10. Why Use ABC
Some organizations abandon pursuing activity-based costing (ABC) because they continue with the misconception that ABC is too complex to create and maintain.
They falsely believe the benefits from ABC’s information for insights and better decision support do not exceed the effort to create the ABC information.
There is a dozen more “barriers” that prevent pursuing implementing ABC. None are valid.
CFOs and accountants remain in the 1960s. They need to arrive in the 21st century.
These slides that I created describe why organizations should implement and use ABC.
9. Movie Sequel - "Accountant Pirates of the Caribbean"
Please forgive me for my persistent rant and criticism against accountants who budget poorly or continue to calculate the substantial and growing high indirect and shared costs originating from resource expenses such as salaries, supplies, power, information technologies, and travel. I cannot seem to hold back my frustration.
When I observe managerial accounting practices and methods that ignore driver-based budgeting principles or simply allocate indirect and shared expenses typically as large combined “pool” using a single broad-brushed cost allocation base (e.g., number of units produced, sales amounts, direct labor input hours, head count, square feet/meters), I do not know if I should laugh or cry!
Accountants as pirates
The cost allocation methods just described violate what should now be well known by accountants as the “causality principle.” Expenses should not be “allocated” implying using any convenient base denominator in the calculation that converts 100% of the expenses into 100% of costs. Expenses should be “assigned and traced” in proportion to how the expenses are consumed. This means that the various work activity costs that belong to end-to-end and cross-department processes should be disaggregated and re-assigned using a quantity or volume metric that reflects the consumption rate.
Now at this point some readers of this article have stopped reading and gone off to do other things like process journal entries and admire how elegant their debit and credit T-accounts look. Many of them suspect they are going to hear another heralding of the virtues of activity-based costing (ABC). That's fine. Let me write to the rest of you.
First, what were pirates and what is piracy? A definition for piracy is an act of robbery typically at sea but also applicable on land. It refers to raids across land borders. Can I use a pirate analogy for misguided accountants? I believe I can if you allow me to use some imagination.
When accountants mis-allocate calculating past period historical costs (e.g. product costing), the result is simultaneously over- and under-costing compared to the economic reality because re-assigning expenses and costs is a zero-sum-error calculation. Are the accountants “robbing” anyone? Yes. At one level they are acting like Robin Hood taking from some (i.e., product costs) to give to others. At a more personal level they are “robbing” managers and employee teams from having reasonable cost accuracy from which to draw insights for decisions such as product, service-line, channel, and customer rationalization. Accurate reported output costs and profit margins lead to a better understanding for determining how much and what types of resources to use to maximize the organization’s mission to stockholders (commercial companies) and stakeholders (in the government public sector).
What about “raids across land borders?” If you continue with this piracy analogy, one can substitute the borders of the organization chart with land borders. We all acknowledge that organizational silos exist at some level despite the lean and Six Sigma quality management community’s pursuit to eradicate the self-serving behavior of and organization’s departments. When accountants focus on departmental cost center reporting of actual versus budget spending, they make managers either happy or sad, but rarely any smarter. Managers rarely see or sufficiently understand the cross-departmental costs of activities. And the reported costs of the products and service-lines that consume these expenses are flawed and misleading due to non-causal broad-brushed averaging earlier described.
Unethical or irresponsible? Shame on versus shaming accountants
I recently posted a question in the website discussion group of one of the professional accounting institutes. Based on this institute’s definition of code of ethics, which is now has higher interest based on financial scandals like Enron, I asked if accountants are behaving unethically or just irresponsibly when they basically and most likely knowingly miscalculate output costs. There were a range of responses including several who defended accountants as simply just “doing their job” and that the total costs do perfectly reconcile without error. (Now there is an auditor’s mentality. Correct in the whole, and everywhere incorrect in the parts.)
What about my behavior in writing this article? Am I placing shame on accountants or shaming them. There is a difference. Shame exists when one admits they have a committed act and therefore are dishonorable. Shaming is an assault on the worth of an individual. Shame results in the accused diminished self-esteem and at the extreme to be dismissed and banished from the organization they were a member of – a harsh penalty.
If I am shaming an accountant for their lack of caring to provide their managers and workforce with reliably valid information for decision making, if they already have low self-esteem then I might cause them to have an irreversible downward spiral. I certainly do not want that to happen. But I will maintain my position and assign shame to those accountants who themselves know who they are. They know they are admittedly using misallocating cost calculations that violate costing’s causality principle. It is a principle. The causality principle is not a law like they can be handed a traffic ticket from a policeman.
Why does any of this matter?
Why am I standing my ground and persistent? Management accounting has an imminent important task ahead. Most commercial companies are shifting from being product-centric to customer-centric for a whole host of reasons including that customers now view most suppliers as selling commodities. This means a supplier’s competitive edge will come from offering differentiated services to increasingly granular micro-segmented types of customers. It is no longer about just increasing market share and growing sales. It is about growing profitable sales. If accountants do not have mastery on tracing expenses to channels and customers they place their company at peril and risk.
This article was previously published on www.information-management.com
8. Some Accountants are the Blind Leading the Blind
I recently met a management consultant specializing in management accounting and FP&A whose intentions were sincere. However his advice was surprising, but not totally surprising, to me.
He mentioned to me that a company had inquired to him whether they should consider using activity-based costing (ABC). His next step was initially encouraging. He contacted the accounting departments of the inquiring company’s major competitors. He asked them if they are using ABC. The answer from them was that none of them are.
A missed opportunity for good advice
I was hoping the next thing he would tell me is this. I was hoping he would inform the inquiring company that they had an opportunity to gain a competitive edge.
I presumed he would say to them, “I have good news for you. Your instincts are correct. You have realized that the amount of your indirect and shared expenses has grown large relative to your direct expenses. You may understand that this expansion is a result that your products and services have expanded with much diversity and variations. And the result is that complexity has caused this increase to manage the complexity. By your using a highly aggregated indirect cost pool with a single allocation factor that has no cause-and-effect relationship with those indirect expenses, the consequence is that you are simultaneously over- and-under-costing your products. Their costs exactly reconcile in total but not in with parts. This is because cost allocations are a zero-sum error condition. Your competitors do not realize this, but you do. Go for it. Implement ABC. Your company will much better understand their profit margin layers and where it makes and loses money – and why.”
Sadly, he advised the inquiring company that since its competitors do not use ABC then that is evidence that ABC is of little benefit.
How long can this ignorance continue?
My ranting and raving
Those readers who follow my blogs and articles about this topic recognize that I have been relentless in criticizing the ‘homo accounticus’ accountants who remain in the stone age. They are exposing their organizations to a risk that the enterprise risk management (ERM) community rarely references – invalid and flawed cost information that leads to misleading profit margin information.
I remain in awe. The advanced and mature organizations that have adopted ABC would never go back to traditional standard costing (unless a new mindless CFO or CEO shows up and rejects ABC as too complicated and abandons it).
The longer these types of primitive accountants delay applying ABC, the greater the risks. The issue here is not mainly about product and standard service-line costing. The issue is about the emerging need to report and analyze channel and customer profitability. This includes the broader scope of marketing, distribution, selling, and customer service expenses that are below the product gross profit margin line.
Open your eyes. It is apparent that today customers view almost all suppliers’ products as commodities. They want to be specially treated and serviced. This means that suppliers must provide differentiated services to increasingly differentiated micro-segments of customers. These are cost-to-serve costs, not product and standard service-line costs.
An increasing pressure comes when suppliers recognize that they have high maintenance customers, in contrast to low maintenance ones, whose extra costs erode profits. The objective of sales and marketing is no longer about growing market share and sales, but rather it is about growing profitable sales. Accountants must accurately measure the ‘middle line’ to subtract from the ‘top line’ because the ‘bottom line’ – profits – is a derivative from both of them. And to use large aggregated cost pools with a non-causal allocation factor (e.g., sales amounts, number of labor/machine input hours) to allocate costs is irresponsible. The results are distorted.
When the consultant advised his inquiring company that their competitors are not using ABC, then it is a case of the blind leading the blind. And, remember, that in the land of the blind the one-eyed man is king.
This article was previously published on www.epmchannel.com
7. The CFO’s Expanding Role – Reality or Delusion?
Am I alone in wondering if the many references and articles concerning the CFO’s emerging role as a “trusted advisor” is more hype than reality?
Increasingly, I read articles and research studies alleging this emerging CFO role to be actually happening. In an article written by Gianni Giacomelli, senior vice-president at Genpact, titled “Can a CFO Innovate?” he states:
“Modern financial executives are moving toward a more central and expanded role as stewards of the company's longevity, using the finance function to enable growth, especially in new markets and in response to market changes. For those who are ready for change, the new finance is an exciting and rewarding way to help shape a more intelligent enterprise that is better connected to the market and its customers.”
Really? Just to be a devil’s advocate for a moment, what proof do we have that Gianni’s observation is true? When we cut to the chase, what are CFOs more concerned about – regulatory compliance or organizational performance improvement? Certainly, many CFOs monitor and report on performance using scorecards and dashboards. But do they actively participate in assisting line managers to move those dials. As examples:
- Do they assist sales and marketing managers with identifying which types of customers to retain, grow, win back, and acquire?
- Do they assist operations managers to determine which productivity actions and projects will realize gains in efficiency, effectiveness, quality, and cost reduction?
Or do they simply serve as gatekeepers and keep score?
Bean counter or bean grower?
In an article by Myles Corson, a consultant with the Financial Accounting Advisory Services of Ernst & Young LLP, titled “The Evolving Role of Today’s CFO”, he writes:
“In addition to overseeing the company's financial health, CFOs are increasingly involved in setting operational and commercial strategy, navigating their companies safely through tighter credit markets, more complex regulation and unstable trading conditions. … As organizations continue to adjust to market volatility and economic uncertainty, CFOs must increasingly provide expert advice to support boardroom decisions. In fact, many CFOs feel that they are in an exceptional position to offer this level of strategic counsel because of their ability to gather information from disparate parts of the company.”
But is this evolving role one of just better reporting or one creating a greater impact on analysis and decisions?
In a survey conducted by Mary Driscoll of the America Productivity and Quality Center, titled, “A New CFO Priority,” she writes:
“Surprisingly, only five percent of survey respondents believe that finance is currently delivering game-changing value to their enterprises. Is this cause for concern? … Finance organizations that are seen as a partner to the business generate thoughtful, clear, and authoritative analyses. However, the biggest barrier preventing business partnership is the lack of time to perform this same work.”
My intent is not to be a naysayer and deny there is truly an evolving and expanding role of the CFO. In fact, my intent is just the opposite. I am a believer that, particularly given the opportunity provided by the connections of technological forces ( advanced analytics, cloud, in-memory computing, mobile and social computing) the CFO’s finance and accounting function is uniquely positioned at this moment in time to accelerate the adoption rate of enterprise and corporate performance management (EPM/CPM) methods along with emerging business analytics to gain crucial insights that were previously inaccessible and truly facilitate business innovation in new and novel ways. Finance and accounting professionals have developed a strong quantitative aptitude – which technology will only further fuel.
Delusion or reality?
But do we know or just think we know? Which is it - delusion or reality? I bemoan the slow progress in performance improvement methods such as the adoption of activity-based costing (ABC) principles. If ABC is done at all it is typically only taken as far as product and service-line gross product profit margin line reporting and does not look beneath that line to report and analyze channel and costs-to-serve for arguably more critical customer profitability reporting and analysis. And what about marginal / incremental expense analysis for that matter? This involves classifying available / used resources as sunk, fixed, step-fixed, semi-variable, or variable. This involves an understanding managerial economics, not just managerial accounting. How many finance organizations have built core competencies in these functions? My suspicion is that many finance organizations are for the most part dealing with more fundamental problems and have yet to build core competencies in many of the practices espoused by analysts, consultants and business pundits.
For now though, my opinion is the CFO function is about to enter a golden age of business analytics and managerial accounting. But we need more evidence. Are CFOs taxiing on the runway, or have they begun lift-off?
This article was previously published on https://www.information-management.com
6. How Many Types of Key Performance Indicators (KPIs) are There?
It seems the Holy Grail for scorecards and dashboards seem to be organizations seeking to answer, “What should our key performance indicators (KPIs) be?” At the heart of selecting KPIs should be their linkage to the executive team’s strategy. However, there are different stakeholders in an organization, such as internal managers and investor governance boards. Each stakeholder has different needs. Hence there should be different types of KPIs for different purposes.
Performance measures reported in scorecards and dashboards is one of the core components of integrated enterprise and corporate performance management (EPM/CPM) rivaling in importance other improvement methods such as customer relationship management and managerial accounting. Regardless of the type of KPI, analytics (such as segmentation, correlation, regression, forecasting, and clustering) should ideally be imbedded in each method, and they are critical for employees to achieve and exceed KPI targets.
Author Brett Knowles, founder of the consulting firm PM2 (https://www.hirebook.com) and a veteran of the balanced scorecard thought leader community, has given much thought to the topic of different KPIs for different purposes. In Volume 4, Number 6 of his firm’s Performance Measurement &Management newsletter Brett describes different types of KPIs in an article titled “Five Distinct Views of Scorecards – and Their Implications.” With Mr. Knowles permission, here they are abbreviated with my minor edits:
- Financial Valuation – A scorecard view is needed to describe what the organization does in a way that the financial world can understand: monetary currency (e.g., dollars, Euros). All activities need to be financially valued, including tangible assets (e.g., buildings and inventories) and intangible assets (e.g., brand equity, employee retention, and customer loyalty). Several methodologies exist that grapple with this need, including economic value added (EVA) and activity-based costing (ABC).
The challenge is that more than 80% of value is created by intangible assets, yet traditional accounting systems do not do a good job of capturing intangibles. The balanced scorecard has proven to be a great tool for making the intangible assets visible and valuable.
Information in this area needs to be:
- Centered on outputs, outcomes or deliverables,
- Closely related to existing valuation mechanisms,
- Standard, repeatable and reliable.
- Navigation – Internal managers need to make informed decisions on a frequent basis that are consistent with the medium- and long-term strategy. Strategy, cascaded downward into the organization through a strategic balanced scorecard and into operational dashboards, dictates both what should be done and how important it is. This view of performance measures creates alignment of employees’ actions and priorities across all functional and regional boundaries and consistency across time. This is where the EPM/CPM methods with imbedded analytics play a critical role.
Information in this area needs to be:
- Very responsive to shifts in the work activities,
- Process based,
- Related to overall effectiveness and efficiency.
- Incentive Compensation – Scorecard frameworks lend themselves to rewarding employees for contributing to the success of the organization. Over-performers should be distinguished from under-performers. A key to this view is for the executive team to assign aggressive yet achievable target measures.
Information in this area needs to be:
- Related to the value that the team can control and create,
- Output and outcome related,
- Accurately measurable and repeatable across locations and time.
- Benchmarking – An effective way to determine whether an organization is making progress is to compare it to other “things” (“comparatives”). There are many comparatives available: competitors, best-in-class, world-class. In the true sense, even target, forecast and revised-forecast are all comparatives too.
The challenge with the benchmark view of scorecards is that the data is sparse and with “dirty” quality. Also, there can be apples-and-oranges inconsistencies (e.g., including or excluding data, measuring different start-and-end times of processes). Comparatives do not typically go into enough detail to provide operational insights into diagnosing any identified issues and root causes, nor do they cover the full breadth of the executive team’s strategy.
Information in this area needs to be:
- Available from other sources,
- Understandable and relatively comparable,
- Strategically related to the organization.
- Evaluation – Periodically, there is the need to get an accurate measurement of how the organization is performing. Periodically the organization needs to undertake such activities as customer surveys, employee surveys, supplier assessments, etc.
These activities are too expensive and time consuming to be conducted often enough to be useful for navigation, but can be used to underpin selection and validation of navigation indicators, support incentive compensation models and be used in reporting performance to outside stakeholders.
Information in this area needs to be:
- Survey based,
- Comprehensive and rigorous,
- Closely related to overall deliverables.
Brett summarizes his five views by stating that most organizations need to consider their organization’s performance in two or more of these views. For example, a shared service IT department may need to prove and measure its contribution to the organization’s overall valuation, provide monthly navigational information for the project managers (and service level agreements [SLAs] for their internal customers), and develop a compensation package for use around the globe. They may also need to compare themselves to industry benchmarks.
The various and numerous stakeholders need to initially develop some confidence that the scorecard model adequately describes their view of the organization. Consider building the various views as a way to speed implementation of a pilot scorecard. A simple way to do this is to create a single enterprise-wide strategy map, but link different indicators to it for each of the views.
My feeling is Brett is on to something important. As I have previously written there is confusion and lack of consensus as to what a balanced scorecard is. There is ambiguity. Further many organizations neglect to first construct a strategy map from which to derive its KPIs. A strategy map is orders of magnitude more important than its companion balanced scorecards and cascaded operational dashboards. They are simply feedback mechanisms.
Understanding that there are multiple scorecard views can bring clarification.
This article was previously published on www.epmchannel.com