The short answer to this question is, "Everything". Information provided by the costing system determines how the business is managed, what product opportunities are pursued, what price is charged and so forth. What if the information paints a misleading picture? It simply means wrong decisions will be made, wrong behaviours will be rewarded, and in time the business will decline. Just how real is this possibility?
Distortions of the Traditional Cost World:
Surveys of organisations worldwide show that over 50% employ standard costing while close to 40% use marginal costing in their internal accounting. Standard costing - the more widely used method - possesses well known shortcomings that can drive wrong behaviours. Specifically, by incorporating fixed costs into product costs on a volume, direct labour or machine hour basis, it encourages high inventories (since high production volumes lead to an over-absorption of fixed costs and high inventory valuation, which causes cost of sales to seem low and thus leads to high reported paper profits).
However, it is simple common sense (lately emphasised by proponents of lean and TOC methods) that the company only actually makes money when the products are purchased and paid for, not when they sit in finished goods stores.
Lean Accounting:
Lean focuses on increasing speed and reducing waste, both of which have the effect of reducing inventories. Indeed the ideal in the lean world is continuous flow. Goods are produced just in time, and thus minimal inventories are held. TOC relaxes the no inventory rule by allowing some protective buffer inventories for the constrained resource and at the finished goods end. Even so, emphasis is on low inventories.
It was obvious to the originators of lean (Toyota) and TOC (Eliyahu Goldratt) that traditional accounting could not support or drive their process based systems. Alternatives were needed.
Learning Your ABCs:
Activity Based Costing was invented in the 70s and 80s and offers a more accurate method of allocating indirect costs on the basis of cost drivers. These drivers are activities carried out in the course of producing the good or service. Each product is allocated costs to the extent that it consumes the relevant driving activity.
By allocating costs on a more accurate basis, ABC mitigates some of the shortcomings of traditional accounting. In particular, it helps in the proper assignment of the cost of complexity. Complex to make products or services bear their full cost of production and so the business can price them properly in the market or discontinue them. There is an incentive to eliminate product and service complexities that are not visible to or valued by the customer.
Put Yourself through the Throughput World:
Throughput accounting arose directly from the Theory of Constraints. It recognises that the constrained resource is what determines how quickly the product moves through the value chain from the suppliers through internal processes to the customers or the rate at which money comes into the business in exchange for goods or services. The relevant variables in throughput accounting are throughput (T), inventory (I) and operating expense. Inventory represents money spent on things intended for conversion to throughput, while operating expense (OE) is the amount required to convert inventory to throughput.
The aims of this system, in order of importance, are to provide management with information that enables the maximisation of throughput (T), while reducing inventory (I) and operating expense (OE). Decisions are evaluated on the basis of their impact on the following system wide metrics:
Net profit (NP) = T-OE
Return on Investment (ROI) = NP/I
Productivity = T/OE
Investment turns = T/I
Conlusion:
Adoption of business process thinking requires information systems that support actions leading to high throughput, low waste and low inventories. Traditional accounting systems with their focus on local (rather than system wide) efficiencies, and cost minimisation often lead to decisions at variance with lean and throughput thinking, and can delay the potential gains obtainable from their adoption.
Samuel Okoro is the CEO of Leapfrog Alliance Ltd, a management training and consulting firm that helps organisations to reduce costs and improve quality through better business processes. His personal passion is to help move Third World business to world-class levels. For further details please visit
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