IN PART FIVE, BEGINNING with this chapter, the full spectrum of management accounting will be discussed not only for measuring past period costs but also the forward-looking future view of budgeting and “what-if” tradeoff analysis. Chapter 14 will describe a practical approach to implement a progressive, repeatable, and reliable production management accounting system in a few weeks, not months. This is intended to dispel the notion that the extra benefits from the extra effort to implement a progressive management accounting system is not cost-justified. But by reducing the effort relative to the benefits, it can make sense to proceed.

THE NEED FOR MORE QUANTITATIVE AND FACT-BASED FINANCIAL INFORMATION

At the federal level in the United States, the President's Management Agenda, Office of Management and Budget (OMB), the Government Accountability Office (GAO), and Congress are demanding transparency and accountability of effectiveness of government programs. Federal agencies are required to assess and determine performance. And funding will increasingly be determined according to demonstrated results.

The purpose is to improve performance and program management by creating a focus on results. Ineffective programs are being reformed or constrained, or are facing closure. Programs deemed ineffective or with questionable results are losing budget funding and face poor publicity. Agencies find themselves defending program missions and their budgets to the US Congress.

Agencies at the state and local level in the US face similar pressures. In many states, the governor, state legislature, and the public are impatient and demanding accountability and transparency of government effectiveness, as well as improved efficiency.

All government agencies globally are faced with the daunting challenge of determining and proving program effectiveness. In addition, they are asked to assess costs, justify budget requests with performance information, and communicate expected and tangible results. They are being held accountable for every taxpayer dollar going toward their services and programs. The need for more quantitative and fact-based financial information, a strength of ABC/M, is undeniable.

Government organizations are intrigued – or perhaps feeling threatened – by the prospect of adopting a new, better management accounting method such as ABC/M. Experience has shown that eliminating some common misconceptions about ABC/M substantially eases the path to its acceptance and use. This chapter describes some simple truths about the purpose of ABC/M, its scope, and its applicability to public sector enterprises as well as to private industry.

Remember that rules are many and principles are few. ABC/M is a management accounting method based on the costing's causality principle of cause-and-effect relationships, similar to the law of physics that states every action involves an equal and opposite reaction.

WHAT IS ABC/M?

First, let us look at some of the concrete benefits that accrue to an organization when it adopts ABC/M. The system serves a variety of purposes. After reading Chapter 8, some benefits should be obvious, but others may be less clear.

ABC/M is an alternative to the tyranny of traditional cost allocations. Imagine that you go to a restaurant with three friends. You order a little salad and they each order a great big and expensive prime rib steak or lobster. When the waiter or waitress brings the bill, they all say, “Let's split the check evenly.” How do you feel? Not fair to you. Not equitable.

Well, that is how many product and service lines also feel in a traditional cost accounting system when the accountants and comptrollers group allocate the typically large indirect support and overhead expenses as costs using broad averages without much (or any) logic. They spread those indirect expenses like butter across bread. There is minimal or no linkage between the true proportional consumption of the expenses and their allocation to the individual products, service lines, or end users. This is unfair. It is unfair in what is being costed, and it is unfair to people who use this information for insights and to make decisions.

ABC/M is a method that gets it right. In our restaurant example, ABC/M divides the check more fairly. It creates four individual checks – you pay for only what you consume. You don't subsidize the others or receive a generous gift from the others. To many ABC/M practitioners, the word allocation is one they wish had never existed. It implies inequity to so many people because of past abuses in their organization's accounting practices. The word allocation practically means misallocation, since that is usually the result. ABC/M practitioners often say that they do not allocate expenses; instead they trace and assign expenses into costs based on cause-and-effect relationships – costing's causality principle.

Many operations people cynically believe that accountants count what is easily counted – but not what counts. Outdated, traditional cost accounting obstructs managers and employees from seeing much of the relevant costs that are accurately attributable to their outputs. This problem has become increasingly significant as indirect expenses have ballooned relative to direct expenses.

Figure 9.1 reveals that, over the last few decades, indirect and overhead expenses have been displacing direct, recurring expenses as the major share of total expenses as organizations mature. Under the traditional cost accounting system, the organization has a reasonably clear view of direct expenditures for front-line labor and for material purchases. It has little insight, however, into the causes of its support and overhead spending.

For example, a banking institution is experienced at monitoring the work of its tellers and other employees who perform recurring work that is closest to the products and services benefiting its customers. It uses cost rates and performance-related factors, such as labor variance reporting, to calculate standard costs that are output-related. Many banks consequently know their standard cost per each deposit, per each wire transfer, and so on. They do not, however, have comparable financial information for the many vice presidents working on the second floor to the top of their building! The only financial information applied for those expenses is the annual budget plan, under which spending is monitored for each department or function only to see if the spending is under or over the budget.

When you ask people why, in their view, indirect and overhead expenses are displacing direct expenses, they almost invariably say that it is due to technology, equipment, automation, or computers. In other words, organizations are automating what were previously manual jobs. This cause is only a secondary factor. The primary cause for this displacement shift reflects the gradual proliferation in the diversity and variation of products and service lines that have occurred over the last few decades. Organizations now offer a greater variety in products and services and use more and different types of distribution channels to serve a wider variety of end users and service recipients. For example, manufacturers offer products with more colors and sizes. As another example, 20 years ago most entry-level soldiers in the US military were considered similar. But today, not only are extra expenses associated with the corps' composition (e.g., the influx of women), but there are many more different functions for which entry-level soldiers must be trained.

Greater variation and diversity (i.e., heterogeneity) creates complexity and in turn requires more indirect and overhead expenses to manage the complexity. Thus, a larger overhead component of expense does not automatically mean that an organization is becoming inefficient or bureaucratic. It may simply mean that it is offering more variety of products and services to a broader and more diverse array of recipients: citizens and stakeholders.

If you're not convinced by this explanation, the authors ask you to interview a long-time employee who is soon to retire. Ask someone in a manufacturing company, “How thick was your company's product catalog when you joined the organization, and how thick is it now?” For government employees, ask what types of citizens or government agencies the organization served at its creation, and how many more types it serves now. Their answers will reveal that the real reason for increasing overhead becomes evident. It is a result of increasing complexity needing to be managed.

Whatever the derivation of indirect support and overhead expenses, it is clear that traditional cost accounting methods have failed to meet the challenge. What ABC/M does is extend the visibility now pertaining to direct spending to illuminate what has for many organizations become the lion's share of spending – the indirect expenses. ABC/M then becomes an organization-wide method for understanding true work-activity costs and thus provides a reliable basis for predicting the outcome of decisions affecting the future.

ABC/M can also be used for calculating the output costs from direct expenses when the organization is not applying cost accounting.

ABC/M is a better gauge than benchmarking with blinders. Some governments and government organizations fool themselves into thinking that they are efficient when they benchmark their activities against similar activities performed by other governments or organizations. Their consulting firms sometimes even maintain benchmarking databases that are restricted to government agencies. The cost rates may be unfavorable relative to private sector companies, but without such comparisons, government agencies relying on benchmarked data may unknowingly continue to believe there is little room for improvement.

ABC/M can be used effectively either as an alternative to benchmarking or as a means of improving benchmarking as an informative tool. Alone, it gives management a true picture of cost/benefit relationships and thus a firm basis for effecting beneficial change. It can also serve as an essential adjunct to accurate and useful benchmarking. ABC/M requires standard activity and output “dictionaries.” These standard definitions enable apple-to-apples comparisons, rather than apples-to-oranges.

Acquiring accurate information about costs is one of the biggest hurdles for public officials trying to save money and improve services, particularly for newly elected or appointed officials. Reasonably accurate information about costs is a key to making almost every other change initiative possible. ABC/M information is an effective enabler. Yet most governments and government organizations simply do not have sufficiently good information about their costs – perhaps about their expenses, but not their costs.

WHAT ABC/M IS NOT

It is a mistake for ABC/M project teams to refer to ABC/M as an improvement program or a new change initiative. When that occurs, managers and employees often label the new project as a fad, fashion, or “flavor of the month.” ABC/M information is simply used as a means to ends. It makes visible the economics of the organization and the consumption of resource expenses by its work activities and the outputs that consume them. Money is continuously being spent on organizational resources whether ABC/M measuring is present or not.

ABC/M is analogous to a physician's stethoscope that allows listening to one's lungs and heartbeat. Your heart is beating and you are breathing regardless of the presence of the stethoscope. In a similar way, an organization is continuously burning up its resource expenses through its processes and the work activities that belong to them, and it then traces the activity costs to who or what is consuming the resources. This is occurring whether ABC/M is monitoring these events or not.

The authors are deliberately dumbing down and understating ABC/M for an important reason. In the early 1990s, when ABC/M was beginning to get serious attention, the management consulting community began selling the system as consulting services. Unfortunately, in those days the consultants hyped and oversold ABC/M as a magic pill that could possibly solve all of an organization's problems. This raised management's expectations too high. If the consultants did not solve the problems that their client thought it had engaged them for in the first place, the blame fell on ABC/M for not working. But ABC/M worked just fine. It is simply full absorption costing, but done correctly – complying with costing's causality principle. It was just that some of the consultants did not accurately sell the system to their client – nor at times adequately understand how to interpret and use the ABC/M information. But that has changed now. The consultants have realized that their value-add is to help their clients solve their problems, and the ABC/M information is an important enabler to the solutions to those problems.

In many cases, organizations oversized the initial ABC/M system (e.g., with 1,000+ activities) well beyond the size needed to see results and get quick hits. It is important that an organization realize early on that ABC/M provides fundamentally good information to be used for understanding, discovery, and decision-making. Then ABC/M is better positioned for longer-term and wider acceptance. Chapter 14 describes the rapid prototyping with an iterative remodeling implementation approach that prevents oversizing ABC/M with a “right-sized” costing system that is good enough for better decision-making.

So, the authors are deliberately managing expectations about ABC/M by reducing one's perceptions that it provides all the answers. ABC/M restacks the costs but does not root them out. ABC/M's information can be a great enabler for providing answers; the key phrase is that it is an enabler.

There are many acronyms related to organizational improvement, TQM for total quality management and BPR for business process reengineering, to name a couple. They all focus on continuing improvement of work and the pursuit of excellence in daily operations. Many of these programs emphasize the following:

• Management of processes rather than resources
• Elimination of waste

One common thread runs through all of these improvement techniques: a focus on work activities and their relationship to services or products provided to customers or citizens. ABC/M information can turbocharge all of these performance improvement programs. When ABC/M is combined with operational information, such as performance measures (e.g., the balanced scorecard's KPIs), it becomes an even more powerful tool in making sensible and substantial changes.

In the authors' opinion, it is inevitable that all organizations will eventually rely on some form of an ABC/M information system to assist in effectively managing their affairs. So there is no reason to hype or overstate the power of ABC/M. It will continue to claim widespread global acceptance simply based on its merits and based on the utility and benefits that the ABC/M information provides.

LET THE “HOW” AND “WHY” DRIVE THE EFFORT

In the end, 90 percent of ABC/M is organizational change management and behavior modification, and 10 percent of it is the math. This will be further discussed in Part Seven. Unfortunately, most organizations initially get those two functions reversed. They spend way too much time defining and constructing their ABC/M information system and very little time thinking about what their organization will do once they have the new ABC/M information. This presents a problem.

Poor implementation has adversely affected the rate of adoption of ABC/M. When ABC/M systems fall short of manager and employee teams' expectations, it is usually because the initial ABC/M system design was, as mentioned, substantially overengineered in size. The typical initial ABC/M system is usually excessively detailed and is well past diminishing returns on extra accuracy for each additional incremental effort of extra work to construct the ABC/M system. One manager reacted to seeing his first ABC/M report by saying, “I feel like a dog watching television. I don't know what I'm looking at!” With a fraction of the effort and in a much shorter timeframe, the implementation team could have started to produce reasonable and comprehensible results.

It is important to start getting results from ABC/M quickly because of the potential organizational shock that managers and employees may experience when they receive and view the new ABC/M information. That is, it is important to start realizing what kind of new (and possibly disturbing) information might come from ABC/M.

When people see the ABC/M information for the first time, they will see things they have never seen before – even though some of it will not be pretty. For example, there may be a manager who for years believed that his or her services were very efficient relative to those of other departments, functions, or agencies. But when ABC/M finishes more properly tracing the true consumption of expenses, the result may be an unpleasant surprise. The total costs of that manager's department services, as well as the calculated per unit costs per each output of service, may be well above comparable benchmarked costs of similar services elsewhere! That manager will not be happy to see this information, nor happy with whomever reported that information. Do not underestimate the level of resistance that can come from exposing managers and employees to the ABC/M information. You are dealing with human nature.

There is an important lesson here. Treat the ABC/M information responsibly. ABC/M is not an accounting police tool or a shame-and-blame tool, but rather an organization-wide managerial information system to be used for self-improvement. Its information is not intended to embarrass anyone and should not be used to punish anyone. In many cases no one really knew what the true costs were. Many suspected that the existing expense and cost allocations were wrong, but they did not know what the correct calculations would reveal. ABC/M finally gives managers and employee teams the hope that they can see the truth and reality. But seeing the information and using the information are not the same thing. There is much more thinking required when it comes to using the ABC/M information for managing and decision-making.

There is an old fable that says that all truth passes through three phases:

1. First, it is ridiculed.
2. Next, it is violently opposed.
3. Finally, it is accepted as being patently obvious.

Whether the perceived villain is the ABC/M method, or the costs of output information computed by the ABC/M system, keep this in mind. There will be resistance to ABC/M. And the resistance is not so much due to people being afraid of change – although that is a factor – but that they are afraid of uncertainty. The irony is that ABC/M information provides truth and reality, but until the ABC/M information is revealed, people are not sure what will be shown or how it might be used.

In short, even if an ABC/M system is in place, do not expect changes to automatically follow. Using the information is the hurdle.

COMMERCIAL BUSINESSES VERSUS GOVERNMENT ENTITIES

ABC/M advocates generally find the doubting Thomas syndrome more prevalent in the public sector than in the business world. In making their argument against the applicability of ABC/M to their work activities, government employees often cite two facts: (1) government does not operate with a profit motive in mind, and (2) government is normally a supplier of services rather than products. Both are true. In this part, we will look at these and other differences among ABC/M users as well as the growing similarities.

ABC/M has a different flavor when applied to not-for-profit organizations and governments rather than to commercial businesses. The general concepts of ABC/M remain foundational. But there are some different purposes and conditions that alter the focus and even the design of ABC/M for government organizations.

A significant difference in contrast to commercial businesses is a government agency's absence of a profit- and wealth-maximization motive. The system of reporting layers of profit contribution margins used by commercial organizations to focus on opportunities is meaningless. Some quasi-private public sector organizations, such as a military base commissary, pursue full cost recovery through pricing and fees, and do not have to maximize profit to enhance the owner's or investor's wealth. Just breaking even with the sales revenues recovering the total costs may be the goal.

Many other public sector organizations have no fee or price structure and no revenues from buyers or consumers. The organization is funded with a spending budget issued by an authorized body, such as a municipal board of directors or the US Congress, and it delivers services to other agencies or citizens without any exchange of payments. A local police or fire department and a national aviation agency are examples. Citizens are not expected to purchase their safety in pieces or on an as-needed basis; it is an expected service.

Another difference between the private and public sectors involves the targeting of specific markets and customers. Not-for-profit and government organizations usually do not have the luxury of determining whom they wish to serve. Tax authorities deal with all taxpayers, and their work is defined by law. Public hospitals are required to attend to all patients, water municipalities cannot easily withhold their product from different groups in society, and so forth. Not-for-profits cannot simply abandon or ignore certain types of recipients of their products or services, even those making relatively high demands. Hence, they cannot easily adjust their cost structure by simply targeting certain groups to serve or to avoid in the way that commercial businesses can.

Despite these differences, the similarities between commercial and not-for-profit organizations are substantial and growing with time. There is a convergence with their uses of modern managerial improvement methods. Some public sector agencies are managed indistinguishably from for-profit businesses. They are increasingly adopting private sector business practices, and in some cases are competing with commercial businesses. They can and do benefit from the same management tools and techniques used by the private sector. For example, when a government agency introduces a previously nonexistent surcharge or converts to a fee-for-service arrangement, isn't this comparable to a commercial business charging higher prices to those willing to pay more in exchange?

SERVICE-BASED VERSUS PRODUCT-BASED ORGANIZATIONS

In an earlier reference to outputs such as “finished reports” that may be intangible but can still be defined, we were distinguishing between cost structures of product makers and of service providers. As pointed out, ABC/M and its costing principles are applicable to either case. This is because ABC/M is concentrating on how any output is consuming the work activities, including whatever expenses support those work activities.

However, a few differences between a service provider and a product maker/distributor with a high reliance on equipment are important:

• In service organizations, the resources generally are more flexible and interchangeable than in capital-intensive organizations where equipment may be dedicated to making only certain products or only doing certain things. In service organizations, some people can multitask or move among different tasks. In contrast, in capital-intensive companies that make and distribute products, the moment that their equipment is purchased, they have committed themselves to a certain level of available capacity (and cash outlay expenses) regardless of the level of subsequent use of that equipment. Service companies effectively have the luxury of “postponing” the addition of resources – mainly workers – until they are needed. In short, service companies can more quickly adjust the level of their capacity. With people as their most flexible resource, it is also the capabilities, not just the capacity, of their workers that allow more variety of outputs to be delivered. The more capabilities, the more flexibility. That is one reason that organizations are increasingly investing in training and education of their workforce, and even their suppliers' and contractors' workforces.
• When an organization is operating at near full capacity and needs to significantly alter its own cost structure, service organizations have an advantage over a hard goods provider. Presuming that the service organization in this case is truly as lean and agile as it can be, it can still alter its own cost structure by influencing the “future demand workload” side of the supply-and-demand equation. It may be able to offer a greater number of service level options (with varying prices or promotional features) to induce customer behavior more in harmony with its cost structure. Providing service-level options would be similar on a personal basis to choosing to ship a package with overnight delivery or with two-day, three-day, or other rates. By inducing the customer or service recipient to make the appropriate choices, an organization can shift the demand workload away from workers operating at full capacity and toward workers with some idle and unused capacity.

In the end, if one steps back and views service sectors versus product making sectors, the two forms appear to converge. There are more similarities than dissimilarities. ABC/M can be easily modeled for both forms using common ABC/M principles. If anything, service organizations arguably have some advantages in adapting to the guidance provided by use of an ABC/M model.

Chapter 10 will expand on applications of ABC/M.