COST ACCOUNTING & FINANCIAL PLANNING

LECTURE 1 - AGENDA Cost accounting systems – some basics ABC as a more accurate costing method The issue of cost system complexity and how to deal with it TDABC as a solution for complexity Revisiting the causality principle Prof. Teemu Malmi 2016

PRODUCT / SERVICE COSTING AND PERFORMANCE MANAGEMENT You need to know your product / service costs for: –Pricing decisions –Product mix / portfolio decisions –Process changes - re-engineering –Content changes - R&D –Markets and terms of trade –Cost control over time –Financial statements: COGS and Inventory valuation –….. Prof. Teemu Malmi 2016

COST ACCOUNTING SYSTEMS – SOME BASICS What are the key cost system design parameters which determine how product / service / customer costs would look like? How would you describe a cost accounting system design? Prof. Teemu Malmi 2016

TRADITIONAL FORMS OF PRODUCT COSTING Prof. Teemu Malmi 2016 Costs accounted for:Name: Direct (manufacturing) costsVariable costing = Direct costing = Marginal costing + Indirect manufacturing costsAbsorption costing (manufacturing overhead) + SGA etc. costsFull costing (overhead)

Prof. Teemu Malmi 2016 MORE INFORMATIVE WAY OF PRESENTING MARGINS Sales Price (Product / service) - Material costs = Margin 1 (Similar to Theory of Constraints) -Other variable cost = Margin 2 (Traditional contribution margin) -Indirect costs that can be traced based on causality = Margin 3(Similar to ideas of Activity-Based Costing) -Indirect allocated costs = Margin 4(Full costing)

COST STRUCTURE TODAY Overhead costs are proportionally higher than in the past  Traditional systems focusing primarily direct or only manufacturing / service process costs may produce distorted product costs Prof. Teemu Malmi 2016

WHY DO WE NEED TO STUDY VARIOUS ALLOCATION METHODS? There is no right way of dealing with overheads, but there are better and worse methods to allocate them Different allocation methods produce different product costs => right decisions? Every manager (not to mention controller) needs to understand how costs are calculated in her organization, and whether the figures can be trusted to be ”correct“ Prof. Teemu Malmi 2016

ALL COST SYSTEMS FUNCTION IN A BASICALLY SIMILAR WAY Expense categories are created – starting from book- keeping Costs are mapped to departments, production centers or activities Costs are then attached to cost objects (= Two-Stage Allocation, sometimes more simple procedures used) The way activities are determined and links between stages (allocations) are made makes the difference Prof. Teemu Malmi 2016

LECTURE 1 - AGENDA Cost accounting systems – some basics ABC as a more accurate costing method The issue of cost system complexity and how to deal with it TDABC as a solution for complexity Revisiting the causality principle Prof. Teemu Malmi 2016

ACTIVITY-BASED COSTING SYSTEMS Originally developed to addresses the problem of overhead costs and to calculate product costs “right” - to make right decisions After that, used also for other purposes like business process development, etc. (Activity-Based Management) More complex and heterogeneous operations, products and services are, more likely conventional methods lead to distortions in product costs In theory, ABC is not a full costing method; only costs that are caused by a cost object are assigned to it Prof. Teemu Malmi 2016

Activity-Based Costing Operational ABM Doing things right Performing Activities More Efficiently Value analysis Process re-engineering Performance measurement Strategic ABC Doing right things Choosing Activities, Products, Customers… Product design Product mix Customer relationships –pricing, order size, delivery, etc. Prof. Teemu Malmi 2016

SOME MYTHS ABOUT ABC It is expensive to apply It is a complex endeavor Keeping models up-to-date requires a lot of effort It is not the question of ABC logic, but how it is applied in practice! Prof. Teemu Malmi 2016

OVERHEAD COST POOLS / ACTIVITIES A separate cost pool should be used if the productivity of resources is different and if the pattern of demand varies across the products The optimal number of cost pools will change over time as an organization (structures, products, services,...) changes Accuracy is determined by how many pools you set up, how you determine cost object for each pool and how you define the cost driver for each pool Prof. Teemu Malmi 2016

ACTIVITY HIERARCHY PRODUCT-LINE SUSTAINING BRAND SUSTAINING PRODUCT SUSTAINING CHANEL SUSTAINING CUSTOMER SUSTAINING ORDER RELATED UNIT BATCH Prof. Teemu Malmi 2016

DETERMINING COST DRIVER / OVERHEAD RATES ABC is a model of resource consumption The cost of unused resources are not allocated to cost objects (products) Cost of resources supplied = Cost of resources used + Cost of unused capacity Prof. Teemu Malmi 2016

ILLUSTRATION: Prof. Teemu Malmi 2016 Cost of capacity $ Capacity ConceptAmountDriver rate Theoretical8 760 h13,7 €/h Target6 000 h20 €/h Practical5 000 h24 €/h Normal4 800 h25 €/h Budgeted4 000 h30 €/h

QUESTION If there are always truly joint costs in most organizations, and there is no way of assigning these joint costs to products or services based on causality, is there any advise you could give to those who still would like to allocate those costs to products or services e.g. for pricing purposes? Prof. Teemu Malmi 2016

LECTURE 1 - AGENDA Cost accounting systems – some basics ABC as a more accurate costing method The issue of cost system complexity and how to deal with it TDABC as a solution for complexity Revisiting the causality principle Prof. Teemu Malmi 2016

THE ISSUE OF COST SYSTEM COMPLEXITY AND HOW TO DEAL WITH IT What makes cost systems complex? Any rules of thumb to keep systems simple? Prof. Teemu Malmi 2016

LECTURE 1 - AGENDA Cost accounting systems – some basics ABC as a more accurate costing method The issue of cost system complexity and how to deal with it TDABC as a solution for complexity Revisiting the causality principle Prof. Teemu Malmi 2016

TIME DRIVEN ABC Response to the complexity of traditional ABC Time surveys are replaced by managerial estimates Modelling the complexity by time equations Prof. Teemu Malmi 2016

TIME DRIVEN ABC Problems of traditional ABC a la Kaplan –As surveys of time spending are laborious and expensive, organizations undertake them seldom, and hence data may not be accurate –Normally one driver rate per activity, e.g. €/per shipment. If shipments are not similar, system distorts cost information, or there is a need to add more activities to the system, hence increasing its complexity –Normally 100% of time is distributed to the activities = assumes all resources are fully utilized –If not all resources are required for output, driver rates become too high Prof. Teemu Malmi 2016

TIME DRIVEN ABC In TDABC managers estimate the cost per unit of time for each resource / resource pool and how much cost objects (product, service, customer, etc.) require this resource This instead of assigning costs to activities and from activities to cost objects Activity based costing without activities??? Prof. Teemu Malmi 2016

EXAMPLE Customer service department process customer orders, handle customer inquiries and perform credit checks 28 employees, total department expenses $ per three months orders, 1400 inquiries and 2500 credit checks in three months Prof. Teemu Malmi 2016

TRADITIONAL ABC CUSTOMER SERVICE DEPARTMENT Activity% of Time SpentAssigned CostActivity QuantityCost-Driver Rate Process customer orders70 %$392, $8 per order Handle customer inquiries10 %$56, $40 per inquiry Perform credit checks20 %$112, $44.80 per credit check Total100 %$560,000

TIME DRIVEN ABC Estimate cost of resources –First capacity utilization rate –Then cost per time unit ( e.g. $ 0,8 per minute in customer service) Estimate time required by cost object –Management estimates how long it will take to perform a certain job, service or to make a product –The point is to estimate how long a certain activity takes, e.g. to handle one order, not how much time (in %) a person uses for this activity Determine the cost driver rate –The cost of customer service clerks $ 0,8 per minute X the time it takes to handle one order (e.g. 8 minutes) = $ 6,4 per order Prof. Teemu Malmi 2016

TIME DRIVEN ABC Activity Unit TimeQuantityTotal Time UsedCost-Driver Rate Total Cost Assigned Process customer orders $6.40$313,600 Handle customer inquiries $35.20$49,280 Perform credit checks $40.00$100,000 Total Used $462,880 Total Supplied $560,000 Unused Capacity $97,120 Cost per minute = $ 560,000 / 700,000 = 0,8 $/min

TIME DRIVEN ABC ActivityUnit TimeQuantityTotal Time UsedCost-Driver RateTotal Cost Assigned Process customer orders $6.40$326,400 Handle customer inquiries $35.20$40,480 Perform credit checks $40.00$108,000 Total Used $474,880 Total Supplied $560,000 Unused Capacity $85,120

TIME DRIVEN ABC Maintaining the model –Cost of resources may change (= increase), so the unit cost of resource / resource pool per time should be revised –Activities may become more efficient. Less time required – therefore time usage in time equations should be revised –For example, new database halves the time required to perform credit checks. The new database increases the cost of resources, but the saved time in performing checks is likely to reduce the costs allocated to e.g. a customer Prof. Teemu Malmi 2016

MODELLING COMPLEXITY Time equations may allow less activities to the model E.g. sales people handling phone and internet orders, time spending is followed by customer set-up, order entry and order expediting Time Equation: Order entry 5 + (3 x number of line items) + 15 (if new customer) + 10 (if expedited order) The cost of each order is simply total time of that particular order multiplied by the cost per minute Modelling the process instead of using three activities Less effort on data collection Prof. Teemu Malmi 2016

SUMMARY OF TDABC How TDABC will reduce model complexity? Prof. Teemu Malmi 2016

LECTURE 1 - AGENDA Cost accounting systems – some basics ABC as a more accurate costing method The issue of cost system complexity and how to deal with it TDABC as a solution for complexity Revisiting the causality principle Prof. Teemu Malmi 2016

REVISITING THE CAUSALITY PRINCIPLE Consider a post and logistics operator, such as Itella in Finland Itella has built an infrastructure that enables them to handle regular mail as well as packages Infrastructure involves places, where you can leave mail and packages you want to send, logistics hubs, transportation equipment, and an organization that delivers mail and packages to customers Moreover, there are IT-systems and various SGA related activities incurring costs Prof. Teemu Malmi 2016

REVISITING THE CAUSALITY PRINCIPLE Mail services are regulated, package deliveries are fiercely competed One of the key issues for Itella is pricing of its services If you would need to compute the cost of delivering mail (e.g. one traditional letter) and packages (one piece of package), how would you do it? Prof. Teemu Malmi 2016

REVISITING THE CAUSALITY PRINCIPLE Would you change your suggestion, if you knew that: –To be able to operate in postal services, firms need to have a permission from the state –Permission requires firms to deliver regular mail five days a week and maintain mail boxes and service locations close to where people live to allow citizens an easy access to mail services –What is the cause for a large amount of costs post operators incur? Prof. Teemu Malmi 2016

SUMMARY Overhead allocation is the biggest concern in calculating full costs – you need to understand how it is done and is it done properly There are many alternative ways to allocate overhead costs – remember that not all costs can be assigned following causality Good results can usually be achieved by determining right number of activities/overhead cost pools, understanding the nature of costs in each of them (unit, batch, product, etc.) and selecting appropriate cost drivers – avoid plant wide rates! Prof. Teemu Malmi 2016

SUMMARY Key learning points today? Prof. Teemu Malmi 2016