Gary Cokins
12. Management Accounting 101, 102 and 103 Courses
Management Accounting 101
“Break the GAAP Rules to Find the Jewels”
Welcome, accounting class, to Management Accounting 101. No need to take your seats. All you need to know is this: Do not allocate indirect expenses to products and service lines using cost allocation factors like spreading butter across bread. Examples of factors are the amount of sales, number of units produced, number of employees, number of labor hours, or square feet. None of those comply with costing’s causality principle.
Trace and assign indirect expenses into calculated costs using driver quantities so that they are similar to direct costs. Your line managers and executives will appreciate you because you will have unhidden the costs by making them visible and substantially more accurate. This will enable your colleagues to gain insights and make better decisions. Class dismissed.
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Management Accounting 102
Welcome back, accounting class, to Management Accounting 102. This brief lecture is intended to inspire you. It ends with a pop quiz.
Let’s reflect on the giants of the scientific revolution from past centuries. Copernicus shocked the world by placing the Sun rather than the Earth at the center of the universe. Galileo Galilei was the father of the scientific method and applied the telescope to test theories. Johannes Kepler then described planetary motion with our planets, including the Earth, orbiting around the Sun. His work helped Isaac Newton develop his theory about gravity that every particle attracts every other particle in the universe with a force that is directly proportional to the multiplicative product of their masses and inversely proportional to the square of the distance between their centers. Albert Einstein then refined Newton’s work with his general theory of relativity describing gravity as a geometric property of space and time - spacetime.
All of these advances replaced misconceptions with reality.
Pop Quiz – In what decade in this 21st century will accountants replace distorting and misleading cost allocations with reality based on cost accounting’s causality principle?
Please hand in your paper with your answer.
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Management Accounting 103
Welcome back, accounting class, to Management Accounting 103. This is my final lecture. It will describe how to resolve the “cost allocation” problem I described in my 101 class and if what I now teach is followed will propel CFOs and accountants out of the 1960s into the 21st century. The solution is activity-based costing (ABC).
There has been a slow adoption by accountants to apply ABC as a replacement for the flawed and misleading traditional “cost allocation” methods for indirect expenses (commonly referred to as “overhead”) from standard cost accounting systems. As I mentioned in my 101 lecture, they allocate indirect expenses like spreading butter across bread using non-causal and broadly averaged cost allocation factors. Examples are the number or amount of direct labor input hours or currency, units produced, sales volume, headcount, or square feet/meters. None of those reflect the true consumption of expenses that unique and diverse products and service lines consume of the end-to-end processes and the work activities that belong to the processes.
After ABC decomposes the single and typically large indirect cost pool into multiple cost pools – the work activities – and traces and assigns them based on a cause-and-effect relationship there is no surprise to those managers who are suspicious. What is discovered, compared to the traditional costing, is that some of the products and service lines are being over-costed and the others must be under-costed because allocations have zero-sum error. Traditional costing does exactly reconcile the indirect expenses in total into the product and service line costs. That satisfies the auditors for external financial regulatory and statutory reporting, but the costs are wrong in the parts. This means that CFOs and accountants are providing their managers and executives with those flawed and misleading costs I mentioned which means the profit margins are also wrong.
The benefits from applying ABC in comparison to traditional cost allocation methods that violate “costing’s causality principle” are numerous. Key benefits are: (1) extremely more accurate profit and cost reporting of outputs, products, services, channels and customers; (2) transparency and visibility of the “drivers” for work activities and their magnitude; and (3) past period calibrated cost consumption rates that are essential to multiply against future forecasted demand volume and mix that determine resource capacity requirements – workforce headcounts and spending amounts. These rates are needed for what-if scenario analysis, make-versus-buy decisions, and capacity-sensitive driver-based rolling financial forecasts and budgets.
Causality is at the heart of ABC. For example, if the quantity of the activity driver increases 20% then its activity cost should also increase 20%. The work activities are what consume the resource capacity expenses. Any CFO, financial controller, or FP&A analyst who are using traditional cost allocation methods and are not using ABC where it is applicable (which is for most organizations) is being irresponsible in their duty to provide valid information to managers and employees. The information they are providing is faulty, distorted and deceiving. Line managers deserve better from their CFO to support their decisions.
Thank you for taking my management accounting 101, 102, and 103 courses. You will soon graduate. I wish you success as you join an employer to act not as an accounting “bean counter” but to be a “bean grower” to help your organization with insights and making better decisions than with stale and arcane cost allocation methods from the 1960s.
Class is dismissed.
11. Identifying and Measuring the Cost of Error and Waste
When managerial accountants and information system builders better understand the nuances for designing their cost measurement system, they are more successful.
One of the challenges for a cost measurement design team is to right-size the system.
This means to balance simultaneously its level of detail, relevance, and accuracy with the level of administrative effort made to collect data and report the transformed information.
Any managerial accounting textbook will proclaim that there are multiple purposes for managerial accounting ranging from......
The full article is available in the file attached below
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