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During economic chaos, organizations must evolve--has your cost/profitability system (CPS) evolved? While a company's business model has likely evolved in response to the current dynamic economic climate, its CPS has failed to reflect these changes. Until the system is updated, the CPS will function inefficiently.

Managers have long known that understanding the costs of activities, products, services and customers has a big impact on their profitability. "Do the right things right" and "Know your CCCs (costs, competitors and customers)" are well-known proverbs in the business world.

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Historically, organizations have sought technology to perform cost and profitability calculations that are often tedious and complex. But the complexity of business, the market climate (especially the current chaotic environment), and the methods for calculating and reporting cost and profitability have changed considerably over the years. The challenge now is to keep the calculations transparent enough to understand, yet complex enough to accurately reflect reality. The juxtaposition of these attributes should yield actionable information that improves insight and, ultimately, bottom-line results.

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A CPS is a well-thought-out, fully integrated set of techniques that are used to collect, accumulate, assign, and report both cost and/or profit for an organization's numerous cost objects. Examples of cost objects include a critical process in the production function, a cost centre like a distribution centre or a department, or it can be a final product or customer for a division or entire entity. In short, cost objects are whatever is of interest to a manager at any level. CPSs support every business process from research and development, design, production, sales and marketing, distribution, to customer service and shared services.

An effective CPS can support these ends; enabling organizational efficiencies, resource alignment, and financial performance along the way. However, managers often disagree with the activity, product, and service costs reported by their CPS. Managers often need to change or ignore those numbers to reflect reality in order to make better strategic and operational-control decisions. The older a CPS system is, the more likely this issue exists; while a company's business model has likely evolved in response to the current dynamic economic climate, its CPS has failed to reflect these changes. Until the system can be updated to capture the manner in which a company currently conducts business, the CPS will function inefficiently.

To determine the extent of the gap between operations and the systems used to track cost and profitability of the enterprise, the Business Research and Analysis Group (BRAG) conducted a world-wide survey about costing and profitability. The goals for the survey were to identify major benefits realized from an organization's CPS, to determine the key success factors for an effective CPS, to identify major reasons why an organization's CPS fails, and to determine best CPS practices. Over 400 organizations provided responses about how they measured their costs and profitability, the benefits they received, and the issues they were experiencing.

The survey provided valuable insights into how technology impacts the task of calculating activity, product/service, and customer costs, and how it can hinder or help companies' understanding of their businesses and competitive environment. The results indicate that many organizations are dissatisfied with the information provided by their CPS.

Key finding 1: Benefits from CPSs are not being realized

Identifying, measuring, and understanding the disconnect was at the core of the BRAG survey. The results revealed that companies use a CPS for three major purposes: external financial reporting (including inventor), valuation and cost of sales), strategic decision making, and operational control. Since the first purpose is primarily an issue of compliance with external reporting standards, the second and third purposes are more of interest to those charged with operational management.

In order to achieve significant-benefits from a CPS, certain key success factors must be present. The CPS must fit the organization's business model, be flexible, be integrated with the planning process, have an effective reporting architecture and yield information that is understandable and actionable. When these factors are present, it is reasonable to expect benefits to accrue. Such benefits can be classified into four general areas: strategic decision support, operational control support, planning, and performance evaluation.

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Respondents were queried about more specific beneficial components and asked to specify the extent that their organization's CPS had achieved each component (Exhibit 1). For example, components of strategic decision support included support for product pricing, design, value-chain outsourcing, and profitability analysis of both customers and products. Components of operational control included support for making operational improvements, cost control, and accurate measures of activities or processes. By assessing these components, the BRAG team was able to extract three major findings about how cost/profitability systems are used (and misused) in organizations.

Key finding 2: Top concerns are with cost allocations

One of the key findings from the survey is that, while the vast majority of respondents believe that at least some benefits are present, only a small minority (25 per cent) agree or strongly agree that their CPS accurately assigns overhead costs to customer, products, or services (Exhibit 1). Further analysis revealed that CPS users overwhelmingly complained about all aspects of cost allocation (Exhibit 2). Managers want realistic accuracy; they want the results to reflect reality, not give them more decimal places. They want more timely feedback and greater ease of maintaining and updating CPS as processes change. The findings also indicate that organizations are dissatisfied with their existing costing methods. Finally, it appears that the weakest link in the CPS chain is the manner in which costs are allocated.

Confirming results of other reported surveys, a wide variety of costing methods are used, including equal allocations, output-based, and activity-based allocation; but no single method dominates usage. In fact, a significant per cent of organizations do not allocate many internal value-chain functions--a fact that most likely reflects the general dissatisfaction with cost allocation results--better to not allocate arbitrarily if it distorts costs and results in dysfunctional decision making and behavior that is not congruent with organizational goals.

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Key finding 3: Activity-based costing/management (ABC/M) provides superior decision support

An ABC/M system is a well-thought-out methodology for accumulating the cost of activities or processes (logically related groupings of activities) that are critical success factors for an organization or subunit. Why go to the trouble and expense to accumulate hundreds or even thousands of activity costs? The answer lies in the "well-though-out" part of the definition. If managers think through the critical activities or processes that are being performed and managed in their area of responsibility and then a system is designed to report these costs along with the metrics that cause the costs, a powerful tool is created for cost control and managerial effort exerted in congruence with organizational goals.

This is certainly not an easy proposition, but to many who have developed ABC/M systems, the benefits far exceed the costs. Do .ABC/M systems have to be deployed across the entire organization? No. Identify the functions in the value chain that are core competencies and designate these as targets for ABC/M deployment. For example, a company like Kroger (a retail food chain) might deploy ABC/M in its distribution function because of its substantial cost and critical impact on financial performance.

Contemporary thinking, reported by many professionals and researchers, is that activity-based methods do not pass the cost-benefit test and are being abandoned. The BRAG study reveals that relatively few organizations in the study that, deployed ABC abandoned it. To the contrary, ABC provides superior decision support for both strategic and operational-control purposes.

The study revealed that standard costing systems are still the most popular, especially in the production function of the internal value chain (42 per cent use standard costing compared to only 18 per cent for ABC). ABC systems are used across the value chain, but do not dominate like standard cost systems. All respondents were asked to compare the value of ABC to standard costing in the production function regarding major decision support components. As shown in Exhibit 3, the results lend additional support to the value of ABC and demonstrate that the vast majority of organizations believe that:

* The use of activity-based costing helps them to understand their operations better than standard costing.

* ABC provides more useful product costing information than standard costing.

* ABC provides more useful information for process improvement programs than standard costing.

Key finding 4: Capability gap in best practices organizations

The BRAG study team investigated how well organizations' CPS serve strategic decision making and cost control purposes in order to gain insight into best practices. Of the 400 respondents to the survey, BRAG isolated the top three per cent by determining stringent criteria for best practices.

Further evidence of the staying power of ABC was disclosed when best-practice organizations were isolated. Of these best-practice CPS organizations, 80 per cent currently use ABC in some form while only slightly more than 30 per cent of the other companies do so.

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In addition to the gap found in the use of ABC, the study also found a significant gap in the CPS capabilities of best-practice organizations compared with those that were not best practice (Exhibit 4). Most notably, the CPS for a non-best-practice organization was less likely to include capabilities to analyze customers--customer-facing activities, profitability, and resource consumption. These capabilities are critical when dealing with tight margins and demanding customers. Another significant capability gap revealed best practice organizations had CPS integrated with other management decision systems, where non-best practice organizations often did not.
Exhibit 4: Capabilities of best practice organizations and non-best
practice organizations

CPS Capability                Best Practice  Others       Difference
                              Organizations

Calculation of the cost of    100 per cent   31 per cent  69 per cent
our customer-facing
activities

Integrated with other         100 per cent   41 per cent  59 per cent
management decision systems

Accurate identification of    100 per cent   46 per cent  54 per cent
which customers are
profitable and which are
not

Accurate identification of    100 per cent   60 per cent  40 per cent
which products/services are
profitable and which are
not

Calculation of channel,       90 per cent    41 per cent  49 per cent
product, and regional cost

Cost information at all       90 per cent    42 per cent  48 per cent
necessary Levels (customer,
product/service, key
processes, key activities,
etc.)

Calculation of the            80 per cent    26 per cent  54 per cent
proportion of resources
consumed by each customer
type

Calculation of the            80 per cent    26 per cent  54 per cent
proportion of resources
consumed by each individual
customer

Ability to handle reciprocal  80 per cent    29 per cent  51 per cent
costing

Traceability of               80 per cent    44 per cent  36 per cent
allocations--how they were
assigned at any level


Interestingly, these results remained consistent when considering the length of time organizations had used their current CPS. In each case, the significant capability gap remained between best practice and non-best practice organizations. BRAG suggests, therefore, that when an organization applies the appropriate resources to design a CPS correctly upfront, it has the staying power to adapt as business conditions change--that is, it is a dynamic CPS.

Getting the most out of your CPS

What is clear from the BRAG study findings is that CPS implementations have not evolved at the same rate as economic pressures, customer requirements, and product complexity.

Based on the survey findings and their expertise in the field, the BRAG team recommends that if an organization is not realizing benefits from its CPS, executives should assess the organization for root causes. For example, a cause might be:

* The technology itself could be revealing its limitations; missing the flexibility, features, integration, or reporting required for attaining expected benefits of a CPS. This is a strong indication that an upgrade may be in order.

* Lack of education about CPS or systems training could be preventing users from getting what they need from an existing CPS.

* Management could be a barrier, in which case a cost/benefit analysis could make the case for moving to a modern system. The issue might be as simple as getting funding for a much needed upgrade--or more complicated like funding for a whole new system.

It is clear that there are benefits from having a strong and dynamic CPS, and it is up to organizations to ascertain whether their current CPS will help them achieve those benefits or not. If your organization is one of the majority, unsatisfied with its CPS, it may well be worth the time to look into an internal process improvement in the cost accounting area. Give some consideration to deploying an effective allocation system--and perhaps an ABC allocation method is worth a second look.

Denis Desroches is a principal for the enterprise planning field with Oracle Corporation. Toby Hatch is a senior strategist for enterprise performance management with Oracle Corporation. Raef A. Lawson, PhD., CFA, CMA, CPA is vice-president of research and professor-in-residence for the Institute of Management Accountants (IMA).William O. Stratton, PhD., CMA is professor of accounting at the Udvar-Hazy School of Business of Dixie State College of Utah.

By Denis Desroches, Toby Hatch, Raef A. Lawson, CMA, and William Stratton, CMA
COPYRIGHT 2009 Society of Management Accountants of Canada
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2009 Gale, Cengage Learning. All rights reserved.

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Title Annotation:business strategies
Author:Desroches, Denis; Hatch, Toby; Lawson, Raef A.; Stratton, William
Publication:CMA Management
Date:Dec 1, 2009
Words:2152
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