Deeper cost accounting v/s Activity Based Costing

Recently I met few professionals in India, who are the head of Management Accounting function of their respective organizations. This was in relation to selling my services of implementing Activity Based Costing (ABC) concept at their organization. Incidentally those were non-manufacturing organizations. While they were interested in understanding what ABC can do, at the very same time they also seemed to be convinced that ABC will not be any value addition to them. The primary reason they mentioned was, ABC is used for better allocation of the costs and we have designed our cost centers to such a detail that we need not do the allocation. We can find the cost centers directly for 90% of the expenses. Hence, there is no need to invest the time, money and other resources in ABC project. This is one of the reasons why professionals are saying ‘No’ to ABC in India. This made me think what could be the possible reasons behind this kind of thinking.

The costing has been used formally in manufacturing industry for a long time. The primary reason was to complete the Financial statement. The financial statement requires valuation of inventories (raw material, work-in-progress, finished goods etc.). This inventory valuation is generally considered with the costs up to the manufacturing stage. Eventually the same information was used for other management decisions like pricing. The post manufacturing costs were added and the organizations reached at a total cost of the product. With the good old days when price was cost plus margin, people added their expected margin and priced the product. Even in today’s business scenario professionals say the price is not always cost plus margin, but decided by the market, they use the ‘same cost’ for calculating the profitability of the product.

This has helped professionals believe that costing means ‘Product Costing’. Each and every unit of currency that is spent in the organization is linked to one or the other product that is produced and/or sold. Unfortunately the same logic has been used by the ‘Service Industry’ (banking, insurance etc.) when people started calculating the cost of the service (similar to the product in manufacturing industry). While doing this these professionals knew that there are no ‘labor hours’ or ‘machine hours’ available for taking the overheads to the services of the organization. In fact for service organizations almost every unit of currency spent is an overhead. Parallel to this the manufacturing organizations got a very important tool for automation the recording of their transaction, ‘the ERP’. Like all the other processes it also helped the management accountants to automate the basics of costing, that is ‘Cost center Accounting’. This automation helped them to manage more cost centers as well as booking of expenses to one or more cost centers at the source.

The ability to create, maintain more cost centers and identifying expenses to these cost centers at the source created a feeling that, if we can identify the expenses the source cost centre we can be more accurate in costing the product. To certain extent this is true also. These online transactional processing (OLTP) systems are now available for service industries like Banking, Insurance etc. That is when the ‘costing’ cells were created in these industries. The very difficulty of defining the product (for example we can calculate the cost of a television set, but how to calculate the cost of ‘Saving Account’ was an issue) probably led them to various options like identifying more cost centers.

I have already mentioned that, these professionals were interested in understanding about ABC, but they were trying to convince to themselves that ABC is no better (read as different) than the detail cost center accounting. Here in this post you will not find how ABC is different from traditional costing or Cost center accounting in detail way, but a comprehensive way of looking at costing model in any organization. More cost centers with more detailed information will not help a company decide whether or not to drop or add a product line, accept or reject new business, outsource business processes or bring others in-house, make a component or buy it, add a shift or work existing personnel overtime. They won’t help identify in-process movement and storage, order picking, or outside storage of raw materials as a major non-value adding issues. They won’t be able to tell you which customers or product lines are profitable and which are not. By itself, having “more cost centers” is entirely useless.

While talking on this subject to the veterans in this field, they put their views. One of the analogy that was used was the ‘Elephant and the seven blinds’. Anyone who honestly believes that “all they need are more cost centers” has a very narrow view of the impact cost information has on business decisions – they have only touched one elephant in one spot but now think they know everything there is to know about elephants.

An Economic Cost Model that Represents the Entire Elephant, by Doug Hicks

A valid economic cost model serves the needs of all interested parties in an organization. Such a model is an accurate representation of the company’s internal cost economics. By populating it with the appropriate data – data that will differ from one usage to another – a valid economic cost model will generate the accurate and relevant cost information required by all parts of the elephant. It will work whether the decision at hand is strategic or tactical. It will work whether the information needed is fully-absorbed or incremental. It will work using historical information or projected information. It will measure process costs, product costs, service costs, and customer costs. As shown in the Figure, it is the engine that takes the relevant data and processes it appropriately to provide support for management decisions and actions of all types.
Constructing a cost model based on only one blind man’s perception of an elephant is a terrible waste of a company’s resources. It solves only one problem, ignores all the others, and often adds many more. Until management accountants understand that a valid economic cost model of the entire organization is the key to providing management with the information it needs to survive and grow in an ever more competitive world, they will continue to “Rail on in utter ignorance of what each other mean, And prate about an Elephant not one of them has seen!” (DTH&Co. – Winter 2006 – Blind & Elephant).

Management accountants can perform an important role in the design of an ABC system. Based on their skills and training, they can help identify what is appropriate for analysis (product, customer, process, etc.) and explain the probable causes of an existing cost system’s deficiencies. In addition, based on their detailed knowledge of the information in their company’s costing information systems, they are uniquely qualified to judge the level of aggregation appropriate to the ABC costing system. They can use their understanding of costing methods to recommend appropriate methodologies for the assignment of costs to activities and cost objects. Finally, they will be able to use their understanding of the information and cost relationships to support the system once it is implemented. Gary_Cokins_SAS_IMA_on_Activity-Based_Costing