Cost Management Systems

This article focuses on the tools that a cost accountant may need to use in order to supply managers with the information they require in order to make decisions for the organization. There is an exploration of the activity based costing (ABC) cost management system as well as a comparison between the ERP and BoB applications.

Cost accounting is a type of accounting which measures, analyzes and reports financial and non-financial data relating to the cost of acquiring or using resources in an organization. Cost accounting assesses product cost information that can be used by internal and as well as external decision makers. These decision makers need reliable information in order to assist the organization in developing their mission, vision and objectives. This information is also helpful when an organization is in the process of implementing a new strategy, devising and controlling the value chain, and evaluating organizational performance. By providing managers with such pertinent information, they will be equipped to complete their established goals.

Financial Accounting vs. Strategic Cost Management

Financial professionals such as cost accountants are primarily responsible for providing managers with information about cost and benefit measurements. However, cost accounting tends to be of limited value to some managers because they are focused on financial accounting issues. There are differences between financial accounting and strategic cost management.

• Financial Accounting: Cost information may be highly aggregated, historical and must be consistent with GAAP.
• Strategic Cost Management: Cost information may be segregated, current and relevant to a particular purpose.

In order for cost accountants to be effective in completing their jobs, they will need assistance such as that provided by a cost management system which collects data and information. Such systems help to provide managers with the cost and benefit information they need to make decisions for the organization.

Characteristics of Successful Cost Management Systems

A cost management system (CMS) consists of methods that are developed to assist in the planning and controlling of an organization's cost managing activities in the short and long term. As managers develop their strategies, they must address two main challenges -- profitability in the short term and securing a competitive position in the long term.

Key Roles of a Cost Management System

In addition, there are two key roles that a CMS should address. It should be able to:

• Manage the organization's core competencies in order to take advantage of opportunities and minimize potential threats.
• Link plans and strategies to the organization's performance.

Primary Goals of a Cost Management System

The primary goals of a cost management system are to:

• Develop accurate product costs.
• Assess product/service life-cycle performance.
• Improve understanding of processes and activities.
• Control costs.
• Measure performance.
• Allow the organization to pursue different strategies.

A good CMS should be able to:

• Provide a way to develop accurate product and service costs. Product and service costs are a factor when managers are planning, preparing financial statements, and assessing employee performance and productivity.
• Provide information about the life cycle performance of a product or service. The financial statements do not list this type of information; therefore, it is imperative that financial professionals are able to collect the information from another source. This type of information will allow managers to assess costs incurred in one stage to the costs and profitability of other stages.
• Control costs.
• Generate information that will assist managers with measuring and evaluating performance.
• Generate information that allows the managers to define and implement organizational strategies.

Designing a Cost Management System

There are many factors to consider when designing a cost management system. However, one of the key factors is the need to integrate the organization's current information system. When evaluating this possibility, one should ask the following questions:

• What input data are being gathered in what form?
• What outputs are being generated and in what form?
• How do the current systems interact with one another, and how effectively?
• Is the current chart of accounts appropriate?
• What significant issues are not being addressed by the current system, and could these be integrated into the current "feeder" systems?

Motivation, information and reporting are three primary components of a cost system. An example of the motivational component is the use of performance rewards for the top management team when they reach goals. Performance rewards could be short term (i.e. cash) or long term (i.e. stock options). The informational component focuses on whether or not there is a strong foundation for the financial budgeting process. An example of the reporting component is the continual collection of basic financial information such as statements.

Activity Based Costing

In the past, many cost accountants would randomly add a broad percentage of expenses to the direct costs in order to account for the indirect costs. This practice became a problem when indirect and overhead costs started to rise. The cost accountants realized that the technique they had been using was not accurate. As a result of this situation, the accounting field sought to find a solution and the concept of activity based costing was developed. Activity based costing (ABC) can be defined as a method of allocating costs to products and services. It is a management tool that provides better allocation of resources; is applicable to both appropriations and revolving funds; and relates total costs (resources consumed) to work accomplished (outputs produced) (OSD Comptroller iCenter, n.d.). In most cases, outputs are:

• Produced to satisfy customer requirements
• Quantifiable, measurable, and auditable
• Consistent from fiscal period to fiscal period to allow cost comparisons
• Incorporated into existing or modified financial management systems
• Identifiable so that costs can be more easily allocated

Development of Activity Based Costing

Activity based costing was first introduced in U.S. manufacturing companies during the 1970s and 1980s. In 1988, Robin Cooper and Robert Kaplan began to promote the concept as a solution to problems created by traditional cost management systems. Activity based costing was seen as a way to provide managers with accurate information so that they could make the best decisions. Many experts believe that this method is the best way to measure an organization's performance (Accounting Software Research, n.d.). The method can estimate costs for specific activities that occur in the organization.

Uses of Activity Based Costing

Many will use the system to:

• Focus on the total cost to produce a product or service.
• Have a system to serve as a basis for full cost recovery.

Benefits of Activity Based Costing

According to Value Based Management.net (n.d.), some of the benefits of activity based costing are that it can:

• Identify the most and least profitable customers, products and channels.
• Determine the true contributions to and detractors from financial performance.
• Accurately predict costs, profits and resource requirements associated with changes in production volumes, organizational structure and resource costs.
• Identify the root causes of poor financial performance.
• Track costs of activities and work processes.
• Equip managers with cost intelligence to drive improvements.
• Facilitate better marketing mix
• Enhance the bargaining power with the customer.
• Achieve better positioning of products (par. 2).

ABC has the potential to identify, describe, assign costs and report on a company's operations. It can assist in improving business process effectiveness and efficiency by determining the true cost of a product or service. In most organizations, the true cost is critical because it identifies products and services that make and lose money; finds an economic break-even point; allows different options to be compared; and creates opportunities for cost improvement and strategic decision making. The OSD Comptroller iCenter (n.d.) has reported that some of the advantages of using the system are:

• It avoids or minimizes distortions in product costing that could be a result of arbitrary allocations of indirect costs.
• It can generate useful information on how money is being spent, if a department is being cost-effective, and how to benchmark for quality improvements.
• It provides a clear metric for improvement by encouraging managers to evaluate the efficiency and cost effectiveness of program activities

Implementing an Activity Based Costing System

In addition, the center has listed a four part process in implementing an activity based cost management system.

• Identify activities. The cost accountants will conduct an in-depth analysis of the operating process of each responsibility unit. Each process may consist of one or more activities required by the outputs.
• Assign resource costs to activities. This step is sometimes referred to as tracing, which refers to the ability to trace cost to cost objects in order to determine why costs were incurred. There are certain organizations (i.e. Department of Defense) who will divide the costs into categories such as:
• Direct. Costs that can be traced directly to one output.
• Indirect. Costs that cannot be allocated to an individual output.
• General and Administrative. Costs that cannot reasonably be associated with any particular product or service produced (i.e. overhead).
• Identify outputs. The decision makers will identify all of the outputs for which an activity segment performs activities and consumes resources.
• Assign activity costs to outputs. The final step involves the assignment of activity costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs' consumption or demand for activities.

Application

Software for Business

Many organizations adopted the use of computers in their business practices in the early 1960s, and the main purpose was to provide a simple way of automating many of the routine business tasks that had been performed manually. Sometime during the 1970s, some organizations elected to customize software packages to meet the needs of their individual businesses (Moriarty, 1999; Shields, 2001 & Davenport, 2000). As a result, these organizations felt a need to have someone overseee sure the systems were meeting the needs of the organization, especially as related to financial transactions. Given the nature of the system, some organizations have the information systems department reporting to the controller or vice president of finance (Shields, 2001). Vendors started to offer fully integrated suites of applications during the late 1980s, and the enterprise resource planning (ERP) packages became popular in the 1990s. There was a high demand for these packages because organizations realized that they had to (Davenport, 2000; Moriarty, 1999; Shields, 2001 & Scapens, 1998):

• Maintain high cost legacy systems
• Continually look for new functionalities
• Address Y2K issues
• Keep pace in making sure that their systems were prepared to operate in a global economy

At some point, the chief financial officer may request a gap analysis to be conducted of the system in place. A gap analysis is the study of the differences between two information systems. One of the reasons why it is conducted is to make sure that the organization is utilizing the best system. The goal of a gap analysis is to look for ways to reduce gaps that may be hindering the benefit and cost effectiveness of the system to the organization.

Enterprise Resource Planning Software

"Single vendor-based enterprise resource planning (ERP) software became the dominant strategic platform for supporting company-wide business processes" (Hyvonen, 2003, p. 156). Many organizations used an enterprise resource planning (ERP) system in order to link their feeder systems into an integrated cost management system, which will allow them to:

• Standardize information systems and replace different "legacy" systems
• Integrate information systems and automate the transfer of data among systems
• Improve the quality of information, including purchase preferences of customers
• Improve the timeliness of information by providing real-time, on-line reporting

ERP System vs. BoB System

Although this was the favored method (Cooper & Kaplan, 1999), many expressed concern about the system's ability to have the proper degree of flexibility in order to meet organizational and industry requirements (Booth, 2000; Davenport, 2000 & Light, 2001). Given these concerns, there were some companies that continued to "use conventional best of breed (BoB) or standalone system components of standard package and/or custom software" (Hyvonen, 2003, p. 156).

Hyvonen (2003) conducted a study to evaluate how organizations determine if they should use an ERP or BoB system, especially as it related to management accounting functions. His data was gathered by mailing questionnaires to large and medium-sized industrial business units in Finland. The questionnaire highlighted questions that dealt with the background regarding the organization's implementation of its information system, perceived problems with the management accounting function, and the adoption of modern cost accounting and management accounting techniques. The results showed that:

• When the IS project was introduced by the financial department, the solution tended to be BoB. However, when the idea originated from another department, the solution tended to be ERP
• The two most articulated motives behind IS projects were the Y2K problems and the need to develop business processes. Therefore, information systems may be installed for technical reasons or to enhance strategy and competitiveness. It was found that a technologically focused implementation was intended only to provide core information systems functionality to an organization, with little business change as possible

Viewpoint

According to Rogoski (2004), all expenditures and billings recorded will end up in the financial department. Unfortunately, most clinical applications and financial applications do not work together. They work independently, which causes duplication of efforts for the employees that have to process the information. As a result of this problem, some vendors have chosen to create fully integrated clinical and financial software while others continue to sell whatever is best at the time (best of the breed philosophy). Many chief financial officers are electing to do business with those organizations that create information systems that will satisfy their organization's needs.

Top leaders such as Ron Bunnell, CFO of Banner Health, and Dan Deets, CFO of Hunterdone Healthcare, Inc., have found that they have access to information that they need to cap costs and improve efficiencies in delivering healthcare services as a result of integrating the clinical and financial systems. The integrated systems provide a better way to track the inflow and outflow of revenue for both clinical and business initiatives. Having the ability to have access to all types of financial data has provided the CFOs mentioned above the opportunity to have more negotiating power when dealing with managed care contracts. There is an ability to monitor the relationships that these healthcare systems have with payers over a period of time. In addition, the integrated systems allow the healthcare organizations to identify weak areas that need to be improved so that they can increase their revenue.

Conclusion

Financial professionals such as cost accountants are primarily responsible for providing managers with information about measurements of costs and benefits. In order for cost accountants to be effective in completing their jobs, they will need assistance such as that provided by a cost management system. The cost management system helps to collect the cost and benefit information managers need in order to make decisions for the organization.

In the past, many cost accountants would randomly add a broad percentage of expenses to the direct costs in order to account for the indirect costs. This practice became a problem when indirect and overhead costs started to rise. The cost accountants realized that the technique they had been using was not accurate. As a result of this situation, the accounting field sought to find a solution and the concept of activity based costing was developed.

However, there have been reports that suggest that ABC loses power in large-scale operations, and can be difficult to implement and maintain (Kaplan & Anderson, 2005). As a result, Kaplan and Anderson (2005) made a recommendation that would simplify the process through an approach called "time-driven ABC."

Hyvonen (2003) conducted a study to evaluate how organizations determine if they should use an ERP or BoB system, especially as it related to management accounting functions. Some of the results from one of his research questions showed:

Adopters of BoB ERP Total N % of all respondents Activity-based Costing 35% 65% 100% 23 27% Target Costing 29% 71% 100% 7 8% Life-cycle Costing 50% 50% 100% 4 5% Activity-based Management 25% 75% 100% 8 9% Balanced Scorecard 38% 62% 100% 21 24%

Terms & Concepts

Activity based costing (ABC): A method of allocating costs to products and services.

Activity Based Management: Similar concept to activity based costing. However, activity based management analyzes activities for their degree of customer value-added. After identifying activities that add little or no customer value, Activity Based Management Cost System looks for ways to reduce or eliminate them by redesigning activities and processes.

Balanced Scorecard: An analysis technique designed to translate an organization's mission statement and overall business strategy into specific, quantifiable goals and to monitor the organization's performance in terms of achieving these goals.

Cost Accounting: The process of identifying and evaluating production costs.

Cost Management System (CMS): The process whereby companies use cost accounting to report or control the various costs of doing business.

Enterprise Resource Planning (ERP) System: A business management system that integrates all facets of the business, including planning, manufacturing, sales, and marketing. As the ERP methodology has become more popular, software applications have emerged to help business managers implement ERP in business activities such as inventory control, order tracking, customer service, finance and human resources.

Financial Accounting: Reporting of the financial position and performance of a firm through financial statements issued to external users on a periodic basis.

Life Cycle Costing: A process to determine the sum of all the costs associated with an asset or part, including acquisition, installation, operation, maintenance, refurbishment and disposal costs.

Target Costing: A disciplined process for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future.

Bibliography

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OSD Comptroller iCenter (n.d.). Activity-based costing. Retrieved August 6, 2007, from www.defenselink.mil/comptroller/icenter/learn/abconcept.pdf.

OSD Comptroller iCenter (n.d.). Accounting for operational readiness. Retrieved August 6, 2007, from www.pentagon.mil/comptroller/icenter/learn/abconcept.Htm.

Rogoski, R. (2004). Investment pay off with financial information systems. Health Management Technology, 25(8), 14-17. Retrieved August 6, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23676885&site=ehost-live

Scapens, R., & Jazayeri, M. (1998). SAP: Integrated information systems and the implications for management accountants. Management Accounting: Magazine for Chartered Management Accountants, 76(8), 46-48. Retrieved August 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=1085898&site=ehost-live

Shields, M. (2001). E-Business and ERP: Rapid implementation and project planning. New York: John Wiley.

Value Based Management.net (n.d.). Activity based costing. Retrieved August 6, 2007, from http://www.valuebasedmanagement.net/methods%5Fabc.html

Suggested Reading

Beheshti, H. (2004). Gaining and sustaining competitive advantage with activity based cost management system. Industrial Management & Data Systems, 104(5), 377-383.

Irani, Z., Ghoneim, A., & Love, P. (2006). Evaluating cost taxonomies for information systems management. European Journal of Operational Research, 173(3), 1103-1122.

Nicolaou, A. (2003). Manufacturing strategy implementation and cost management systems effectiveness. European Accounting Review, 12(1), 175-199. Retrieved July 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9683551&site=ehost-live