Cost Management as a Strategic Weapon Raef Lawson, PhD, CMA, CPA Vice President-Research & Policy Institute of Management Accountants November 17, 2016 1:30 2:20 pm
Cost Management as a Strategic Weapon - Agenda Accountants as Drivers of Economic Value Information for Effective Decision Making The importance of decision models Activity based costing Strategic Cost Management Customer value / profitability Process improvement The Accountant as a Decision Leader
Accountants as Drivers of Economic Value What is Management Accounting? Management accounting is the internal business building role of accounting and finance professionals who work inside organizations. These professionals are involved in designing and evaluating business processes, budgeting and forecasting, implementing and monitoring internal controls, and analyzing, synthesizing, and aggregating information to help drive economic value. 2016 IMA
Driving Economic Value Economic Value? An organization s ability to generate income over time. Drive? To supply a motive force that powers advancement towards an objective. 2014 D. T. Hicks & Co.
Have Accountants Been Driving Economic Value? Not really. The demands of external reporting, regulatory compliance and financial administration have kept accountants from performing their role in driving economic value. Obsession with GAAP-based financial and performance measurements has also kept accountants from contributing to their company s economic value. Management has depended on the accountant to keep them out of trouble and provide traditional reports, but has not looked to him or her to provide new insights that can drive the organization s economic value. 2014 D. T. Hicks & Co.
Information for Effective Decision Making
The Importance Of Decision Models Most phenomena are too complex to be completely understood. To function effectively we create models of those phenomena. These models represent our internal version of the outside world that makes the world more understandable and easier to deal with. Good decisions require good models. 2012 D. T. Hicks & Co.
Typical Accounting Model ABC Corporation Costs Direct Material, Services and Components Operating Costs Direct Labor Operating Costs Overhead Selling, General & Administrative Costs Direct-Labor Based Overhead Rate Percentage of Total Accumulated Cost Variety ABC Corporation Cost Objectives
Typical Uses for Costing Information Determine the cost of a purchased component or service Determine the benefit of creating a manufacturing cell to replace three independent operations Estimate (or measure) the cost of managing an exhibit while it s on a multi-show, multi-state tour Compare the cost of acquiring business for each market served by the company Does the traditional costing model provide a valid understanding and perception of reality?
The General Ledger View is Structurally Deficient for Decision Analysis Chart-of-Accounts View Insurance Claims Processing Department Actual Salaries $621,400 Equipment 161,200 Travel expense 58,000 Supplies 43,900 Plan $600,000 150,000 60,000 40,000 Favorable/ (unfavorable) $(21,400) (11,200) 2,000 (3,900) Use and occupancy 30,000 30,000 Total $914,500 $880,000 $(34,500) When managers get this kind of report, they are either happy or sad, but they are rarely any smarter! t 2016 www.garycokins.com
Cost Accounting Information is NOT Decision Cost Information Cost Accounting Information Decision Cost Information Includes only inventoriable costs Satisfied with entity-wide inventory and COGS measurement Populated with GAAP-defined cost data Locked into only one or where alternative rates are possible two sets of assumptions. Permits the direct labor-based assignment of costs even when inappropriate Focuses on fully-absorbed costs Must include all business costs Demands accuracy at process, product and customer levels Populated with economic cost data appropriate to the situation different costs for different purposes Must allow for unlimited sets of assumptions Requires assignment of cost on a basis consistent with the company s operating realities Must generate both fully-absorbed and incremental cost information 2011 D. T. Hicks & Co.
Changes in Cost Structure over Time Broadly averaged cost allocation was acceptable. 100% Cost Components Direct Material Overhead (indirect expenses) Cost errors are large and misleading. Direct Labor 0% 1950 2000
Activity-Based Costing Activity-Based Costing (ABC) is a lens for taking the complex operations of a business enterprise and developing a cost model that accurately reflects the relationships between the company s costs, activities, and products. The purpose of Activity-Based Costing is insight, not calculations. 2004 D. T. Hicks & Co.
Activity-Based Costing Products and services cause activities and those activities cause costs Associate costs with the activities that make them necessary and accumulated activity costs with the products or services that make them necessary 2004 D. T. Hicks & Co.
Single and Multiple-Stage ABC Resources Resources Activities Activities Objects Objects Simple ABC Expanded ABC 2016 www.garycokins.com
ABC An Important Underlying Principle The effectiveness of an activity-based costing model or system is more dependent on its design than on its method of implementation or the data used to populate the model or system. It is better to estimate the right things than to precisely measure the wrong things. It is better to be approximately correct than to be precisely wrong. 2014 D. T. Hicks & Co.
Customer Value / Profitability
Customer Profitability using ABC $ 30 sales - 28 expenses = $ 2 profit Net Revenues Minus ABM costs = profit Unrealized profit revealed by ABM $ 2 profit
Value of Company = f(value from Customers) The only value a company will ever create is the value that comes from its customers the current ones and the new ones acquired in the future. To remain competitive, one must determine how to keep customers longer, grow them into bigger customers, make them more profitable, serve them more efficiently, and acquire relatively more profitable customers. 2016 www.garycokins.com
What about Costs Below Product Costs? INCOME STATEMENT Sales $ 100 - Product direct costs -20 - Overhead cost -10 ---------------------------------------------- = Gross profit margin $ 70 - selling costs -20 - distribution costs -10 - marketing costs -20 - administrative costs -10 ---------------------------------------------- = Total Profit $ 10 The accountants report these by each product (but they are wrong without ABC).? We have no visibility of these costs by customer (except in total)! 2016 www.garycokins.com
Why Do Customer-related Costs Matter? The Perfect Storm Customer Retention It is relatively much more expensive to acquire a new customer than to retain an existing one. Sources of Competitive Advantage As products and standard service-lines become commodity-like, then the shift is towards servicedifferentiation. CRM s One-to-One Marketing Technology has become the enabler to (1) identify customer segments, and (2) tailor marketing offers. Power Shift The Internet is shifting power from sellers to buyers.
Migrating Customers to Higher Profitability Very Profitable High (Creamy) Product Mix Margin Low (Low Fat) Types of Customers Low Cost-to-Serve High Very unprofitable 2016 www.garycokins.com
Customer Sales Volume Versus Profits Customers tend to cluster. Medium-volume customers can be much more profitable than large-volume customers! $ profitable Profitability $ 0 $ (unprofitable) $ small $ large Sales Volume (logarithmic scale) These losers drag down profits 2016 www.garycokins.com
A Shift in the CFO s Emphasis The CFO must now help Sales and Marketing better target customers. The spending budget for sales and marketing is critical but it should be treated as a scarce resource used to generating the highest long-term profits. This means answering questions like: Which type of customer is attractive to newly acquire, retain, grow, or win back? And which types are not? How much should we optimally spend attracting, retaining, growing, or recovering each customer microsegment?
Optimizing Customer Value You can destroy shareholder wealth creation by over-spending unneccessarily on loyal customers for what is needed to retain them. under-spending on marginally loyal customers and risk their defection to a competitor. The optimum spending level for differentiated services varies for the various micro-segments of customers. You need to have accurate costing models/information on which to base these decisions.
Process Improvement
Activity Analysis for Process Improvement Patient Care Form (PCF) Processing by an HMO 2016 R Lawson
Activity Analysis for Process Improvement Target an activity for improvement No Is activity required by a customer? Activity analysis judges work based on need, efficiency, and value. Yes Eliminate the activity to reduce cost Yes Can activity be eliminated? No Can the driver frequency be reduced? Yes Reduce the activity frequency to reduce cost No Does activity contain low-value added tasks? Yes No Eliminate low-value added work to reduce cost All cost reduction opportunities identified 2016 www.garycokins.com
There is No One Correct Cost There are different costs for different purposes! A management accountant has to think; not just memorize mechanics. Management accounting consists of concepts to be applied, not forms to be filled in 2007 D. T. Hicks & Co.
The Accountant as a Decision Leader
Administration vs. Management vs. Leadership Management and leadership are not the same thing. Management copes with complexity, relying on budgets, plans, targets, and organizational charts. Managers tend to follow rules and are risk adverse. In contrast, leaders cope with change change that is accelerating. Leadership requires vision, direction-setting, inspiring employees, and intelligent risk management. - Gary Cokins
Administration vs. Management vs. Leadership Administration Management Leadership Compliance Controlling Complexity Driving Value Record keeping Transaction recording Tax compliance Plans and budgets Performance measures Tax strategies Strategy execution measures Management economics Decision support systems 90.0% 9.8% 0.2% 2014 D. T. Hicks & Co.
Making Quality Management Decisions Businesspeople tend to blame poor performance on outside conditions that are beyond their personal control; a bad economy, unfair competition, unfavorable economic policies, etc. It s not my fault! In reality, poor performance is most often the result of ineffective decisions; inappropriate management responses to outside conditions. 2014 D. T. Hicks & Co.
What Makes Decisions Ineffective? Cognitive biases mental errors caused by our simplified information processing strategies. Dysfunctional goals, objectives, or incentives inappropriate measurements for gauging the success of a decision Single-point decisions treating decision making as an event a discrete choice that takes place at a single point in time. Poor costing models Accountants are in a unique position to serve as decision leaders and add substantial value to their organizations. Adapted from 2014 D. T. Hicks & Co.
Decision Maker vs. Decision Leader A decision maker has ultimate responsibility for making the decision. A decision leader takes the lead in ensuring the quality of the decisionmaking process. 2014 D. T. Hicks & Co.
The Accountant as a Decision Leader Information generated by accountants is part of almost every business decision Accountants are the closest thing most companies have to an economist Accountants are already active in systems development and act in an oversight capacity Accountants have wall-to-wall responsibilities within the organization Accountants are present when most major decisions are being discussed by or presented to decision makers 2014 D. T. Hicks & Co.
How Does an Accountant Become a Good Decision Leader? Be on the alert for cognitive biases that corrupt the decision making process and take steps to eliminate them. Insure that the economic measures used to support decisions are comprehensive, accurate, relevant, and based on a valid economic model of the business. Work to develop effective decision-making systems that provide a structure within which key management decisions are made. 2014 D. T. Hicks & Co.
Thank you! - Questions?