Film lovers remember the line from the 1995 movie Apollo 13 when astronaut James Lovell said “Houston, we have a problem”. He was alerting mission control that there was a technical failure with their spacecraft that put the success of their mission in jeopardy. Today there is a similar problem with most organizations’ managerial costing practices. There are serious failures with the decision support information they provide to their managers that put the success of those organizations in jeopardy.
Vast changes have taken place in the business environment during the past fifty years. Fifty years ago logistics constrained markets to certain geographical areas, but now globalization, improved transportation and shortened turnaround times have resulted in markets that are worldwide. Product and service variety were limited; now they are broad and approach being limitless. Competitors were domestic and few; now they are global and many. Purchase decisions were often based on long-standing personal and corporate relationships; now they are based almost exclusively on data. The differences between operating in the late 1960s and late 2010s are endless.
Despite these changes, the managerial costing practices followed by many 21st Century organizations are little different than they were fifty years ago. While the world around them changed and other parts of the organization reengineered themselves to meet the challenges of the new environment, accountants continued to follow traditional cost accounting practices that reflected a world that no longer existed. That does not mean, however, that the entire management accounting community was asleep at the switch.
The evolving changes in business and its information requirements were recognized by managerial accounting thought leaders in the 1980s, and since then many innovative managerial costing practices that more closely meet the needs of a 21st Century organization have been developed. Left on their own and pressured by the demands of external financial reporting, however, most accountants have been reluctant to promote these new, more appropriate practices within their organizations. They have computerized their old practices, but have not changed them. Cost models created for financial reporting that in no sense match the operating reality of the business continue to be used for internal decision making.
The radically different business environment of the 21st Century necessitates a mindset change. Organizations can no longer afford to rely on their externally-oriented financial accounting systems to provide the internal cost and decision support information required to make quality business decisions. These systems focus on “compliance” and protecting the investment community. The internal cost and decision support information system must focus on “value creation” and contributing to the financial success of shareholders, owners, and stakeholders. One would think that value creation would receive as much (if not more) attention as compliance. Sadly, that has not been the case.
Not only do financial accounting’s oversimplified methods of costing products and service misstate critical measures of performance, issues such as costs required to serve customers with radically different behavioral patterns continue to be ignored. Few companies have the ability to report channel and customer profitability below the product/service gross profit margin line. As a result, they are unable to correctly measure profitability by service channel or customer group, which is particularly troubling for companies which are working to reorient strategy around a customer, rather than a product, focus. Similarly, the prices paid for goods and services from a supplier continue to be treated as their “cost” despite all of the expenses, activities and investment required to make those goods and services available when and where required. This results in poorly reasoned vendor selection, in-sourcing, out-sourcing and offshoring decisions.
So Why Is This a Problem?
Financial accounting’s oversimplified product costing practices caused one profitable manufacturer of highly engineered products to lose its manufacturing business and forced it to downsize and become an engineering services business. A non-profit, long-term health care provider’s inaccurate measurement of resident service costs caused it to accumulate a population of residents that substantially eroded the endowment that made the attainment of its mission possible. Failure to accurately measure channel maintenance and fulfillment costs led a distributor of restaurant equipment’s profits to fall as it granted substantial discounts to high-volume customers with excessive channel maintenance and fulfillment costs. Offshoring enabled an auto supplier to reduce the price of a major component by $3 million. Unfortunately, the $3.5 million it spent to implement that decision was lost (not connected to the component or outsourcing effort) in the financial accounting system. The examples are endless, yet organizations continue to rely on oversimplified financial accounting information to make critical business decisions.
Such is the state of cost information at the vast majority of today’s organizations. And it’s not like financial executives are unaware of the problem. A survey conducted by the IMA (Institute of Management Accountants) and Ernst & Young indicated that 80% of Chief Financial Officers believe the cost information they provide to their organization’s decision makers is inaccurate. More alarmingly, less than 20% have plans to do anything about it.
Models and Decision Making
Models are essential to our functioning as human beings. Individuals use models to understand the phenomena around them. The late Dr. Alfred Oxenfeldt, a long-time authority on decision economics, put it this way, “The brain works by constructing an internal version of the outside world. Its conclusions reflect that internal version rather than the actual outside world; the validity of its conclusions depends largely upon whether these internal representations accurately mirror the outside world.”
Models are also essential to business decision makers. They use those models to understand the business phenomena around them. Their organization’s cost model is one of those models. If that cost model does not provide an accurate version of reality, the cost information on which they base their decisions will not accurately mirror the outside world and will negatively impact the quality of their decisions. Effective, value-adding managerial cost information cannot be derived from the rules and regulations-driven, one-size-fits-none cost models of financial accounting. It must come from economic reality-based models; models that reflect the fundamental economics that underlie an organization’s actual operations.
Why the Failure to Update Costing Models?
Financial executives who are responsible for these inadequate and misleading financial accounting oriented costing models are generally aware of the problem, but many have chosen to not to do anything about it. They appear to ignore the problem because there is little pressure from the managers who use accounting information to improve its accuracy and relevance, and because accountants have so many other “mandatory” duties to perform related to external financial reporting for regulatory compliance.
In the baseball book and movie Moneyball, Oakland Athletics’ general manager, Billy Beane, meets a recent Yale graduate who studies baseball statistics. The statistician tells Beane that “Baseball thinking is Medieval.” He convinces Beane that baseball scouts are too enamored with an individual player’s talent rather than what it takes for a team to score runs and win games. The message of Moneyball is that there needed to be a mindset change with how baseball teams are built to win games. Accountants today are like “old school” baseball scouts. They are stuck with an out-of-date, rules-and-regulations view of costing. By mentally and physically segregating compliance oriented cost accounting thinking and systems and economic reality-based managerial costing thinking and systems, accountants can experience a mindset change from long-held myths about how a company makes money, and better support managers and executives in their quest to “score runs and win games.”
But accountants are not entirely to blame. They are creatures of their environment. They do things that they have been taught to do and respond to the direction and incentives given to them by their organizations. They share responsibility with the institutions that educate them and the organizations that employ them.
Accountants are comparatively undereducated by colleges and universities about economic reality based decision support managerial costing methods and models. Higher education, spurred on by the powerful financial accounting community, focuses on teaching about compliance with the myriad of promulgations, rules and regulations which organizations must follow to survive in a complex business environment. Comparatively little incentive is given by the broader business and management community to teach internally focused, economic reality focused, value-creating managerial costing skills. Failure to comply with accounting rules can result in serious and immediate consequences. Accountants can go to jail for deliberately violating financial accounting rules. Failure to comply with sound managerial costing practices can also lead to serious financial consequences, but those consequences are longer-term. Additionally, accountants will not face jail time if they fail to comply with sound managerial costing practices - they simply look for another job where they can ply their financial accounting skills after their organization experiences financial failure.
Every decision maker needs to more aggressively demand more accurate and relevant, economic reality-based decision support information from their accounting and finance staffs. It is important to understand that a wide array of solutions have been developed to address “the costing problem” over the past thirty years. These solutions have been well publicized and proven successful at many firms. The issue is not “is there an answer?” The issue is “how do we get accountants to face the problem and implement solutions to create and improve cost information for internal decision making?”
The challenge for executive management and boards of directors is that immense importance, salary and financial incentives, and legal sanctions are placed on external financial reporting. It is critical to recognize that the external financial reporting model has significant flaws that can derail strategies and cripple a business. As part of a solid strategic planning and business risk management process, it is critical that executive management and boards of directors examine how effective their line managers find financial information for their day-to-day decision making.
Top management must take the initiative and demand their accountants adopt costing practices that represent the fundamental economics that underlie the operation of their businesses. They need to create a culture where the operational users of cost information “trust” the information provided by their accountants, see it as consistent and reflective of the resources and process they manage, and, most importantly, use it to make better decisions to be more competitive.
The executive management team and the board of directors need to inspire their accountants to be more progressive and experience the “mindset change” referenced earlier. Consider this observation by John Nash, the Princeton University mathematician and Nobel Laureate in Economics. In the 2001 Academy Award-winning movie about Nash’s life, A Beautiful Mind, he says:
“I like numbers because with numbers truth and beauty are the same thing. You know you are getting somewhere when the equations start looking beautiful. And you know that the numbers are taking you closer to the secret of how things are.”
The development and use of economic reality-based managerial costing models will take you “closer to the secret of how things are” as well as “how things could be” and “how to get them there.”
The managerial costing mindset, models and math can also be used to create operational models of processes used in project management solutions, manufacturing enterprise solutions, asset management systems, sales and marketing management solutions, and other operational and workflow solutions. It is not just about the costing of products and services; it is about the application and use of sound managerial economics and clear “cause and effect” logic in managing an organization to higher levels of success. Most management accounting systems are inadequate for this purpose because they are based on extremely oversimplified financial models that do not adequately connect to the fundamental economics that underlie an organization’s operation. The accounting profession has fallen far behind other business disciplines and must now start providing managers with causal and relevant information to effectively lead their organizations.
An executive management team with courage, will, and leadership skills will shift their organization’s costing practices from the status quo to progressive managerial costing practices. They will not allow the externally-oriented financial accounting system to distort and impair the managerial cost information their decision-makers need to obtain the insights needed to make quality business decisions. They will provide the correct information for optimal decisions of all types.