Accountancy & Management: Spotting the cost drivers brings value: UK firms use outdated costing systems, argue Colin Drury and David Pettifer

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NEARLY three quarters of UK manufacturing companies are using questionable information to make decisions, the Chartered Association of Certified Accountants says.

Accounting data that is required to meet the needs of external financial reporting, rather than specialist management accounting information, is often the basis for the options taken, according to a survey of more than 300 companies carried out recently by the association.

This is because, to meet financial accounting requirements, product costs need not measure resources consumed by each individual product to provide information that is sufficiently accurate at the aggregate level for valuing stocks and measuring profits.

Rather than investing in two separate systems - one for stock valuation and the other for decisionmaking - over the years most companies have opted, on a costs versus benefits basis, to invest in a single system designed to meet stock valuation requirements. Traditional costing systems accurately measure direct labour and material costs but overheads - costs that cannot be traced directly to products - are generally spread across all products by the use of some arbitrary rule.

The most widely used overhead allocation basis is direct labour hours, but direct labour only averaged 12 per cent of total costs in the companies surveyed. This can result in a situation where a very small change in the number of direct labour hours worked has an unrealistic and dramatic effect on the costs allocated to products. Also, for many overhead costs, resources consumed by products are unrelated to direct labour hours.

Traditional product costing systems for meeting stock valuation requirements were designed several decades ago when overhead costs were relatively small and distortions arising from arbitrary overhead allocations were not significant. Information processing costs were high and it was therefore difficult to justify the use of more sophisticated methods of tracing overheads to products. Today, overheads are often the dominant costs and information costs are no longer a barrier to introducing more sophisticated systems.

A considerable amount of publicity has been given to the writings of Robert Kaplan and Robin Cooper from Harvard Business School. In a series of articles in the late Eighties, they argued that traditional management accounting systems were obsolete and no longer provided relevant information to meet the requirements of a modern manufacturing and competitive environment. They claimed that managers were making decisions about product mix, abandonment and pricing on the basis of unreliable information and therefore businesses were running the risk of making wrong decisions and/or losing out to competitors.

Cooper and Kaplan have been the main pioneers in publicising activitybased costing (ABC) as a solution to providing more relevant product-cost information. ABC systems assume that activities cause costs and a link is made between activities and products by assigning costs of activities to products based on an individual product's demand for each activity.

The first step is to identify the main activities performed in the organisation, such as machining and assembly as well as support activities, including purchasing, packing and despatching. The next step is to identify the factors (called 'cost drivers') that influence the cost of each activity. For example, if production scheduling cost is generated by the number of production runs that each product generates, then the number of set-ups would represent the cost driver for production scheduling. Finally, the cost of activities is traced to products according to a product's demand (using cost drivers as a measure of demand) for the activities. So, if product X requires 20 set-ups and product Y requires only five, then product X will be assigned with four times more of the production scheduling costs than product Y.

Since it was first publicised in 1989, ABC has been vigorously marketed by management consultants from the big accountancy firms. According to the survey, 37 out of 300 UK manufacturing firms have implemented, or are in the process of implementing, ABC. Virtually all of these were the large organisations. Many non-manufacturing organisations (for example banks and utilities) have also implemented ABC. Important driving forces have been deregulation, increased competition and an expanding product range, which have created the need for more accurate cost measurement for analysing profits by products, customers and markets.

Organisations are now turning their attention to ABC because it also provides a mechanism for managing costs. It is in the area of cost management and resource planning, rather than product costing, that ABC now has the greatest potential.

The philosophy of activity-based cost management is that costs can be controlled more effectively by focusing directly on managing the forces that cause the activities (the cost drivers) rather than cost.

The reporting of the costs consumed by the significant activities of a business, and their cost drivers, provides the basis for understanding what causes overhead costs and directs attention to where steps can be taken to improve profitability. Knowing the high costs of material movements or the cost of maintaining many different components highlights the need to carry out these activities more effectively.

For example, using the system in a building society demonstrated the cost of processing high-volume/low- value deposit accounts and raised the issue of whether to impose charges on these accounts.

As well as using cost-driver rates to measure activity performance and efficiency, companies are finding that knowledge of cost-driver rates provides a more suitable basis for budgeting. This is because they can be linked directly to planned output and help to identify the expenditure and resources required.

ABC may not be appropriate for all companies, particularly those where overheads are relatively small and that do not produce a wide range of products. And many of the benefits of ABC can also be obtained by implementing a partial ABC system that focuses only on the most important activities.

Nor should the method be used to produce monthly profit statements. Traditional systems can be used for that, leaving ABC for strategic decisions and profitability analysis.

While many of the largest companies are redesigning their cost systems and implementing activitybased approaches, the survey reveals that the majority continue with old methods.

These companies may have decided that the cost of using another measurement system - to make decisions - outweighs the benefits. However, it may be simply that they are unaware of alternative ABC systems. Whatever the explanation, companies should be cautious about adopting financial accounting rules to support management decisions. Management accounting information should not be merely a by-product of external financial accounting systems.

Colin Drury is a professor at the University of Huddersfield and David Pettifer leads the Cost and Activity Management Service with Price Waterhouse in Leeds. The report 'A survey of Management Accounting Practices in UK Manufacturinq Companies', by Professor Colin Drury, Steve Braund, Paul Osborne and Mike Tayles, is available from the Chartered Association of Certified Accountants, 29 Woodside Place, Glasgow G3 7QE, price pounds 9.95.

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