An organization's managerial accounting system design can help or hinder the journey toward completing the full vision of performance management as we have been defining it in this monthly column. Understandably, people with nonfinancial backgrounds and training have difficulties understanding accounting; for many of them, accounting is outside their comfort zone. But a gathering storm in the community of management accountants clamoring for so-called advanced accounting techniques (e.g., activity-based costing, resource consumption accounting, lean accounting) is confusing even the trained accountants and 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 predecessor's captured learning. In a sense, financial accounting's generally accepted accounting principles (GAAP), although varying from country to country, also have codified rules and principles (though with lots of loopholes) to 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 inherited from the accountants they succeeded at their organizations. Accountants burn the midnight oil with lots of daily problems to solve, so they infrequently get around to improving or even reforming their organization's management accounting information to benefit their managers and employees. The escalation of global compliance reporting, such as with Sarbanes-Oxley, majorly distracts from investing time in evaluating improvements to the organization's managerial accounting system.
In managerial accounting, although rules are many, principles are few. Sadly, many accountants were apparently absent from school the day they were supposed to learn that the purpose of managerial accounting is to provide data that influences peoples' behavior and supports good 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 taking and delivering one additional customer order? For starters, 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 anything is calculated based on assumptions that an organization has latitude to make. For example, should we include or exclude a sunk cost such as equipment depreciation in a product's cost? This latitude 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 not continuous; they occur as infrequent and sizably punctuated reforms.
If we travel back through time and revisit the weeks in which an organization's initial managerial accounting system was first architected, we 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 the economic conditions it faces govern the initial financial accounting system design. For example, if the organization's output is nonrecurring with a relatively short life cycle, such as 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, engineered-to-order products, then they will likely begin with a job-order cost accounting scheme.
In contrast, if the product made or standard service line delivered (e.g., a bank loan) continuously recurs (as, consequently, will associated employee work activities), then the initial financial accounting method may take on a standard-costing approach (of which activity-based costing is simply a variant) where the repeating material requirements and labor-time effort of work tasks is first measured. Then the equivalent costs for both direct material and labor are assumed as constant and applied in total based on the quantity and volume of output - products made or services delivered. The actual expenses paid each accounting period to third parties and employees will always slightly differ from these 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.
Enter a New Character to the Story: Shared and Indirect Expenses
For organizations that were founded with recurring products and work, typically with longer product life cycles, none of them can last long-term as a one-trick pony. Inevitably, the proliferation of different types of products (e.g. colors, sizes, ranges) or standard service lines evolves in order for an organization to remain viable. Innovation is key to any organization's survival. Increases in the diversity and variation (i.e., heterogeneity) of outputs quickly results in complexity, which in turn requires additional support people and system resources to manage the increasing complexity. Gradually these support-related expenses are no longer insignificant or immaterial, and the organizational managers begin requesting visibility of these costs, too, not only as part of the organization's monthly expenses, but also as they are associated with each product or standard service line - the calculated costs.
This need of managers to view output costs consumed, not just input expenses incurred and 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 so-called overhead cost allocations.
This stage is where concepts like support department to support department step-down overhead expense allocation evolved, and in the 1980s its more granular allocation method: activity-based costing. And some readers know the story from here. Many organizations now realize that their predecessor accountants' method of choice was a single convenient cost allocation factor that simplistically relied 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, then, 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, and any error to allocate that spending into calculated costs is a zero-sum error game. As a result, some products will be overcosted and therefore all of the other products must be undercosted. Hence, the cost data being used by managers and employee teams for decisions or profit margin-validated pricing is somewhat (and in many cases grotesquely) flawed and misleading. Activity-based costing resolves this problem with its rational cause-and-effect, cost-tracing logic.
Increasingly, more organizations are coming to this realization of flawed reporting, but they are intimidated by the perceived tall heights that they would need to scale to return to the levels of cost accuracy once enjoyed when output diversity was narrow and overhead expenses were small. Inevitably they come to grips with their predicament. Should they reform their managerial accounting method using activity-based costing principles? Or should they take no action and remain with the status quo, hoping that the lack of transparency of indirect costs, their drivers, and the degree of misleading information will not too adversely result in bad decision making? To change or not to change - both are choices where either option could be inappropriate.
When one considers managerial accounting as having a "stages of maturity" framework, progressing to the next, higher stage does not necessarily equate to being better off. Each progressive advance, which is typically a disruptive and punctuated reform change to an organization's existing managerial accounting method, should be evaluated as being worth the change. Is the climb worth the view? That is, the test for advancing is if the incremental benefits in the form of better and more accurate information exceeds the incrementally higher investment and administrative effort to collect, calculate and deploy the information.
Sound managerial accounting practices and relevant performance measurements are the foundations for achieving the full vision of performance management. Accountants must assess how well they enable their organization's decision making. But organizations effectively pursuing performance management will have to apply some level of activity-based costing.