Is It Better to Have No Costing than Bad Costing?

I recently had an exciting conversation with Kris Moreels, founder and managing partner of B&M Consulting, a firm that specializes in designs of managerial accounting and strategy execution performance management systems. Kris and I share a common history as management consultants engaged by organizations to improve a weak and deficient managerial accounting system. He made the profound statement with which I titled this article, “Is it better to have no costing than bad costing?” What did he mean?

The prevalent thinking is that an organization’s managerial accounting system will calculate costs differently than its financial accounting system. This is because financial reporting must comply with regulatory rules for external compliance reporting typically that oversimplify the rigor required to calculate the relatively more accurate costs from a managerial accounting system. Of course, the culprit here is the allocations of indirect and shared expenses. Traditional cost allocations apply convenient broadly averaged factors, such as using number of department employees or direct labor input hours, to reassign indirect expenses to product costs.

Violating Accounting’s Causality Principle

The obvious flaw, not recognized by all accountants, is that these types of allocation factors violate the cause-and-effect relationship principle of accounting. That is, the resulting costs do not reflect the unique consumption for how individual products distinctively draw on the processes (and the spending for them) and the work activity costs that belong to those processes.

The activity-based costing methodology resolves this shortcoming by decomposing resource expenses, such as salaries and supplies, into disaggregated work activities and then reassigning each activity cost to the products and service lines consuming them using a causal activity cost driver. An example of an activity cost driver in a bank would be the number of wire transfers for the work activity “processing wire transfers.”

When Is Good Enough Not Enough?

The accounting department could argue that the majority of expenses are direct to products. However, they may be challenged to prove this assumption with facts. In almost all industries and government agencies, in the last few decades their offerings and services have proliferated in diversity and variations to satisfy customers’ increasing needs for customization. For example, more colors, sizes, and ranges. This creates complexity, and increasing indirect and shared resources have been added to manage the complexity. Indirect and shared expenses (e.g., information technology) are now substantial in magnitude relative to direct expenses.

For the accountants who may be aware of this relative shift in their organization’s composition of expense categories, they may argue that their direct costs are precise and their broad but flawed cost allocation probably closely matches what using multiple activity driver factors would produce in the calculation. How do they know? Maybe their assumption of “good enough” is not sufficiently accurate for good decision-making.

Without Facts, It Is an Opinion

There is abundant evidence that when activity-based costing replaces traditional broadly averaged cost allocations without causal relationships, the before-and-after product cost error differences are grotesquely large. This means organizations not using activity-based costing (or weak designs of it) are providing inaccurate and misleading information to their users, who are making analysis and decisions based on that flawed information. Examples are gross profit margin analysis and benchmarking studies.

As Kris hints, leaving the users to apply intuition and gut feel about costs may be better than reporting defective and misleading data. Maybe information users and operations managers can rely on evolving Lean management and Six Sigma quality programs to improve their costs. My belief is that in the absence of facts, anybody’s opinion may be a good one – but usually the biggest opinion wins. That would be the opinion of a supervisor or of a supervisor’s supervisor. To the degree that the decisions of higher-level managers and executives rely on intuition, gut feel, or politics, then the organization is at risk.

As organizations expand their costing to include nonproduct cost-to-serve expenses (e.g., customer service, selling, distribution, and marketing expenses) for customer profitability analysis, the problem of bad costing will only be exacerbated.

So, is it better to have no costing than bad costing? Is it better to not mislead managers and leave them to rely on intuition and whatever other nonfinancial information to make decisions? I would not take that risk. Today organizations speak in the language of money. If you cannot speak that language, it is difficult to communicate your ideas and build supportive cases for change.

Categories: Finance