To most FP&A professionals and accountants there is confusion and a lack of consensus on how to allocate costs to products and service lines. I refer to this as “a mystery in a box to accountants”. To solve this mystery here are three lectures to accounting students from a skilled and experienced accountant – me – that explains the problem and how to solve it. For those who have already graduated from college and may even have a CPA, I encourage you to sit in the back of the lecture hall and audit these classes.
Management Accounting 101
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 or meters. 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.
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. Wisdom is knowledge tempered with judgement.
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.
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 that I described in my 101 class. If what I now teach you is followed it will propel CFOs and accountants out of the 1960s into the 21st century. The solution is activity-based costing (ABC).
I refer to ABC with this: “Break the GAAP rules to find the jewels”. Here is how and why.
But first as background, 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 have always been 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 cost allocations have zero-sum error. It is true that 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 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.
Are CFOs and accountants being irresponsible or worse yet unethical when they misallocate costs? Statutory and regulatory compliance for external financial reports is defined as requiring adherence to the letter of the law. CFOs do that. But ethics is about practicing honesty and treating people fairly. With this definition, a case can be made that CFOs who fail to use progressive management accounting techniques, including ABC, are being unethical.
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.