About This Chapter
The essence of a successful organization is the ability to plan and control costs and to have the information to make viable financial decisions. To carry out these activities, managers need data that are relevant to their responsibilities and that are received in sufficient time to take action. They also need to understand the terms and definitions used in relation to the costs of various activities and feel confident in engaging, manipulating, and analyzing cost information.
To meet managers’ needs for cost information, a significant part of management accounting is concerned with cost accounting, which is based on collecting and analyzing both financial and quantitative data. Traditionally, cost accounting concentrated on specific, detailed historic costs over a short time period. Increasingly, cost accounting is becoming future oriented and more concerned with internal and external costs. The time frame for strategic cost accounting has become elongated, and attention is paid as much to the why of a situation as to the what. Costing has become not just a method of data collection but an important indicator of how to better manage the organization in pursuit of its strategy.
Types of Accounting
Accounting has a long history if one accepts the broad definition of keeping records of economic activities. There is evidence that the practice can be traced back for thousands of years.1 A critical milestone in accounting was the publication in Venice in 1494 of Pacioli’s Summa de Arithmetica, Geometria, Proportioni et Proportionalita. It is argued that this guide to bookkeeping revolutionized commerce throughout Europe and accountants apply the same principles today.2
There have been many changes in accounting over the last 500 years. The developments over that time in the UK have been documented,3 and those with a shorter history in the United States.4 Accounting records are a source of historical practices and provide information on changes in accounting applications, organizational structures, and management practices.
Most of the early history is concerned with accounting information that is intended for the owners of a business. Not only would they want to know whether the business was profitable on a yearly basis but they would also wish to scrutinize the money they were owed and the money they owed to others. As businesses became larger and more complex, with managers in charge of daily operations, so did the nature of the accounting information required. The owners required more detailed information, on different sections and activities of the business. They also wanted the information more frequently.
This change in demand for different types of information led to a new type of accounting. The method of accounting for the entire business became known as financial accounting, and the more detailed accounting was named cost accounting. There is general agreement that this “new” type of accounting became firmly established in the 19th century. Businesses were beginning to perform many internal processes that had previously been outsourced to independent craftsmen. There was a need for internal financial information, and cost or management accounting was the answer.5
The term “cost” accounting tends to refer to the actual methods and techniques for identifying the total costs of each part of productive activity. These results are usually compared with past or planned results. Management accounting is reporting the results to internal managers. This may be on a monthly, weekly, or in some instances on a daily basis. The terms are sometimes used interchangeably, but we will refer to cost accounting as the process of collecting the data and to management accounting as the reporting of information. Both manufacturing and service organizations use cost/management accounting. It is important to emphasize that there are no regulations requiring organizations to use cost/management accounting.
Before we concentrate on strategic cost analysis (SCA), we will summarize the characteristics of the two types of accounting you may encounter.
The dominant characteristics of financial accounting are as follows:
•It is intended to provide information in the form of structured financial statements.
•The information will be the financial performance, financial position, and cash activities.
•The statements will be for a period of time, at least annually but for larger companies also half-yearly and sometimes quarterly.
•The recipients of the information are considered to be external and mainly investors or lenders.
•The form and content of the financial statements are highly regulated. In the United States, the regulations are issued by the Financial Accounting Standards Board. Many other countries, including members of the European Union, follow International Accounting Standards.
•For larger companies, particularly those whose shares are listed on a Stock Exchange, the financial statements are considered a public document.
The dominant characteristics of cost/management accounting are as follows:
•It is collected, collated, and communicated to managers for planning, control, and decision making.
•It is intended for an internal audience and is voluntarily implemented by an organization to meet its own needs.
•There are no regulations controlling the cost information an organization uses.
•There are several techniques that fall under the heading of cost accounting. Organizations use the techniques that best meet their needs and will revise and refine the techniques, if necessary, to be applicable to their own detailed operations.
•Management accounting information is private to the organization and usually is not publicly available.
Some organizations may extract their data from the same records both for financial and for management accounting reporting. The main purpose of the original records is to produce data for financial accounting. Although the records may be suitably flexible to extract appropriate cost data, the core concepts of financial accounting tend to be pervasive, for example, determining which transactions are deemed as revenue expenses and counted as costs in the current financial period and which transactions are capital expenses and appear on the organization’s balance sheet. In this book, we assume that organizations have the technology and knowledge to have a specific cost accounting system.
The relationship of the two accounting systems is most visible in the following:
1.Listed companies in North America are required to produce interim financial statements quarterly and in the UK biannually. Usually, the cost data for these periods must be aligned with the financial disclosures. It would be imprudent for a company to disclose quarterly or biannual financial information that does not relate to the cost information available internally and that does not produce information that enables reasonable predictions of the annual financial results.
2.Different cost accounting methods have their own specific issues. Process costing used in many companies has some specific problems, one being finding the cost of finished inventory and work in process. This information is required to meet financial accounting regulations. It also meets financial disclosure needs and provides valuable cost information. We will consider process costing in Chapter 2.
3.Cost accounting, as with financial accounting, uses the “accruals” concept of accounting for transactions. This means that transactions are recognized when they take place and not when cash is received or paid. Although the events may be simultaneous, such as when you pay at the checkout of a supermarket, in business there is frequently a delay between delivery of goods and payment for them. Often, transactions are complex, and accounting standards set out the requirements for these transactions to be recognized for financial accounting purposes, but these also frame the cost for strategic cost purposes.
Financial accounting requirements are complex. We do not wish to overemphasize the influence of these requirements on strategic cost accounting, but it is important that you are aware that sometimes the reasons for unresolved issues may lie with financial accounting requirements and not the methods and techniques of strategic cost accounting.
Strategic Cost Analysis
SCA helps companies identify, analyze, and use strategically important resources for continuing success.6 The technique focuses on an organization’s various activities, identifies the reasons for their costs, and evaluates strategies for creating a sustainable competitive advantage. The technique provides organizations with the total costs and revenues of strategic decisions. This requires creative thinking, and managers need to identify and solve problems from an integrative and cross-functional viewpoint. Examples of SCA include the following:
•Deciding on product mixes and production volumes
•Outsourcing decisions
•Cost reductions
•Investment and profit growth in different markets
•Responses to suppliers’ and competitors’ activities
•Changes in consumer demand
In this chapter, we explain the four key questions to which, as a manager and regardless of the type of organization, you will need the answers. We consider the different types of organizations and how the nature of their activities influences cost methods and techniques. We also explain your need for different forms of cost information to plan, control, and make decisions. The penultimate section explains the process of SCA.
Before you continue with the chapter, we wish to emphasize that strategic cost accounting is entirely a voluntary practice carried out by organizations. There are no rules or regulations that indicate how strategic cost accounting should be conducted. It is entirely the responsibility of management to determine their needs. If the cost information generated is of no value to managers, it should be abandoned.
As strategic costing systems are designed to satisfy the needs of managers within an organization, the application and terminology of specific costing methods and techniques may develop within the culture of that organization and not correspond exactly with the terms commonly used in the literature. As long as you understand the concepts and the principles, this should cause no problems.
The Four Key Questions
What Did It Cost and Why?
This is possibly the most frequent question asked by managers, to which the answers given by accountants are usually misunderstood. The term “cost” is slippery and defies one simple definition. It is therefore helpful to describe and classify the term in a variety of ways. Precision can first be given to the question by defining what is meant by “it,” which is known as the cost object.
A broad definition of a cost object is anything for which cost data are required. This can refer to labor, materials, products, services, organizational subdivisions such as departments or divisions of a company, or specific activities. The term is also used to refer to a measure of organizational output, and we discuss the various types of output later in the chapter.
As well as defining the “it” for which you require cost data, you will also need to specify the nature of the cost. Are you only interested in the cost of material used in manufacturing a product, or do you also need to know the cost of the machine time taken in manufacturing? There are various bases of classification and, importantly, as we will see in Chapter 2, the amount of “cost” for a particular unit of production or service can change depending on the level of activity.
The more precise you are in referring to the nature of the cost, the better your analysis of cost data is. You want to know not only what a particular cost is but also how you can analyze the data effectively to enhance your managerial performance.
This question is about setting standards and conducting comparisons. The present cost can be compared with the following:
•Previous costs for the same activity. This will show whether we did better or worse than for a prior period of time. Unfortunately, all the errors and deficiencies in incurring the previous cost may obscure whether performance has improved.
•Costs for alternative courses of action. This could arise from outsourcing or switching to different products or processes.
•Planned costs. These will involve the careful assessment of predetermined costs for a specific period of time. Most organizations have some form of budgetary control system.
•Costs of external organizations. This information may be difficult to acquire, but strategic competitiveness should be a part of an organization’s portfolio. We consider this topic in the final chapter when we discuss Big Data.
In Chapter 3, we explain standard setting, and you will probably find that you will be involved in this activity in the organization where you work. There may be a system of standard costing or of budgetary control or both. Planning future costs is a major part of these costing techniques.
How Can We Improve?
Improvement usually relates to change that involves determining appropriate financial measures for a particular activity and monitoring changes in performance. Establishing appropriate measures usually presents problems, and a variety of solutions can be employed. At the organizational level, financial measures such as profit as a percentage of the investment in the company may be used. Where information is available, similar measures can be made at the divisional level. As a manager, you have a certain area of responsibility, and your focus is on how you manage the performance of your responsibility area and how you can improve it.
Cost accounting is an internal information system used by managers, and usually performance measures are related to costs incurred and can be compared with one of the aspects discussed in the previous section. You need to be able to analyze your actual performance compared with that expected and make decisions about improvements. This material is covered in both chapters 4 and 5.
What Is Our Next Strategic Move?
Whatever your responsibility level in an organization, your performance is aligned with corporate strategy, and you may be involved in determining the strategy of the organization where you work. In the context of SCA, what is your contribution? In a survey of 500 market leaders, three distinct strategies used by top performers in 2012 were identified.7 One of these was cost and complexity reduction to make operations more flexible, leaner, and more accessible to customers. Whether you are working in a service company, a manufacturing company, or some form of public organization, the benefits of cost and complexity reduction can decrease the financial outlay in bringing the product or service to the customer.
You will have the challenge of attempting to introduce cost and complexity reduction so that the organization, and your part of it, is highly responsive to customer demand and recognizes local and global business conditions and economic events. In Chapter 6, we explain how certain techniques of SCA can help you to achieve this.
Making the Fit
We observed earlier that management accounting and cost accounting are internal systems unfettered by regulations. Managers in the organization decide the types of cost information they require. This structuring of the system by managers is known as contingency theory, which postulates that organizational structures and systems are a function of environmental and firm-specific factors.8
If you work in a large organization, you will find that the management accountant is usually responsible for providing cost data analyzed in a particular way. In a smaller organization you may find that you have to collect the cost information. The following factors generally shape the costing system:
•The type of organization
•The size of the organization
•The output from the activity
•The purposes for which the cost information is required
These factors determine the techniques selected when presenting information in a form that can be analyzed to support and monitor strategic decisions.
The Type of Organization
Cost accounting is practiced in hospitals, banks, universities, and manufacturing companies and by plumbers, electricians, landscape gardeners, charities, and any other organization or individuals who need to know the financial consequences of the activities they undertake or plan to undertake. In many instances, managers want to know the cost of a specific output from an activity, as that forms the basis of the price to be charged.
In non-profit organizations, the total amount of funds available for a period of time or a specific range of activities is predetermined. Thus, managers must ensure that the costs for which they are individually responsible fall within those limitations. Strategies will have financial boundaries set on them by external factors, such as donations and government grants. The country in which the company operates can also have an impact. In a comparison of the strategic management practices of Fiat and Toshiba, the authors concluded that some relevant differences appear to originate from typical cultural differences between the Western and the Japanese worlds.9
You should bear in mind that organizations have very different activities. Some will be manufacturers with substantial production facilities. Others will be merchandising companies that do no manufacturing but buy in their goods and sell them at a profit. A very large sector of the economy comprises service organizations and, within this category, you have a great diversity ranging from financial institutions to hospitals, hotels, airlines, and others. They all have a need for cost information, but the type of organization will determine the nature of information the managers require.
As well as calculating the costs for specific outputs, an organization may wish to know the cost of operating one identifiable part of the organization. For example, an engineering organization may wish to know the monthly cost of running a maintenance department; a municipality may wish to know the cost of operating a garbage collection; a publishing firm, the cost of its art department. These are examples of cost centers or pools, which are identifiable parts of an organization for which costs can be collected and analyzed. We discuss these further in Chapter 2.
Organizational Constituents
Managers need cost information to plan, monitor, and control the organization’s performance. But there are many external groups that have an interest in an organization’s performance, and their expectations may influence the nature of the cost information and the assessment of performance. These stakeholders may have differing objectives that influence their assessment of the organization’s performance. These influences also affect strategy choices, and cost analysis is needed to assess the financial constraints.
Commercial organizations quoted on a stock exchange have investors who are conscious of the “market” expectations for profit. All organizations have employees who will be concerned with job security and career progression. Customers, suppliers, and even society have expectations and vested interests in the organizations. Managers will be aware of these when reporting their key performance indicators (KPIs).
The potential impact of external expectations on organizational financial performance was investigated in a project that examined the Central Bank of Norway and a large university hospital in the same country.10 The research assessed society’s expectations of the financial performance of each and the impact on the disclosure of financial results as revealed by their budgeted achievements.
The managers responsible for the approval of budgets in the Bank were aware that society expected that the Bank would operate within its budget. The managers, therefore, set a budget at a high enough level to ensure that at the year’s end there would be no spending in excess of the budgeted amount.
The hospital’s mission was service to the community, and their responsibility, as seen by the community, was to treat as many patients as necessary, even if that meant exceeding the budget. With changes in patients’ treatments and increases in activity, a budget overspend was regarded as evidence that the hospital required greater funding to satisfy the expectations of the community.
This unusual but interesting example demonstrates that strategic cost accounting is framed by the expectations of various groups and is closely connected to human behavior. When using strategic cost accounting, therefore, you must be alert to which group is the main finance provider to the organization and which groups are the main beneficiaries. These are frequently different groups.
Output from Activities
Organizations produce an output, which may be readily identifiable, or a performance measure can be devised. This is sometimes referred to as a cost object, as defined earlier, although the term cost unit may be used to refer to one single measure of output, whether this is a product such as a bottle of detergent or a service such as a night in a hotel.
A specific definition of a cost unit is a quantitative unit of the product or service to which costs are allocated. In Europe, the term “cost unit” is frequently used to refer to one measure of output, although cost object is commonly used in North America. In this book, we will use the term “cost unit,” where it is clear that we are referring to one unit of output. You should find out the term used in your company and the measure of output to which it refers.
The nature of the output will determine the cost object. For example, a large accounting firm carrying out audits may consider the cost object is related to a certain client: the audit job that the firm performs. A garage may also consider its cost object as a repair job insofar as it does a specific task for an identified client. A construction company building a new hospital will consider this a cost object, although it may take several years to complete.
Other organizations may have output that is continuous. A paint manufacturer will not produce a can of paint specific for one customer but will produce daily hundreds or thousands of cans of paint that may be purchased by anyone. The paint manufacturer will therefore want to know the cost of one can of paint. Service companies may also offer an output that is (to all intents and purposes) continuous, although there may be an identified customer. Usually that output is not tangible, and a performance measure must be devised that is useful to the company. For example, a hotel may want to know the cost of an occupied room for one night.
An organization such as a recreation center may offer clients a range of pursuits such as swimming, volleyball, or badminton. The cost information they will most likely collect is the cost per hour or day of offering each of the different activities. Other organizations that offer clients a standard service, such as a beauty salon, may wish to know the average cost of offering each of the standard services.
Managerial Information Needs
In a small business, the owner may be the only “manager.” The cost system is likely to be rudimentary and informal. The owner is likely to make all the decisions, and the performance measure is of the entire business and not different parts of it. The relationship between cost analysis and strategy is likely to be very strong, with only one person using the financial information to make unilateral decisions. However, it is unlikely to be sophisticated.
As a business grows, delegation of decision making takes place. Managers need to receive quantitative and financial data on which to base their decisions. As a manager, you wish to know the cost of the products or services for which you are responsible or the costs of operating your specific area.
To assist in identifying costs that are the responsibilities of specific managers, larger organizations are divided into various functional areas or centers. If you are the manager of a responsibility center, you normally participate in the objectives of that center, and you are given some discretion on their achievement. The cost data that you receive assist you in analyzing your performance.
The centers that you find in an organization are adapted to the nature and purpose of the organization but usually fall under one of the following four categories:
•Cost centers (CCs), to which costs are attributed but not revenues or capital. A cost center does not generate external revenue. For example, in a manufacturing organization, the maintenance department or security would be a cost center. For a magazine publisher, the section providing artwork could be a cost center.
•Revenue centers (RCs), to which revenues are attributed but not costs or capital. The costs of running the revenue center itself are allocated and monitored to the center but not the costs of generating products or services.
•Profit centers (PCs), to which costs and revenues are attributed but not capital. This could be a shop in a chain of retailers or a division of a large company.
•Investment centers (ICs), to which costs, revenues, and capital are attributed. This is possibly the largest type of responsibility center, as the manager will be responsible for resource funding (capital) decisions.
The Process of Strategic Cost Analysis
Some view SCA as a collection of new topics—the value chain, a balanced scorecard, and added economic value, among others—but it is much more than that. It is a different way of viewing cost management.11 SCA is about helping organizations succeed, and this means employing different cost management techniques in different circumstances.
Although we have explained in this chapter that traditional costing as a subject is an internal process shaped by the needs of the organization and the managers within it, SCA is externally as well as internally focused. In a study examining the use of cost information for strategic purposes, Al-Hazmi concluded that “cost information is being used in management thinking to support strategic development in meeting competitive pressures and in restructuring and the reconfiguration of business strategy.”12
Attempts have been made to identify and classify the various techniques that can be used in strategic management accounting. Cadez13 drew together and added to previous contributions to construct a taxonomy of 16 techniques sorted into five categories, with strategic costing falling under the strategic decision-making category. The analysis provides a useful overview for identifying techniques and their categories. It also emphasizes the importance of strategic cost accounting for the short-term and long-term management of an organization. However, it tends to delineate the techniques too distinctly without reflecting their integration and how the dynamism of the subject and the use by companies generate new and fresh practices.
You may be working in an organization that has a traditional costing system concerned mainly with collecting data from past production processes. The question arises as to how you convert that system so you can achieve the benefits that strategic cost accounting offers. It is about not just reading the methods and techniques that are explained but changing your mind-set. The following three steps are advised14:
1.Audit both your existing and planned cost initiatives to ensure that the proposed changes improve the organization’s strategic cost management. The advice given in this book will help you with this stage.
2.Extend the scope of internal costing beyond the walls of the factory. We would emphasize that whether you are in a manufacturing, service, or public organization, you need to investigate the departments and activities that would be managed more successfully with strategic cost accounting.
3.Extend the cost management program beyond the boundaries of the firm. In other words, strategic cost accounting also includes the external environment. We will address this topic in Chapter 6.
We would add one final step. Focus on the future in your SCA, as well as learn from the past.
The Five Forces Model
Possibly the best-known work on strategy is Porter’s15 Five Forces model. His “activity-based view” has made an immense contribution to thinking on strategy, and a full appreciation of the impact of his work is excellently explained by Sheehan and Foss.16 In this section, we focus on Porter’s contention that the following competitive forces affect a company’s profits:
1.The threat of new entrants into an industry or market served by a specific company
2.The bargaining power of suppliers
3.The bargaining power of the consumer
4.The threat of substitute products or services
5.The intensity of rivalry among existing firms
Porter’s thesis is that if a company is to be successful, it must adopt a strategy that combats these forces better than the strategy developed by its rivals. To do this, a company has a choice of three strategies: cost leadership, product differentiation, and focus or niche. We will look at the first two, as Porter argues that a company must choose either of the following:
•Cost leadership, where the organization can offer the market products or services at a low cost compared with that of competitors.
•Product differentiation, where the organization’s products or services are considered by customers as superior to that of competitors, and therefore a premium price for the goods or services can be demanded.
Cost leadership—that is, the lowest delivered cost to a customer—gives an organization several advantages over its competitors. One advantage is that the impact of competition is minimized by allowing the organization to increase profit margins at the prevailing level of industry prices. An organization may also become the price leader because competitors cannot compete where their costs are higher.
Product differentiation allows companies to improve their profit margins by charging higher prices for a product or exempting it from a price-cutting war with its competitors. If the product differentiation has high customer appeal, then retailers will wish to deal in the product.
One argument against cost leadership is that it is not a competitive strategy because customers buy a product not on the basis of a firm’s cost structure but on the basis of their own preferences and priorities, although they may be influenced by price. A cost leadership strategy must involve price cutting to attract the mass market. Additionally, if an organization is in a position where it does not already have a low cost structure, it can risk a price war, as it may not survive it.
Caution must be exercised in assuming whether an organization should or does use a cost leadership or a product differentiation strategy. A study in Brazil (Junqueira et al.)17 found that companies in a competitive environment tended to use a cost strategy rather than a differentiation strategy, which would appear to be the appropriate strategy. The study also found that companies using a cost strategy tended to use more traditional practices compared with companies using a differentiation strategy, which tended to use tools with a wider scope and concentrated more on planning.
The above study was conducted in a particular economic environment, and the results should not automatically be transferred to other situations. However, they suggest that there could be a connection between the strategy a company uses and the costing practices it adopts.
Once the corporate-level strategy has been decided, managers must implement it at the business or operational level. This will require planning, making decisions, and controlling activities to achieve the desired strategy. Managers need cost accounting to perform these functions.
Identifying Costs
You should not interpret the previous discussion on cost leadership as meaning that all companies must pursue cost reductions regardless. Cost leaders compete on low price, whereas differentiators focus on innovation, features, customer service, or other means to attract customers who are willing to pay a premium price. You should not confuse good cost management because companies have different strategies. SCA means that they will have different performance measures and different planning, control, and decision-making methods. Companies use cost and management accounting to pursue their strategies effectively.
You may have heard the phrase “different costs for different purposes.” The implication of this is that each management purpose or objective requires specific cost identification and will require appropriate costing methods and techniques. Because of his or her specific skills and experience, the accountant in the organization will play a prominent role in collecting the cost data and assisting in its analysis. But the accountant is only one part of the integrated management team responsible for strategy.
Each manager is responsible for the performance of his or her own center. To discharge this responsibility effectively and efficiently, you must have a full understanding of what is meant by cost and of the techniques you can use to analyze cost data and evaluate your performance. The purpose of a costing system is to “help guide management in making decisions on how to best use these limited resources strategically.”18
Comparing with Plans
By comparing actual with predetermined performance, management can make assessments and conduct investigations to remedy deficiencies and to promote good practices. The comparison gives both control and the information to make decisions. Comparing with plans is therefore part of a control loop.
With the control loop, the plans should lead to action. The action is then measured and the actual performance compared with the plans. If there are differences, an investigation must be conducted and a decision made. This may be to review the plans, as they were unsatisfactory, or to concentrate on improving the actual performance. At every stage in the control loop, SCA will be required.
The assumptions and decisions about future activity levels are the basis of the plans. An organization may be in an environment where activity levels have a certain degree of predictability either because of constrained capacity of the organization or because of the stability of the marketplace.
Where the activity levels are judged to be reasonably consistent, the organization may determine that its priority is planning and controlling the actual costs of material and labor. Alternatively, and often additionally, it will pay attention to period costs—that is, those costs associated with a period of time rather than actual activity levels, such as rent, insurance, salaries, or administrative costs.
In chapters 4 and 5, we explain the use of standard costing for the direct materials and labor costs incurred in providing a product or service. We also describe the application of budgetary control for the planning and monitoring of period costs. In addition, we demonstrate the use of static and flexible budgets to allow for changes in activity levels.
Organizations that experience a turbulent environment and uncertainty in planning will need to examine various alternative courses of action and have the flexibility to change to meet fresh challenges. A well-constructed and well-implemented SCA system will allow them to do this.
Seeking Improvements
By comparing your actual performance against plans, you can assess your managerial abilities. The next stage is to know how you can improve your performance. A range of techniques have been developed and are still being generated to support managers in their quest for improved performance.
In Chapter 6, we explain the application of these techniques. You will find that each technique has its strong supporters and also its critics. As a manager, you must remember that SCA is about using the techniques that best help you and your organization develop and achieve a competitive strategy. You select the technique that best fits the type of organization, the activities it undertakes, and your own responsibilities. It is there to serve you!
SCA is about gearing your company’s performance to the external economics and the internal dynamics. You must be able to think strategically about the long-run impact of short-term cost changes and use your knowledge and skills to minimize cost pressures on the organizational strategy.
You will experience the daily pressures to cope with internal rising costs, but you must also recognize that there may be uneven cost changes with your competitors. Small, short-term disparities can result in long-term shifts in your cost competitiveness and any cost advantage you enjoy.
Performance Measurement
What to Measure
If you are the manager, you will have some autonomy on how you run the area for which you are responsible. The metrics used to assess how you have performed as a manager are normally based on some form of comparison of your actual costs, revenues, or profits against a predetermined amount. These are usually the financial components of the agreed strategy.
If you manage a cost center, you may demonstrate improved performance by maintaining the quality of the activity but reducing the costs or improving the quality while maintaining the cost level. There may even be circumstances where you are able to reduce cost levels and simultaneously improve quality.
If you are managing a profit center, the absolute amount of profit will be important, but this may also be expressed as a percentage of your sales figure or as a percentage return on the resources you employ. These, and similar, percentage comparisons are valuable for tracing performance over time and for comparing with PCs both within and external to the organization.
Any type of center has performance measurement issues. With CCs, the assumption is frequently held by senior management and the managers of other centers that its costs are too high. The manager of a cost center can always attempt to reduce costs, but this may lead to a reduction in services. For example, a maintenance department will take longer to respond with its services because employee numbers have been reduced. A cleaning department may clean certain areas on alternate days instead of daily.
To overcome these issues, some organizations will make an internal charge for the use of a cost center. For example, a printing department may start charging for leaflets and brochures it produces for other departments. The user departments may then decide to try for external competitive quotes and, if they choose this and accept them, this will reduce the “income” of the print department. The record keeping needed to make the internal charges will be an additional cost.
Sometimes a strategic decision is made to change a cost center into a profit center to avoid these problems. It is not always successful and can result in the “failure of the internal market.”19 This is where other departments use outside resources for their needs instead of the internal provider. If the cost center is a vital internal resource, it cannot be allowed to fail. It will be the responsibility of managers to ensure that the cost levels are consistent with the level of service provided.
The purpose and role of a center are pivotal to the collection and analysis of cost data. Although practices within one country will have similarities, you should be aware that if you have international responsibilities, you may encounter significant differences. A comparison of Germany and the United States concluded that there were differences in practices concerning classification of costs, measures to use when considering changes in costs, and the size and scope of the cost center and managerial responsibility.20
You Get What You Measure
Cost systems affect behavior in the workplace because they either explicitly or implicitly recognize or reward the performance of managers. Bonuses, career progression, and even slaps on the back and congratulatory words are likely to direct a manager’s efforts and behavior. In all probability, the direction followed will be what is being measured and rewarded. This can be in conflict with what is required to achieve organizational strategy.
You can imagine that if the performance of a salesperson is measured on the basis of the number of new customers obtained, there will be a tendency to concentrate on that and ignore maintaining a good relationship with existing customers. If employees are paid a bonus on the volume of work they achieve in a certain time, there may be a lack of attention to quality unless that is also measured in some way.
In an attempt to measure the performance required from employees, some companies construct an array of KPIs. The intention of these is to minimize attention being focused on just one aspect of performance to the detriment of other important aspects. But even here, care needs to be taken, and the SMART criteria technique has been advocated.21 This requires that a KPI must satisfy these five criteria: specific, measurable, attainable, relevant, and time bound. Hursman emphasizes that “relevant” means relevant to the employee and not just the company.
Any KPI system will undoubtedly include financial information, and in chapters 3 and 4, we explain the role of standard costing and budgetary control in establishing plans and providing feedback to allow managers to monitor and control performance. Both researchers and practitioners have identified the close relationship between behavior and the budgetary control systems. These can take many forms.
Budgets are the financial aspect of strategy, and decisions are being made about the amount and type of resources that managers will have to discharge in their work responsibilities. Understandably, managers will be inclined to argue for the maximum amount of resources, as this will make their job easier. The issue of budget “padding” is a common problem. Also, the size of a budget for which a manager has responsibility will sometimes be regarded as a sign by others of their eminence or otherwise in the organization.
In monitoring performance against the budget, managers can be tempted to ensure that the budget amount is completely spent; otherwise there is a fear that the budget will be reduced in the following financial period. Managers may also be constrained from demonstrating any initiatives if there is not scope in the budget to allow it.
The problems of unwanted behaviors should not be overemphasized, but as a manager, you should be aware of them. Costing is not just about numbers. It is about the activities of people and their endeavors to use the resources for which they have a responsibility to achieve an agreed strategic goal.
Conclusions
In this introductory chapter, you should have gained insights into the relationship between an organization’s costing system and its strategic plans. All organizations have limited resources that must be used in providing services and products in a competitive environment, and as a manager you contribute to this effort. To do so, you require cost information, and we have explained how you can direct your attention to the cost information you need and how that information will be shaped by several factors.
Cost is a slippery term, so you need to
•be specific on what is being costed
•know what the cost should be
•understand how performance can be improved
•set the information within the organization’s strategy
There are no regulations that require organizations to have costing systems. It is purely a voluntary activity designed to assist managers in
•planning their activities
•controlling performance against the plans
•making decisions about alternative courses of action
To do this, managers need cost information, but that information must meet the needs of the organization and those of individual managers. Although principles and concepts are explained and discussed in this book, organizations will “customize” them. The following factors influence the shape of the costing system:
•The type of organization, and that will include such considerations as size, structure, and purpose
•The organizational constituents, who may be investors, shareholders, the local community, and society at large
•The output from the activities, which may be tangible manufactured goods, services, or even professional advice
•The information needs of the manager, which will depend on the manager’s role and responsibilities
The process of strategic costing uses many different techniques that are discussed in subsequent chapters. However, strategic costing is not about an array of methods and techniques but about how to help organizations succeed. The process of strategic costing should therefore
•build on the core competencies of the organization
•identify the costs that are relevant to its needs
•generate valuable comparisons with its plans
•support the search for improved performance
The following chapters will explain the purposes, strengths, and weaknesses of various costing techniques and guide managers in selecting those that are most valuable in their search for a strategic solution.
1.Robson (1943).
2.Sangster and Scataglinibelghitar (2010).
3.Parker and Yamey (1994).
4.Previts, and Merino (1998).
5.There has been considerable literature, and useful sources are Chandler (1977), Johnson (1983), and Johnson and Kaplan (1987).
6.Juras and Peacock (2006).
7.Heller Baird and Gonzalaz-Wertz (2011).
8.Chenell (2003).
9.Chiarini and Vagnoni (2015).
10.Fallen et al. (2010).
11.Blocher (2009).
12.Al-Hazmi (2010, p.33).
13.Cadez (2007).
14.Cooper and Slagmulder (2003).
15.Porter (1985).
16.Sheehan and Foss (2009).
17.Junqueira, Dutra, Filho, and Gonzaga (2016).
18.Juras and Peacock (2006, p.34).
19.Scarlett (2007).
20.Portz and Lere (2010).
21.Hursman (2010).