1. Cost Management as a Strategic Weapon
Raef Lawson, PhD, CMA, CPA
IMA Vice President-Research & Policy, Professor-in-Residence
New England Regional Council
September 19, 2017

2. About IMA
IMA® (Institute of Management Accountants), founded in 1919, is a leading professional association of accountants and financial professionals in business.
A network of over members and over 300 chapters worldwide.
Global office in US; regional offices in Asia, Europe and the Middle East.
We are committed to helping strengthen members’ financial management skills, enhancing organizations’ performance, and growing members’ career potential.

3. Agenda
Accountants as Drivers of Economic Value
Information for Effective Decision Making
The importance of decision models
Activity based costing
Strategic Cost Management
Customer value / Profitability
Process improvement
The Accountant as a Decision Leader

4. Accountants as Drivers of Economic Value
What is Management Accounting?
Management accounting is the internal business building role of accounting and finance professionals who work inside organizations.
These professionals are involved in designing and evaluating business processes, budgeting and forecasting, implementing and monitoring internal controls, and analyzing, synthesizing, and aggregating information to help drive economic value.
Source: IMA Statement on Management Accounting

5. Have Accountants Been Driving Economic Value?
Not really.
The demands of external reporting, regulatory compliance and financial administration have kept accountants from performing their role in driving economic value.
Obsession with GAAP-based financial performance measurements has kept accountants from contributing to their company’s economic value.
Management has depended on the accountant to “keep them out of trouble” and provide traditional reports, but has not looked to him or her to provide new insights that can drive the organization’s economic value.
© 2014 D. T. Hicks & Co.

6. Most Managers Rely on Others Outside Finance for Costing Information
Source: 2017 survey of APICS members

7. Neither agree nor disagree (3)
Financial Managers Do Not Believe Accounting Systems Provide Adequate Costing Information
Strongly agree
(1)
Agree
(2)
Neither agree nor disagree (3)
Disagree (4)
Strongly disagree
(5)
Average
Our current accounting system does not provide all of the information required for managerial decision-making.
27%
29% 7%
20%
17%
2.71
There is a need for an improved cost system to support managerial decision-making.
39%
32%
15%
2.2
Improvement in service or product costing information would give our organization a competitive advantage
44%
12% 0%
1.68
Improvement in tracing the costs of activities performed would facilitate process improvement efforts.
46%
51% 2%
1.56
Source: 2017 Survey of HFMA members

8. Information for Effective Decision Making

9. The Importance Of Decision Models
Most phenomena are too complex to be completely understood.
To function effectively we create “models” of those phenomena.
These models represent our “internal version” of the outside world that makes the world more understandable and easier to deal with.
Good decisions require good models.
© 2012 D. T. Hicks & Co.

10. XYZ Corporation Cost Objects
Typical Accounting Model
XYZ Corporation Costs
Direct Material,
Services and
Components
Direct Material,
Services and
Components
Operating
Costs –
Direct Labor
Operating
Costs –
Direct Labor
Operating
Costs –
Overhead
Operating
Costs –
Overhead
Selling, General &
Administrative
Costs
Selling, General &
Administrative
Costs
Direct-Labor Based
Overhead Rate
Percentage of Total
Accumulated Cost
XYZ Corporation Cost Objects

11. Typical Uses for Costing Information
Determine the cost of making a product or providing a service
Determine the benefit of creating a manufacturing cell to replace three independent operations
Estimate (or measure) the cost of managing an exhibit while it’s on a multi-show, multi-state tour
Compare the cost of acquiring business for each market served by the company
Does the traditional costing model provide a valid
understanding and perception of reality?

12. The General Ledger View is Deficient for Decision Analysis
Chart-of-Accounts View
Insurance Claims Processing Department
Favorable/
(unfavorable)
Actual
Plan
Salaries
Equipment
Travel expense
Supplies
Use and
occupancy
Total
$621,400
161,200
58,000
43,900
30,000
$914,500
$600,000
150,000
60,000
40,000
30,000
$880,000
$(21,400)
(11,200)
2,000
(3,900) ––
$(34,500)
When managers get this kind of report, they are either happy or sad, but they are rarely any smarter!

13. Cost Accounting Information is NOT Decision Cost Information
Includes only “inventoriable” costs
Satisfied with entity-wide inventory and COGS measurement
Populated with GAAP-defined cost data
Locked into only one or – where alternative rates are possible – two sets of assumptions.
Permits the direct labor-based assignment of costs even when inappropriate
Focuses on “fully-absorbed” costs
Must include all business costs
Demands accuracy at process, product and customer levels
Populated with economic cost data appropriate to the situation – ‘different costs for different purposes’
Must allow for unlimited sets of assumptions
Requires assignment of cost on a basis consistent with the company’s operating realities
Must generate both “fully-absorbed” and “incremental” cost information
© D. T. Hicks & Co.

14. Changes in Cost Structure over Time
Broadly averaged cost allocation was acceptable.
100%
Overhead
(indirect expenses)
Cost errors are large and misleading.
Direct
Material
Cost
Components
Direct Labor
1950
2017 0%

15. The purpose of Activity-Based Costing is insight, not calculations.
Activity-Based Costing (ABC) is a “lens” for taking the complex operations of a business enterprise and
developing a cost model that accurately reflects
the relationships between the company’s
costs, activities, and products.
The purpose of Activity-Based Costing is insight, not calculations.
© D. T. Hicks & Co.

16. Activity-Based Costing
Products and services cause activities and performing those activities cause costs to be incurred
Associate costs with the activities that make them necessary and accumulated activity costs with the products or services that make them necessary
© D. T. Hicks & Co.

17. Single and Multiple-Stage ABC
Resources
Resources
Activities
Objects
Activities
Objects
Simple ABC
Expanded ABC ©

18. “It is better to be approximately correct than to be precisely wrong.”
Important Principle Underlying ABC
The effectiveness of an ABC model or system is more dependent on its design than on its method of implementation or the data used to populate the model or system.
“It is better to estimate the right things than to precisely measure the wrong things.”
“It is better to be approximately correct than to be precisely wrong.”
© 2014 D. T. Hicks & Co.

19. Strategic Cost Management:
Customer Value / Profitability

20. (Customer) Profitability using Traditional Costing Model$
Contrib Margin ($)
(Sales – Var Costs)
Profit
Sales
Volume
Fixed
Costs

21. Customer Profitability using ABC
$ 30 sales
expenses
= $ 2 profit
Net Revenues Minus
ABM costs =
profit
Unrealized profit revealed by ABM
$ 2 profit

22. Value of Company = f(Value from Customers)
The value a company creates is the value that comes from its customers – both current and future ones.
To remain competitive, companies must determine how to keep customers longer, grow them into bigger customers, make them more profitable, serve them more efficiently, and acquire relatively more profitable customers.
Products and standard service-lines are not the only thing for which accountants should compute costs.
The problem with traditional accounting’s product gross profit margin reporting is you don’t see the bottom half of the picture.

23. ? What about Costs Below Product Costs ? INCOME STATEMENT Sales $ 100
- Product direct costs
- Overhead cost
= Gross profit margin $ 70
The accountants report these by each product (but they are wrong without ABC).
- selling costs
- distribution costs
- marketing costs
- administrative costs
= Total Profit $ 10 ?
We have no visibility of these costs by customer (except in total) ! ©

24. Why Do Customer-related Costs Matter?
Higher customer retention
It is relatively much more expensive to acquire a new customer than to retain an existing one.
Understanding these can be a source of competitive advantage
As products and services become commodity-like, then the shift is towards service-differentiation.
Impact of CRM’s “One-to-One” marketing
Technology has become the enabler to (1) identify customer segments, and (2) tailor marketing offers.
Power is shifting to consumers
The Internet is shifting power from sellers to buyers.

25. Migrating Customers to Higher Profitability
Very
Profitable
High
Profitable
Product Mix
Margin
Unprofitable
Low
Low
High
Very
unprofitable
Cost-to-Serve

26. These losers drag down profits
Customer Sales Volume Versus Profits
Customers tend to cluster. Medium-volume customers can be much more profitable than large-volume customers!
$ profitable
Profitability
$ 0
These losers drag down profits
$ (unprofitable)
$ small
$ large
Sales Volume ©

27. A Shift in the CFO’s Emphasis
CFOs should help Sales and Marketing better target customers.
The spending budget for sales and marketing is critical:
It should be spent in a way that generates the highest long-term profits.
This means answering questions like:
Which type of customer is attractive to newly acquire, retain, grow, or win back? And which types are not?
How much should we optimally spend attracting, retaining, growing, or recovering each customer micro-segment?

28. Optimizing Customer Value
You can destroy shareholder wealth creation by …
… over-spending unneccessarily on loyal customers relative to what is needed to retain them.
… under-spending on marginally loyal customers and risk their defection to a competitor.
The optimum spending level for differentiated services varies for the various micro-segments of customers.
You need to have accurate costing models/information on which to base these decisions.

29. Strategic Cost Management:
Process Improvement

30. Activity analysis judges work based on need, efficiency, and value.
Activity Analysis for Process Improvement
Target an activity
for improvement
Activity analysis judges work based on need, efficiency, and value.
Is activity
required by
a customer?
Yes No
Can activity be
eliminated?
Can the
driver
frequency be
reduced?
Does
activity contain
low-value added
tasks? No No No
Eliminate
the activity to
reduce cost
All cost
reduction
opportunities
identified
Yes
Yes
Yes
Reduce the activity
frequency to
reduce cost
Eliminate
low-value added
work to reduce cost ©

31. Activity Analysis for Process Improvement
Patient Care Form (PCF) Processing by an HMO
© 2016 R Lawson

32. There is No One “Correct” Cost
We need different costs for different purposes!
- A management accountant has to think, not just memorize mechanics. - Management accounting consists of concepts to be applied, not forms to be filled in. - By employing appropriate decision models accountants can help drive the economic value of their organizations.

33. The Management Accountant
as a Decision Leader

34. Administration vs. Management vs. Leadership
Management and leadership are not the same thing.
Management copes with complexity, relying on budgets, plans, targets, and organizational charts. Managers tend to follow rules and are risk adverse.
In contrast, leaders cope with change – change that is accelerating. Leadership requires vision, direction-setting, inspiring employees, and intelligent risk management.

35. Administration vs. Management vs. Leadership
Compliance
Controlling Complexity
Driving Value
Plans and budgets
Strategy execution measures
Record keeping
Management economics
Transaction recording
Performance measures
Tax compliance
Tax strategies
Decision support systems
90.0%
9.8%
0.2%
© 2014 D. T. Hicks & Co.

36. Making Quality Management Decisions
Businesspeople tend to blame poor performance on outside conditions that are beyond their personal control; a bad economy, unfair competition, unfavorable economic policies, etc.
It’s not my fault!
In reality, poor performance is most often the result of ineffective decisions; inappropriate management responses to outside conditions.
© 2014 D. T. Hicks & Co.

37. What Makes Decisions Ineffective?
Cognitive biases – mental errors caused by our simplified information processing strategies.
Dysfunctional goals, objectives, or incentives – inappropriate measurements for gauging the success of a decision
Single-point decisions – treating decision making as an event – a discrete choice that takes place at a single point in time.
Poor costing models
Accountants are in a unique position to serve as decision leaders and add substantial value to their organizations.
Adapted from © 2014 D. T. Hicks & Co.

38. Decision Maker vs. Decision Leader
A decision maker has ultimate responsibility for making the decision.
A decision leader takes the lead in ensuring the quality of the decision-making process.
© 2014 D. T. Hicks & Co.

39. The Accountant as a Decision Leader
Information generated by accountants is part of almost every business decision
Accountants are the closest thing most companies have to an “economist”
Accountants are already active in systems development and act in an “oversight” capacity
Accountants have “wall-to-wall” responsibilities within the organization
Accountants are present when most major decisions are being discussed by or presented to decision makers
© 2014 D. T. Hicks & Co.

40. How Does an Accountant Become a Good Decision Leader?
Be on the alert for cognitive biases that corrupt the decision making process and take steps to eliminate them.
Insure that the economic measures used to support decisions are comprehensive, accurate, relevant, and based on a valid economic model of the business.
Work to develop effective decision-making systems that provide a structure within which key management decisions are made.
© 2014 D. T. Hicks & Co.

41. Thank you! - Questions? Feel free to contact me at: RLawson@imanet.org
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