Henry Paulson, the U.S. Treasury Secretary, is proud of U.S. laws that enforce openness. In an article he authored in the Financial Times1 Paulson said, "Accurate and transparent financial reporting is vital to the integrity of our capital markets and the strength of the U.S."

That's great for the investment community, but what about the haggard managers and employee teams inside organizations who are stuck with flawed, misleading and incomplete internal reporting?

Most managers and employee teams mistrust their managerial accounting system and find their operational, nonfinancial reporting to be imbalanced. If only they could enjoy what regulatory agencies and investors receive - information that is presumed to be accurate and to reflect economic reality. But they don't.

A Quixotic Journey Leading to Mistrust

Paulson continued by saying, "Capital markets rely on trust. Our capital markets are the best in the world and so is our financial reporting system ... that provides reliable information supported by a sustainable auditing industry." But just ask a manager whose monthly cost center or profit and loss statement is getting unfairly overcharged by the accountant's so-called cost allocation system.

Due to somewhat broadly averaged cost allocations based on wide-ranging factors like number of employees or units of output produced, most managers recognize those types of cost allocations do not equitably reflect how much of the resources from other departments or workers his or her processes and outputs uniquely consume. Those cost allocations are likely subsidizing other departments. For example, a manager with minimal employee turnover relative to another with substantial recruiting needs is arguably overcharged if the human resources department expenses are allocated on the number of department employees.

When managers hear the term "cost allocation," they laugh to themselves and call it a "misallocation." And of course some managers are on the other side of the misallocation error and get off easily with the subsidy. It's like a law of physics. For every dupe, there is an equal and opposite dupe.

How can an executive team expect its work force to have trust when it allows flawed internal reporting to continue? And it gets worse. When managers receive their cost allocation, there is no transparency. All they see is a lump-sum charge. So how do they know what it is made up of? Progressive managers recognize that activity-based cost (ABC) principles solve both the problems of poor accuracy and transparency. ABC accomplishes this by tracing with quantity-based driver measures, not broad allocations. ABC assigns the resource expenses of support departments based on cause-and-effect relationships through the individual work activities that belong to processes and into their outputs, which can be end products and service lines. With this information, managers see the internal transparency so that they can consider reducing the quantity of the driver their department uses and thus lower their cost.

What About Incomplete Costs and Missing Information?

Why do the accountants stop at calculating output, product and service-line costs? What about all the distribution, selling, marketing and customer-caused administrative expenses like order entry and billing systems? Why can't these below-the-gross-margin-line costs to serve customers be traced too? This way managers can understand why high-maintenance customers, such as those constantly returning goods or calling help desks or changing schedules, can be relatively less profitable than low-maintenance customers. Well, they can understand these differences if their accountants applied ABC principles to those expenses too. Relevant nonfinancial information may also be unreported (or if it is, may have data quality issues).

The Trouble with Aggregate Measures

How can managers and employee teams explain why their nonfinancial results, like customer service levels, fell below a target measure, often called key performance indicators (KPIs)? Most KPIs are aggregate measures - highly summarized. If managers had monitoring systems (and dashboards are now popular) that were decomposed into other KPIs that influence the more aggregate KPIs, then they could better understand how the measures they control contribute to the higher aggregate KPIs. For example, a KPI for the number of visits to sales prospects during a period would influence the KPI for sales from new customers reported at the end of the period.

This problem can be resolved with strategy maps and balanced scorecards, whether the scorecards are at a strategic level or more operational. And the shareholders or governance boards of public sector government agencies benefit more if the correct KPIs are selected. Strategy maps provide this solution. They are arguably much more important than the scorecard dials because they assure that selected KPIs are not just the ones that can be measured but the ones that should be measured.

A strategy and its associated objectives and metrics represent a hypothetical road map of how an organization will deliver results. Organizations typically select the wrong KPIs or don't think through the consequences of how people will respond to ones monitored.

There is no assurance of the quality of the KPIs selected without proof. A strategy map on its own doesn't qualify. To prove the effectiveness of the selected KPIs and their linkages, one needs to correlate the KPIs to objectives and project initiatives, objectives to the strategy and finally the strategy to bottom-line outcomes. And if the strategy map is not supported with analytical software, then both the map and its scorecard are simply a pretty picture with metric dials rather than a robust method to better understand the cause-and-effect links among the KPIs. The insights gained from KPI analytics can prompt organizations to optimize the type of and capacity level of their resources. If their KPIs were wrong, then there is a high probability their resources have not been aligned to strategy in an optimal way.

Where are the Internal Audit Standards for Performance Measures and Managerial Accounting?

Henry Paulson credits the Chairman of the Securities and Exchange Commission, Christopher Cox, with advocating a strong auditing profession as being essential for a well-functioning national financial reporting system. This provides assurance as to the truth. Again, this is wonderful for regulators and investors. But what about for internal managers and employee teams?

I predict it is inevitable that there will be an accreditation standard similar to ISO 9000 in the quality community and the Malcolm Baldrige Award assessments. Professional examiners will evaluate internal measurement, business intelligence and managerial accounting practices and systems. Only then will organizations be assured of a clean bill of health. (Organizational performance is another story, but let's at least give competitors and public sector organizations a fair start.)

And once boards of directors, ever increasingly activist than ceremonial, catch wind of such an accreditation program for internal systems, its adoption may catch on like wildfire. Governance boards and private equity firm administrators today are more confident that Sarbanes-Oxley Act and Basel II Capital Accord compliance ensures ethics, but they are skeptical about their executive teams having adequate, effective performance measures and managerial accounting for their managers' decision making to continuously improve results or even sustain their organizations in the long term.

Reference:

1. "The key test of accurate financial reporting is trust." Financial Times. May 17, 2007, page 11.