A few weeks ago, I was discussing a paradox with Doug Hicks, president of D.T. Hicks & Co., a performance-improvement consulting firm in Farmington Hills, Michigan. The paradox, which continues to puzzle me, is how chief financial officers (CFOs) and controllers can be aware that their managerial accounting data is flawed and misleading, yet not take action to do anything about it.
Now, I'm not referring to the financial accounting data used for external reporting; that information passes strict audits. I'm referring to the managerial accounting used internally for analysis and decisions. For this data, there is no governmental regulatory agency enforcing rules, so the CFO can apply any accounting practice he or she likes. For example, the CFO may choose to allocate substantial indirect expenses for product and standard service-line costs based on broadly averaged allocation factors, such as number of employees or sales dollars. The vast differences among products mean each product is unique in its consumption of expenses throughout various business processes and departments, with no relation to the arbitrary cost factor chosen by the CFO. By not tracing those indirect costs to outputs based on true cause and effect relationships - called drivers - some product costs become undervalued and others overvalued. It is a zero-sum error situation.
The Perils of Poor Navigation Equipment
I speculated to Doug that I think some CFOs and controllers are simply lazy. They do not want to do any extra work. Doug explained this counterintuitive phenomenon using a fable:
Imagine that several centuries ago there was a navigator who served on a wooden sailing ship that regularly sailed through dangerous waters. It was the navigator's job to make sure the captain always knew where the ship had been, where it was and how to safely and efficiently move the ship from one point to another. In the performance of his duties, the navigator relied on a set of sophisticated instruments. Without the effective functioning of these instruments, it would be impossible for him to chart the safest and most efficient course for the ship to follow.
One day the navigator realized that one of his most important instruments was calibrated incorrectly. As a result, he provided the captain inaccurate navigational information to use in making the decisions necessary to safely and efficiently direct the ship. No one but the navigator knew of this calibration problem, and the navigator decided not to inform the captain. He was afraid that the captain would blame him for not detecting the problem sooner and then require him to find a way to report the measurements more accurately. That would require a lot of work.
As a result, the navigator always made sure he slept near a lifeboat so that if the erroneous navigational information led to a disaster, he wouldn't go down with the ship. Eventually, the ship hit a reef that the captain believed to be miles away. The ship was lost, the cargo was lost and many sailors lost their lives. The navigator, always in close proximity to the lifeboats, survived the sinking and later became the navigator on another ship.
The Perils of Poor Managerial Accounting
Doug continued on with his story: Centuries later, there was a management accountant who worked for a company in which a great deal of money was invested. It was the job of this management accountant to provide information on how the company had performed, its current financial position and the likely consequences of decisions being considered by the company's president and managers. In the performance of his duties, the management accountant relied on a managerial cost accounting system that was believed to represent the economics of the company. Without the effective functioning of the costing practices reported from this system, it would be impossible for the accountant to provide the president with the accurate and relevant cost information he needed to make economically sound decisions.
One day the management accountant realized that the calculations and practices on which the cost system was based were incorrect. It did not reflect the economic realities of the company. The input data was correct, but the reported information was flawed. As a result, the current and forward-looking information he provided to support the president's decision-making was incorrect. No one but the management accountant knew this problem existed. He decided not to inform the president. He was afraid that the president would blame him for not detecting the problem sooner and then require him to go through the agonizing effort of developing and implementing a new, more accurate and relevant cost system. That would require a lot of work.
Meanwhile, the management accountant always made sure he kept his network with other professionals intact in case he had to find another position. Not surprisingly, the president's poorly informed pricing, investment and other decisions led the company into bankruptcy. The company went out of business, the owners lost their investment, creditors incurred financial losses, and many hard-working employees lost their jobs. However, the management accountant easily found a job at another company.
The Accountant as a Bad Navigator
What is the moral of the story? The 2003 Survey of Best Accounting Practices, conducted by Ernst & Young and the Institute of Management Accountants, showed that 98 percent of the top financial executives surveyed believed that the cost information they supplied management to support their decisions was inaccurate.1 It further revealed that 80 percent of those financial executives did not plan on doing anything about it.
The widely accepted solution is to apply activity-based cost (ABC) principles - not just to product and standard service-line costs but to various types of distribution channels and types of customers. The goal is to apply direct costs to whatever consumes resources. For resources that are shared, these costs are to be traced using measurable drivers that reflect the consumption rate - not arbitrary cost allocations.
When one com pares the properly calculated costs and profit margins using ABC principles to costing methods that violate the key accounting principle of cause and effect, the differences are surprisingly huge: The company makes and loses money in opposite areas from what the numbers show. This creates false beliefs throughout the organization.
Why do so many accountants behave so irresponsibly? The list of answers is long. Some believe the error is not that big. Some think that extra administrative effort required to collect and calculate the new information will not offset the benefits of better decision-making. Some think costs don't matter because the focus should be on sales growth. Whatever reasons are cited, accountants' resistance to change is based less on ignorance and more on misconceptions about accurate costing.
Doug Hicks verbalized this observation to me: "Today commercial ABC software and their associated analytics have dramatically reduced their efforts to report good managerial accounting information, and the benefits are widely heralded." Furthermore, the preferred ABC implementation method is rapid prototyping with iteratively scaled modeling, which has destroyed myths about ABC being too complicated. By leveraging only a few key employees and lots of estimates, usable ABC results as repeatable reporting system are produced in weeks, not years. A survey by www.bettermanagement.com reported the number one challenge in implementing ABC is designing and building the model, which is what the rapid prototyping method solves through doing - make your mistakes early and often.
Reasonably accurate cost and profit information is one of the pillars of performance management's portfolio of integrated methodologies. Accountants unwilling to adopt logical costing methods, and managers who tolerate the perpetuation of flawed reporting, should change their ways. Stay on the ship or get off the ship before real damage is done.
Doug Hicks can be reached at firstname.lastname@example.org.
1. The Institute of Management Accountants is at www.imanet.org.
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