WHAT IS COSTING FOR?

Understanding costs

The purpose of cost accounting is to understand costs and thus be in a position to manage costs. There are many different techniques that can be used, but the overriding goal is to have a useful understanding of costs, for better decisions to be made and for progress to be accelerated.

The goal is not only to understand what costs are and what progress is being made ... but to understand also how this progress relates to the progress that should have been made.

Cost accounting provides the data foundation in the corporate setting so that management need not use anecdotes, journalism and publicity brochures for decision making ... and TVM Value Accountancy takes these same ideas and applies them in the broader community setting.

Moving data from neutral

The purpose of cost analysis is to improve understanding.

Good accounting data are neutral, and merely reflect some underlying reality. Cost analysis takes data and puts it in a form that augments understanding. It really does not matter what analysis is done as long as the result is better understanding and improved decision making. It does matter that the analysis is done on top of neutral data. It does matter that data are reliable and reflect an underlying reality.

The problem of deteriorating data

In the 1970s, when fisheries population dynamics was a rapidly developing science, I had a conversation with Dr. Gulland at FAO about the problem of using more and more mathematics to compensate for less and less data. Over the years more and more mathematics has been done on less and less data.

As computational power has increased ... the problem has become more and more serious. It is time to get back to having more and better data.

Accountancy uses rather little mathematics on top of simple data that are well organized. A priority to improve data collection, data flows and data storage will be very valuable.

Cost centers

Cost centers, profit centers, investment centers, departments, etc are all rather similar. The key is to understand what they are doing and what they are costing.

If what they are doing does not seem to have any value ... then some further questions need to be asked and decisions made.

Corporate accounting systems usually have very effective cost accounting capability, but getting useful information from these systems is not always obvious.

Value chain

The value chain has been a critical factor in organizing development, production and marketing around the globe. The value chain has been structured to maximize profit for the involved organizations with little regard to the optimization of community value. The results have been predictable with favorable profit optimization largely offset by value destruction for society.

Transfer prices

Prices are critical in economic analysis and the determination of profit and value to any entity. Transfer pricing is used to put a value on goods and services as they move from one sub-entity to another within an organization, or between controlled entities. They are a tool that can be used to move profit between entities and may have inappropriate consequences.

Management accounting

Management accounting is a subset of accounting that helps to get relevant analysis into the hands of decision makers.

I see management information as the least amount of information that is needed to make good decisions reliably.

Department costs and the variants

A cost center is one way in which costs can be organized to help understand and control costs.

By pulling costs together within a unit called a cost center, it is possible to get information about a company's activities in a simple way.

Responsibility accounting

Responsibility accounting is the name given to accounting where the reports specifically identify the responsible managers. This is a useful technique for getting clarity about who is responsible for what ... and there is rarely much agreement.

Elements of cost

Materials, labor and equipment are the main elements of cost that go into most production activities ... and determine costs.

Fixed and Variable Costs

But these items also determine the behavior of costs and how costs can be improved.

Breakeven

When costs are thought of as being fixed and variable, and revenues are thought of as being directly related to quantities, in a profitable activity, there is a mathematical point where revenues equal the sum of fixed and variable costs. This is known as the breakeven point.

Standards

The techniques of standard costing can be used in TVM Value Accountancy as they are in corporate cost accountancy. A standard is what might be expected based on technical assessment ... compared to an actual which is what actually happened. There are many ways in which the comparison between actual and standard can be made ... the aim of analytical accountancy is for this comparison to improve understanding the most and cost the least.

Useless ... or valuable

Standards my be thought of as being fixed and arbitrary and useless ... or they may be used as a very powerful tool for understanding a lot of complex material in an efficient way. In this latter mode standards come alive. They start off being the best that can be ... best in the sense of reflecting the best data that are accessible ... and then they improve as better data becomes available and is made accessible.

Standard cost

Standard cost accounting helps cost accountants measure cost performance without getting deeply buried in detail. Standard costs are the theoretical cost of an item or service

Standard, actual, variance

The comparison of standard with actual alerts a cost accountant to something that is different and helps put the focus of effort onto something that is out of the ordinary. If actual costs are different from standard costs, then it is time to find out why.

Standard values

The same approach is used for value as for cost. Every activity produces something ... what is the standard value of this output? This can be determined in an arbitrary manner, and then it can be used in an analytical framework, and compared to alternative values that are justified from different other perspectives.

Analysis ... a step to creating value from data

Data are nothing without analysis. The effective use of the product of analysis for decision making and holding people and organizations accountable is what makes TVM Value Accountancy valuable. Experience has shown that performance improves when there is active feedback and there are the data that enables people and organizations to be held to account. People may not like it ... but their performance improves.

The purpose of analysis is to get a better understanding. The data are neutral ... the analysis then produces results that might suggest some conclusions. It really does not matter what analysis is done as long as the result is better understanding and improved decision making.

One value step is moving from data through analysis to understanding ... another is to move from understanding to effective action. In some situations this has been done with wonderful results, but mostly there have been interventions that were more expensive than effective.

Comparative analysis

Comparative analysis has many forms ... including

1. (1) the comparison of data from one locations with another location;
2. (2) the comparison from one time to another time;
3. (3) the comparison from one organization to another
4. (4) the comparison of what should be to what actually is;
5. (5) the comparison of one approach to another approach; etc.

Time series

Time series are very powerful ... the corporate world uses them all the time. Capital markets use time series ... the public needs to have time series that show what is going on that specifically impacts their community.

Historic cost accounting

A valid criticism of accounting is that it is all about history ... and this also applies to cost accountancy. But it is also a fact that if you know something about the past, it is possible better to understand today and the future.

Why history is important

Someone told me a long time ago that if you do not know where you have been, and do not know where you are, you are unlikely to know where you are going.

Clearly knowing everything about the past is going to be costly, consume time and therefore be counterproductive ... but having knowledge about the behavior of costs, prices and values ... and about productivity, profits and value adding are valuable. In fact, there is no high performing corporate organization that does not understand these things.

Appreciation of cost behavior

I have never come across a successful organization where the management and responsible department heads did not have very clear understanding of the behavior of costs and the characteristics that make their products or services valuable. Where key staff understand these things ... there is success.

With cost accounting I am able to learn more about the structure of costs ... material labor, indirect production costs, etc. than most of the operating staff. Because they know how to combine what I know with their real world it is possible to do things that enhance productivity. Knowledge of cost gave people the confidence to try something that they would not do otherwise ... it lowered the risk of trying to improve! Knowledge of cost also helped people to focus on what is important and do things that had a material impact.

In the corporate world, there is a good foundation of knowledge about cost, prices and profits. Not much of this is available to the public, but it is an integral part of decision making in the corporate setting. The situation about cost knowledge in the public sector as a whole and the relief and development sector in particular is remarkably limited. As a result it is fair to say that society gets a lot less from its government than it should ... even at the best of times.

Cost accounting ... two settings

Cost accounting ... and thinking about cost, price and profit are central to management information in the corporate setting. But this is not the case for society as a whole. Cost accounting is weak in most public sector organizations ... and there is no history of cost accounting about society and socio-economic progress. But what works to help understand the behavior of cost in the corporate sector can be modified for use within the TVM Value Accountancy setting. Almost all the tips and tricks that may be used for corporate understanding can also be used to understand how to make better progress in the societal setting.

Corporate accounting systems usually have very effective cost accounting capability, but getting useful information from these systems is not always obvious.

Costing ... use the right tools

American Airlines used to be one of the cutting edge users of computers ... developing the Sabre reservation system and dominating this part of the airline industry. At some point this team was asked to do some costing about the airline operations like baggage handling and airport operations. They tried ... and struggled ... and failed. The computer should not have been the starting point.

Cost accounting is a management tool. The purpose of cost accounting is not to merely exist, but to provide actionable information for managers and the organization's decision makers. Accuracy is not as important as relevance.

Relevance

I was trained in the UK and learned cost accounting initially in that environment. The cost accounting was rigorous, and accurate ... but not very relevant. Later I worked in the USA and found the cost accountancy “sloppy” ... but relevant and effective.

Around this time Rolls Royce in the UK had an accounting system that enabled it to cost everything to 4 decimals points of a penny ... but the cost of building the new RB211 jet engine was wrong by about a billion dollars and the company faced bankruptcy. Meanwhile Pratt and Whitney in the USA with its rather sloppy cost accounting had an excellent handle on what its products cost.

This is not to advocate for sloppiness ... but to speak up for relevance.

The purpose of cost accounting is to build the foundation for the understanding of cost behavior. Today's costs are a combination of both history and today ... and ultimately so also are profits. When applied to TVM Value Accountancy understanding the behavior of cost helps to make socio-economic progress more than a zero-sum game ... or worse, a real world application of “Heads I win ... tails you lose”.

It is helpful to understand not only the behavior of cost ... but also the behavior of productivity. Edward Deming ... one of the history's experts on systems and quality ... would have understood the idea. Cost and productivity are different manifestations of the same system. But cost also has an effect throughout the value chain ... and different parts of the value chain have a whole range of behaviors that impact on both corporate profits and on society.

All of the many different cost elements behave in different ways ... the aggregate cost depends on all of the pieces ... and the unit cost depends on all of the pieces as well ... but not always in ways that are immediately obvious.

At the same time the value elements also behave in complex ways ... sometimes a function of a cost change, sometimes for unrelated reasons.

Cost accounting is boring

Yes ... cost accounting is boring if it is defined as simply the recording of the basis data. But cost accounting is exciting when it helps to understand the behavior of costs, and all the factors that influence these costs. Boredom is usually some reflection of the individual, more than it is cost accounting per se.

Estimating Costs

My formal academic education is in engineering and economics ... and my professional training in accountancy. In the early 1960s, when I was working with Coopers and Lybrand in London I was assigned to recalculate the cost estimates for the Kariba Dam being planned for Zambia. My work showed that the World Bank's estimates were about 50% of what was required. My work not only took into consideration what costs had been in the past but what they were going to be during construction in the future in a remote location ... in other words, I tried to anticipate the behavior of costs rather than treating costs in a simplistic mechanistic manner.

More and more detail may not be the best answer ... ability to look at data in different ways may be more useful.

Cost accounting is a powerful tool ... but it needs to be in the hands of people who have an understanding of accounting and the sectors involved.

Cost accounting is a part of accounting that informs about how much things cost. In the corporate enterprise the cost systems are well developed and our used extensively.

In the not for profit organization, cost systems are much less developed and analysis of costs is rarely integrated into the accounting systems, but done rather as ad hoc studies or as part of monitoring and evaluation exercises.

How much did it cost ... how much should it have cost.

The question “How much did it cost ... how much should it have cost?” is fundamental to managing performance. It is not a question that the relief and development industry wants to answer, nor to get answered.

Many ways to do cost analysis

There are many ways to do analytical accounting. Rather than simply summarizing the accounts for the period based on the organization as a whole, the accounts can be summarized in more detail, as, for example:

• By department
• By cost center,
• By profit center
• By business segment

• By individual product
• By product line
• By process or activity
• By product

Departmental accounting
Cost centers, profit centers, investment centers, departments, etc are all rather similar. The key is to understand what they are doing and what they are costing. If what they are doing does not seem to have any value ... then some further questions need to be asked and decisions made.

Almost all companies will have department accounting so that the costs of a department can be understood and controlled. A department may have multiple cost centers. Department accounting is widespread because it informs about the costs of a department. Sometimes the costs are linked to revenues or activity levels. In Community Accounting applications, analysis of costs between activities in the community provides useful additional understanding. Departmental accounting and cost center accounting are similar, with cost centers often more detailed than the department.

Cost center
A cost center is one way in which costs can be organized to help understand and control costs. By pulling costs together within a unit called a cost center, it is possible to get information about a company's activities in a simple way. The cost center is a common technique in corporate accounting to cumulate costs so that they are easily understandable and can be related to a tangible entity. TVM Value Accountancy also uses the cost center concept to pull together all the cost information about an activity or set of activities.

Cost center metrics

The first thing that cost center analysis shows is cost by element of cost. How much of the cost is for labor and how is this made up ... direct, indirect, overtime, benefits, incentive pay, etc.

How much is for various supplies ... which are important? In a shipping department ... how much was being spent on tires? How much for fuel?

How much for equipment use? How much for equipment lease?

While a cost center does not directly generate profit ... it does have productivity that can be measured. How do the costs compare to metrics of performance ... what we used to refer to as key item controls.

The report shows actual costs ... how does this compare to what the costs should have been for what was done during the period.

Profit center metrics

A profit center may be more useful for performance analysis than a cost center ... or it may confuse. This depends on the structure of the company and the internal value chains. Everything that applies to a cost center applies to a profit center, except that in addition the costs for a period may be related to a revenue as well.

There are some dangers with profit center analysis including the potential problem of signaling profitability at the cost center level when in fact there are big costs not allocated to the profit center, but very meaningful for the company's performance as a whole.

A dramatic example of this is the automobile industry's willingness to ignore the accounting for unfunded pension obligations and other retiree benefits ... but the same thing can happen on a more modest scale..

Investment center
Another way to look at a part of the organization is to do it through the investment. The costs and revenues associated with a particular investment serves the reporting center.

Return on capital employed

One of the most useful metrics is to measure profit and relate it to the amount of capital needed to earn this profit. Relating profit to sales may not be very important when the company's resources are the limiting factor ... the most usual case.

How much equipment and space is needed to earn the profit? This is the fixed capital needed, and might well the a critical constraining factor.

How much inventory is needed? How much receivables? This is the working capital needed ... and is often a much bigger amount than is expected. This may or may not be a constraint, because there are funding possibilities that tie into the level of working capital ... but these do have a cost and an impact on profit.

Product costs
Product costs can be obtained by having accounts and sub accounts for each economic element for every product and charging all expenses to these detailed accounts. This is a costly approach but it can be done. Some systems still do costing using this basic approach.

Cost accounting is boring - II

I have to admit to finding the theory of cost accounting boring ... but the information is far from boring. If I could, I would like to know how much everything around me cost ... and how much it is priced at ... and how much profit is being made with it. I would like to map these facts ... to have charts that show changes over time ... and to have charts that show this from place to place.

Process costs
Many products are produced using an end to end process. This is the case in, for example: chemical factories, steel mills, refineries, and pulp and paper plants. In all of these cases it is possible to cost the product because the cost behavior of each step of the process is well understood.

For each step of the process all the costs ... by element of cost ... are known and the actual and standard are easily compared. When costs vary from standard, the cause can be easily identified and taken into consideration.

Activity costs Many products are produced using an end to end process. This is the case in, for example: chemical factories, steel mills, refineries, and pulp and paper plants. In all of these cases it is possible to cost the product because the cost behavior of each step of the process is well understood.

For each step of the process all the costs ... by element of cost ... are known and the actual and standard are easily compared. When costs vary from standard, the cause can be easily identified and taken into consideration. Project costs
Project costs – construction project Many

Project costs – World Bank project Many

Contract costing – construction project

When 2% of a contract has been billed and paid for, it would seem that 2% of the work would have been done. A pulp and paper mill construction contract had a well known general contractor ... and the contract had a detailed project cost budget that defined the work to be done (together with engineering drawings).

But cost analysis showed that while 2% of the money had been consumed, only 1% of the work had been done ... suggesting a 100% cost overrun for the project at completion. For the contractor this would have been fine ... it was a cost plus contract ... but for the owner it would have been a disaster.

The contractor was spending the money ... payroll was legitimate ... materials and supplies were being bought and paid for ... etc. But something was wrong. We ran a series of cost audit tests and concluded that the workers were too many ... getting in each others way ... and generally more than needed ... and the same for use of materials and supplies. We made the case to the General Contractor who immediately reduced the workforce from 1,400 to 700. When the project was completed the cost was within 5% of the original budget ... way better than a 199% cost overrun.

The transfer price from stage to stage in the value chain can be the difference between a value chain that works and one that does not. A value chain price at one stage becomes a value chain cost at the next stage ... but this cost contains an element of profit as well as just costs.

There is little public easily accessible information about value chain costing, but it is a critical piece of information for the understanding of progress. Progress drives itself when the incentives are right ... where the reward for investment and effort is adequate. Progress stops when the incentive is not there ... and inn a long and complex value chain it only takes one piece of the chain to be devoid of incentive for the whole value chain to crumble.

Note: A number of different value chains are described in the Value Chain chapter.

Location of industry

When I was first taught about location of industry it was mainly about the proximity to raw materials and energy and access to transportation. I observed at the time (1960) that this was changing because of more creative content in the emerging new products, and that location of industry was going to be driven by where the boss wanted to live.

I was much closer to being right than I got credit for at that time ... industry is now much more modular and each module is located where it is most cost effective. Modules that need creativity are in New York and California, modules that need labor efficiency are in China and South East Asia, modules that need natural resources are next to the mineral deposits and oilfields, modules that need to deliver to the consumer are next to the consumer wherever in the world that might be. There is an amazing interconnected global value chain optimized to make profit for the players and the investors.

Regulation ... the enabling environment

The regulatory environment has costs .. and benefits ... and changes the economics of a product, service or business.

PROJECTIONS

Commodity Price Projects and the World Bank

For several years I did financial analysis assignments for the World Bank in connection ... and was frequently faced with questions about the future cost of commodities. The deep study of commodity prices was not my specialty ... but I had some fairly broad knowledge of markets and the behavior of prices, especially in turbulent times.

As a consultant to the World Bank ... ones expertise does not have the same weight as the staff expert. Over and over again the World Bank embraced price projections that the consultants considered completely wrong ... they helped to get flawed projects to have numbers that satisfied World Bank criteria for approval ... and ensured from the start that the World Bank would have a failed project. Nobody at the World Bank has seen fit to allow me to compare the long term price projections made by the World Bank in the period from 1978 to 1982 with the prices actually realized ... but my work during that time suggests that the World Bank was embarrassingly wrong.