how to implement progressive management accounting techniques.
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management finance expert gary cokins says there’s nothing wrong with activity-based costing. except that you’re probably doing it all wrong.
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the problem is, cokins says, it’s convenient for the accountants to allocate the overhead based on allocation factors, like labor hours, number of units produced in a manufacturer, headcount, number of employees, and square feet, even though none of them reflect the unique consumption relationship between how the outputs products and services consumed.
key takeaways:
– the deficiencies with product and service line costing have to do with overhead allocations.
– rapid prototyping is really meant as really to get buy-in and displace misconceptions. the accountants can build a model that replaces percentage estimates with data that can be extracted from erp or production systems.
– the analyses must go below the gross profit margin line, including distribution channel expenses, marketing expenses, selling expenses, customer service expenses, to basically get a p&l almost by the customer to determine whether the largest customer is also the most profitable.
– epm and cpm tools will enable young professionals to move away from vouchering and more toward problem-solving. their jobs will become more meaningful and fulfilling.
– accountants and financial executives really need to create a culture of discovery and investigation. and this is where analytics come into place. because analytics creates questions. it creates better questions and even more questions. and they also need to have tolerance for making mistakes, as long as they learn from the mistakes.
gary cokins is an internationally recognized expert, speaker, and author in enterprise and corporate performance management improvement methods and business analytics. he is the founder of analytics-based performance management, an advisory firm located in cary, north carolina at www.garycokins.com. gary received a bs degree with honors in industrial engineering/operations research from cornell university in 1971. he received his mba with honors from northwestern university’s kellogg school of management in 1974.
gary began his career as a strategic planner with fmc’s link-belt division and then served as financial controller and operations manager. in 1981 gary began his management consulting career first with deloitte consulting, and then in 1988 with kpmg consulting. in 1992 gary headed the national cost management consulting services for electronic data systems (eds) now part of hp. from 1997 until 2013 gary was a principal consultant with sas, a leading provider of business analytics software.
his two most recent books are performance management: integrating strategy execution, methodologies, risk, and analytics, and predictive business analytics. his books are published by john wiley & sons.
connect with cokins at linkedin. find his books at goodreads.com.
transcript
steven sacks
last time in our first webcast in this series, we explored the definition and practical application of enterprise and corporate performance management. please explain how both of these methods relate to profitability and reporting analysis.
gary cokins
well, enterprise and corporate performance management, epm, cpm, that’s their acronyms, they’re actually synonymous. and what they are is really a integration of multiple methods of which product and service and customer profitability is one of them. the others, which we talked about in the previous installment, strategy, balanced scorecard for strategy management, lean management for productivity, enterprise risk management, the move from the annual budget to driver-based rolling financial forecasts. all these like gears in the machine, they fit together. so, what we’re going to talk about today is really one of those components.
steven sacks
well, let’s start with the epm cpm method that you mentioned. the problems with product and service line cost accounting, what are its deficiencies and how can they be resolved?
gary cokins
well, the big problem is overhead allocations. the allocation of indirect expenses to products and, and service lines. i use products and service lines individually, because many organizations back the vast majority of companies don’t have physical products or services. the problem is, it’s convenient for the accountants to allocate the overhead based on allocation factors, like labor hours, number of units produced in a manufacturer, headcount, number of employees, square feet, all of these. none of them reflect the unique consumption relationship between how the outputs products and services consumed, the end-to-end business processes and activities in them. and then, of course, the expenses of salary, supplies, you know, and the like. so the problem is really, it’s convenient for the accountants to do that — what i call butter-spreading, because it satisfies the external reporting, statutory reporting for regulators and the like. but it’s flawed and misleading for internal management accounting.
steven sacks
well, you had mentioned in one of our prior conversations that you said accountants are still living in the 1960s, with their thinking about allocations. is this what you’re alluding to in what you just mentioned?
gary cokins
yeah, because some of this, the solutions that resolve it, of course, one of them is really the predominant one: activity-based costing, which we’ll talk about later. what the issues are, with why people think it’s too big and too complex is that that method was in the textbooks in the 1970s. and here we are for 40-50 years later and the majority of companies and organizations were using activity- based costing to do this, meaning decompose the indirect expense cost pools and trace them and assign them based on a causal-based driver. you know, which is code for a cost allocation factor. it’s been around for 30-40 years. so, i say they’re in the 1960s. and the sad part is, the information that they’re giving their managers, employee teams, executives, is flat and misleading, because when you do it the more correct way, it’s just full absorption costing done correctly. without that, some of the products are over-costed, the others must be under-costed — zero-sum game. therefore, all of the margins and pricing, all of that’s misleading.
steven sacks
well, let’s do a little deeper dive into this because accountants say that activity-based costing or abc, as its acronym is known, is too complex to implement. and it’s too difficult to maintain as a costing system. and then you mentioned something about rapid prototyping as a solution for this. what is prototyping and what role does it play to overcome cpas’ reluctance?
gary cokins
with rapid prototyping, which i’ll describe in just a few seconds, really resolves this other issue of the misconceptions that the accountants have. and abc did get a bad reputation in the 70s, and 80s because the models, and they are models, it’s not t accounts and journal entries. costing’s modeling. you model the expenses consumed into the processes. they were way too large. they were way too complex. they had 3,000 activities. and then they thought, oh, every employee has to fill out a timesheet. and a bunch of other misconceptions. and none of that is actually really necessary in order to properly get a reasonably good model. you know, we have a phrase, it’s better to be approximately correct than precisely inaccurate. and so before they were trying to build so much precision, five digits to the right of the decimal point of a burden rate, when their problem was really two digits on, on the left side.
the way rapid prototyping works, and something i’ve actually been doing the last 20 years, and now i actually like training other consultants and cpa firms how to do this, is i have a workshop with five or six cross-functional employees in a room and basically build a quick model with maybe three activities per department. so if there’s 10 departments, that’s 30 activities. since they’re knowledgeable, have them estimate, hey, when this activity goes to these product families go high level, what’s the split 30-30-40 10-10-80? hey, as long as it’s 100%. everything normalizes 100%. and then here’s the key. the afternoon of the second day after this model has been constructed, bring in the line managers, bring in the executives. have these five or six people who were in the various departments show them it, and the light bulbs go on with everybody. it’s like, oh, that’s how you more properly, if you will, get that overhead fairly into the cost. oh, that’s how we could really validate whether our pricing and profit margins are good or bad. oh, that’s how we could do benchmarking with apples and apples, not apples and oreos. so, the rapid prototyping is really meant as really to get buy in and displace misconceptions. then the next step is to take three or four extra days. build the model, a little deeper. start maybe replacing some of those percentage estimates with data that can be extracted from erp, or production systems. by about the third iteration, two weeks, three weeks later, it’s a permanent repeatable production system. it’s ready to go and be refreshed. and the really important thing is it’s engaging when you’re modeling your own company, rather than oh, let’s just do a case study from mba school.
steven sacks
so, from the perspective of a financial executive, could it be that there’s greater focus on whether their revenue-generating activities are inefficient or there is mismanagement of costs?
gary cokins
it’s probably a combination of the two. i mean pricing should always be market-based in my mind. then that’s a whole price negotiation. the mismanagement of costs, that may be a strong word. it’s just that there’s a lot of opportunity for cycle time reduction, waste removal. that’s where one of the other components of epm fits in. six sigma, quality management, lean management, you know, the process people. but you can never really reduce costs to prosperity. ultimately, it has to be strategic. rationalizing. where do we make and lose money? which products are the margins? which customers are more attractive to retain, to grow, to win back to acquire which types? now, those are strategic questions. that’s really the power of management accounting.
steven sacks
well, speaking about customer or client profitability, you mentioned there is an increasing interest in measuring them. what is the driver behind this greater interest, and can cpas apply client profitability to their, to their own clients within the realm of a cpa firm
gary cokins
customers are the source of value creation for shareholders and owners. we really need to connect them all the way. problem is, when the accountants even when they’re doing activity-based costing, thank you, when those the few who do, they’re stopping at the gross profit margin line. but a lot of products and service lines are commodity, so they’re comparable between your competitors. you’ve got to go below the gross profit margin line, including distribution channel expenses, marketing expenses, selling expenses, customer service expenses, to basically get a p&l almost by customer. and the reason this is relevant is many basically think oh, well, our largest sales customers also most profitable. yeah, but when you get into it, you discover that well, wait, i’ve got high-maintenance customers and low-maintenance. because we’ve kind of got our angels and devils. high-maintenance customers, always changing schedule. everybody’s standard, always special. always calling the helpdesk. always returning goods. the low-maintenance, the angels, we love them. only buy standard, never change schedule, never call the helpdesk, never returned goods. those two types of customers bought same volume, same mix, same price. they’re not equally profitable. the high-maintenance one is eroding a lot of your expenses. so, the key here is that having, i call it the golden gate bridge. you know, built halfway. you really — most of the real decision-making is in the bottom half of a p&l. so, having a p&l by customer is really important. okay, cpa firms. clients, customers. it’s the same thing. there’s going to be behavior, how you’re interacting as a cpa firm with different clients. there’s going to be, you know, i’m sure if you talk to a cpa firm and interviewed someone in the hallway and say, tell me which of your clients is really kind of a pain here like, and why. you know, they start giving you the whole story. well, that typically translates into spending a lot more time. so now we’re spending a lot more time with them, which may not be billable or chargeable. so, we’re truly rationalizing the level of profitability by client or by customer.
steven sacks
so you’ve mentioned, the adoption rate of progressive management accounting methods has been slow. what reasons explain this, and how can the adoption rate be accelerated?
gary cokins
well, the adoption rate has to do with some of the barriers that prevent people from wanting to basically be progressive. and a big one is resistance to change. it’s just human nature. you know, people love to love the status quo. i thought only babies like change, you know, with diapers. but there’s some other more serious ones. some of them have to do with technology, with it, dirty data, low quality data. that can be cleaned up by the by the it firm. but others are fear of knowing the truth, or others knowing the truth. i had one client engagement several years ago as a bakery company, and it was a product manager for the danish and you know, with the jellies, and so forth. it was under their traditional system was most profitable. when we did the abc, i found out that the breads went through easily, but the danishes weren’t plant cleaning and stuff like that, that took extra work. and, so, that product manager saw that when this study is done, or this system has done, he’s not going to be number one anymore. he went to the ceo and said, what are we doing this stupid activity-based costing? we should be quality management. we got kicked out. we were back in a couple of weeks, because the main question, the ceo is asking: where do we make money and lose money? it’s an example of fear of knowing the truth. that man worried much more about his personal situation than his organizational. other, other barriers: fear of being measured. fear of being held accountable. you know, so none of this stuff has anything to do with systems or methods. it’s all behavioral. it’s change management. and to really be successful implementing these methods, you got to have a little bit of psychology, sociology to you. but most, most managers don’t have degrees in sociology.
steven sacks
so, line managers don’t push back to get better information for better decision making. so, because you talked about reluctance, afraid to know the truth or, you know, their decision making. so what can be done to change this? dynamic?
gary cokins
yeah. push back. the real issue is they, most of them don’t trust the accounting data. they know it’s flawed. in fact, some of them are really irritated. especially a product, some of the product owners, because they, they get slapped with this overhead thing based on labor hours or something like that. and they say: wait a second. it’s that other department’s causing all that. i’m not causing any of that, that work. but i’m basically being charged with it. it’s like going to a restaurant with three other friends. you ordered a little salad. the other three are the most expensive item on the menu. and at the end, the waiter or waitress brings the bill they say, hey, let’s split this check evenly. how do you feel? this is unfair. that’s how a lot of the line managers do feel. but, they are a bit reluctant to basically try to get it changed, even though they may mention it because they’ve got enough problems on their own. they got a lot of other priorities, so it hasn’t really risen to the top. and some of them don’t recognize the magnitude of the error. when you do do it properly. it’s not 3% or 5%. you know, like a $100 product is really $102 or 98, it could be $130 or $70. so there’s not the recognition of the magnitude of the error, if it was to be done properly.
steven sacks
so, shifting gears for a second, let’s talk a little bit about knowledge transfer and how these analytical tools will render the audit more of a commodity given that artificial intelligence and robotic process automation and other areas of technology are becoming more mainstream. and what impact will this have on the cpas providing advisory services?
gary cokins
it will have an impact not just on the cpas, but actually the entire accounting profession. and i always say that the epm cpm — and i briefly said, it’s really the integration of multiple methods — that are what i call the gears in the machine. which the real vision is to seamlessly integrate all those gears. with most companies, some of the teeth are broken, some of the gears are, are separated. we really want them, you know, basically meshed together. more torque, more speed, more revolutions per minute, if you will. all producing better information. but when you embed analytics into them, you turbocharged them. you get even more good stuff. regression correlation, clustering, association. i know some, most people listening to me, oh, i took those courses in college. i just want a passing grade and get out of there. well, sorry, you know, it’s here. data science. good news is, you don’t need to go to your attic or basement and get the textbook out and brush it. but you do need the skill sets to be able do some of these. but now here is what’s coming at most organizations and the accountants. it’s artificial intelligence, robotic process automation, machine learning, cognitive soccer. they’re all basically cousins. it’s going to basically eliminate jobs. the computer is going to do what a manual, was done manually. you know, at the low end, clerks, payable clerks, accounts receivable clerks, payroll clerks. you know, the computer is going to follow. they’re kind of doing their processing of the invoices; is gonna be memorizing it after a while it says i don’t need you, i can do it, you know. but the audit, we won’t be having sampling anymore. it’s going to be 100%. because the computer is going to be able to go near near real time or real time to all of the transactions, receivable payments, whatever transactions that are hitting the general ledger. and when it starts seeing anomalies, potential fraud detection, or just strange items, it’s going to be able to detect them. no different than what a manual auditor kind of going through it would have been doing on their own. so, in both cases, the audit, and even internal auditors for a company, their job is basically at risk. the clerks, the payable clerks, because the computer is going to basically replace it. and many think, oh, well, that’s a decade away. this is science fiction. no, this is not that far away. it’s moving faster. you know, when technology the duration time for technology gets faster and faster. remember televisions, the 1950s? how long did it take for 50% of households to have them? then, you know, big computers. then, you know, cell phones. it gets shorter and shorter and shorter each time. it’s going to happen with artificial intelligence or robotic process automation.
steven sacks
so, for those who are going through school now, they’re not just going to be focused on doing auditing or tax. they’re going to have to understand data analytics and a whole bunch of other areas, including technology. so, both in the cpa, the public sector and the private sector, you’re going to be hiring for different skill sets.
gary cokins
yes, but that’s also going to be good for the young people coming in, because their jobs are going to be more meaningful and more fulfilling. they’re going to be solving problems. they’re going to be analyzing. they’re going to be you know, the classical term of the cfo, you know, being a trusted adviser to the line managers. it’s going to facilitate the ability to do all that, as opposed to, you know, number crunching, and kind of boring tick, tick and tie debits and credits. you know, let the computer do, you know, the manual stuff. make your jobs far more interesting and value adding. adding value to the organization because of the contribution that you will be making to the rest of the organization and the shareholders and owners. and this applies in public sector, government, as well, which is a whole other story. most of these principles are universal, and so they can be applied for public sector government just like a regular commercial company.
steven sacks
absolutely. last question i have for you, is what resources can viewers of this webcast go to find out more about epm and cpm?
gary cokins
yeah, these topics, including one particular one is called measuring and managing customer profitability. it’s an article published by the institute of management accountants, because i’ve done — i served a three-year term for them after i retired from — i’m partly retired. and so, which really also suggests, go to the institute of management accountants website: www.imanet.org. a lot of articles also there. and, of course the aicpa and cima and their cgma have articles. i’ve actually authored a couple of books that are on that for the aicpa and the cgma program. so, those could be some resources. and of course, i have authored a lot of books. but i am not pushing my books. i tell people don’t buy the book. go to wiley.com. that’s my main publisher, or amazon. chapter one is usually a free download. and so that’s a quick way of just kind of getting an overview and didn’t have to pay anything.
steven sacks
well, terrific. well, thank you, gary, for providing a deeper dive into cpm and epm as it relates to profitability reporting and analysis. i think the takeaway is it does not matter the type of business that you’re working in, type of industry. having a handle on costs and timely and relevant data, and taking the appropriate actions are really the takeaways from this discussion and the webcast that we did prior to this.
gary cokins
steve, could i just add one thing, though, just be sure closing. because this is something that’s of high interest to me. i think in the past the best leaders and the best executives had the best answers. today, i don’t think that’s the case. today, i think the best leaders and best executives have the best questions. there is too much complexity. there’s too much volatility. there’s too much uncertainty for them to rely on their gut feel, or sixth sense, or the types of answers. they made good answers in the past that got them promoted to the top. they really need to create a culture of discovery and investigation. and this is where analytics come into place. because analytics creates questions. it creates better questions and even more questions. and they also need to have tolerance for making mistakes, as long as you learn from the mistakes. so, that’s sort of my message about leadership.