total spending. To refer to TDABC as activity based costing may be a misnomer as it does not follow the tenets associated with conventional ABC and more closely resembles Industrial Engineering process-based costing and ACA.

In multi-stage costing systems, errors compound – errors in object costs resulting from inaccurate activity costswhich, in turn, result from errors in resource-to-activity allocations are magnified and as such resulting LOB costs cannot be relied upon to make informed management decisions regarding which products and services should be maintained and those targeted for divestiture.

Another weakness of contemporary costing systems is the inability to measure the value of products, services, processes, and activities that can only be derived from the inclusion of stakeholder (customer, employee, etc.)experiential information. These systems express outcomes solely in monetary terms, yet the numbers often do not tell you what to do, your customers and employees do, and the numbers only tell you how well you’ve listened! Excluding customer feedback may pose a grave error when identifying divestiture targets and/or focusing on what is believed to be higher-margin outputs.

Are the ways organizations compute product and service performance impact their ability to make informed decisions and/or selecting the most urgent and beneficial targets for improvement or divestitures? Any multi-stage cost accounting system that relies on pooled, blended, averaged, and allocated costs and that excludes customer experiential data is not suitable for addressing today’s economic and operational challenges.

Warning – divestitures may not produce desired results!

Oftentimes when divesting under-performing and/or low-margin products and services, a common but incorrect, assumption may be made that all costs associated with an LOB would be affected. However, depending on the number of shared resources (personnel and non-personnel) that also contribute to, or support, other LOBs may not be affected by the divestiture and these remaining resource costs will now have to be absorbed by the remaining LOBs which will negatively impact their margins.

The conventional managerial cost accounting systems described earlier that rely exclusively on pooled, aggregated, and allocated resources hide the identity of specific cost components making it impossible to identify which cost elements will, or will not, be affected by a divestiture. When considering a strategy of divestiture of under-performing LOBs, is the way in which costs and profitability are computed and measured hurting the organization’s ability to make such informed decisions? If so, consideration should be given to an alternative approach to identify and measure the impact of divestitures. What is needed is a managerial cost accounting system that:

  • Directly assigns every cost component (personnel and non-personnel) simultaneously to both activities and LOBs without utilizing any intermediate pooling, blending, and allocations that distort outcomes and that produces a complete bi-directional audit trail linking each cost component to both the activities performed and to the LOBs to which they contribute—identifying how each cost component is shared across all organizational products, services, and activities.
  • Measures the financial implications associated with a divestiture – measuring the financial impact, both positive and negative, on remaining products and services.
  • Identifies specific resources affected by a divestiture, supporting redeployment focused on both revenue and margin growth.
  • Supports the validation of acquisition targets that align with financial and operational objectives.
  • Incorporates experiential information gathered from customers and employees necessary to assess the value of processes, activities, and lines of business.

The Solution - A Unique Perspective of Managerial Costing – direct assignment of costs!

The following describes a new category of managerial cost accounting and performance management – Activity Value Management (AVM). AVM is a new way of thinking about cost and the ultimate use of financial and non-financial information to identify opportunities for both performance improvement as well as targeting areas for expansion and divestiture. AVM has its roots, not in accounting, but in the integration of process/activity analysis following the tenets of Value Engineering that incorporates stakeholder input withfinancial outcomes. As such, AVM extends beyond simply costing, but focuses on value creation necessary to improve performance while enhancing customer loyalty and employee engagement. The objectives of AVM with regard to divestitures are to:

  • Improve LOB costing by eliminating the types of errors found in more conventional approaches, necessary to assess the potential financial benefits (if any) of a divestiture;
  • Uncover the most opportune targets for divestiture (if any);
  • Identify specific personnel and non-personnel resources that will, and will not, be affected by the divestiture;
  • Diagnose performance in terms of costs, profitability, customer loyalty, employee commitment, processes, and activities – identifying improvement opportunities that could alleviate the need for divestiture;
  • Focus on value creation and cost optimization rather than cost reduction;
  • Improve customer loyalty while improving employee engagement and satisfaction – identify any negative customer impact that could result from a divestiture;
  • Enhance resource utilization and productivity associated with the redeployment of resources affected by the divestiture.

See Creating Resilience for more details on how to apply AVM to your business.

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