Costing of operations improvement projects
University of South Carolina
The validity of recommendations for managerial action on operations improvement projects is frequently open to question because of faulty communication between the project analyst and accounting. In the last few years, the presence of operations improvement project groups in service, manufacturing and marketing organizations has become quite common. Although titles differ, the similarity of these groups lies in their common pursuit of improvements in operating efficiency through cost reduction, revenue increase or quality improvement. Such projects often require a substantial data gathering effort as well as detailed analysis, evaluation and interpretation prior to the formulation of recommendations for managerial action. Given the emphasis on relevant costing for managerial decision making in the last few years, it is especially surprising that estimation of the cost and revenue impacts of operations changes still presents a problem. Yet, it appears that all too often the project analyst asks one question, someone using an accounting report answers another and the real issue is not addressed.
Operations Improvement Staffs
The primary objective of these groups is the improvement of operations within the organization. The projects they accomplish involve the design or revision of various activities, methods, procedures and systems in the interest of cost reductions, revenue increases or quality improvements. Staff responsibilities may include the internal generation of operations improvement suggestions as well as the review of suggestions from other areas of the organization, the complete analysis of each suggestion, and the planning and implementation of those projects receiving managerial approval. These groups are given various labels: Internal Consultants, Management Services, Operations Research, Financial Services, System Analysis, etc. Regardless of the departmental label or affiliation, such groups are usually comprised of analysts with varying degrees of expertise in general business knowledge, accounting, finance, statistical analysis, industrial engineering, systems analysis, etc.
Operations improvement projects move through in any one of several ways. Frequently, some concerned member of a department or other operating unit will suggest an improvement to his superior who refers it to the project group for analysis. A recurring problem will sometimes cause a manager to seek the assistance of the project group. In still other cases, a project analyst identifies an opportunity for a future operations improvement project while in the process of accomplishing his current assignment.
Operations improvement projects move through five stages from the initial recognition of a need for improvement to implementation.
1. Information gathering,
2. Problem identification,
3. Alternative solution generation,
4. Alternative solution evaluation, and
5. Managerial action.
The selection of an operations improvement configuration from several alternatives or the acceptance or rejection of a single alternative is the culmination of this five-stage process. Decision models which attempt to compare costs of benefits expected to occur over future time periods are used to facilitate these decisions.1 Cost and benefit differential and ratio analyses are quite common and are frequently used in conjunction with present value concepts. Naturally, the actual decision analysis must be preceded by estimation of actual dollar values for the various costs and benefits.
The analyst utilizes an approach Horngren called “a frontal assault on the problem of cost prediction” to estimate the cost and benefits expected to result from implementation of a particular operations improvement alternative.2 This approach requires the analyst to first identify every activity that will be affected by the change. Next, well-known industrial engineering and system analysis techniques such as methods study, time and motion study, engineering design specification, and process and material characteristics are used to establish the quantities of each resource currently utilized by each affected activity. These same techniques and then used to establish the quantities of each resource that will be utilized if the operations improvement is implemented. Theoretically, the analyst then calculates the expected incremental cost or savings for each activity based on anticipated changes in the quantities of resources it will utilize.
What costs should be assigned to a particular alternative in a decision situation? The rule of thumb is quite straightforward:
ONLY THOSE CHANGES IN COST THAT WILL OCCUR IF THIS ALTERNATIVE IS IMPLEMENTED ARE RELEVANT
Managerial accounting, systems analysis, operations research, management science and decision science literature all contain excellent discussions of cost assignment for decision making. While most authorities seem to agree, in principle, with what some have called the relevant costing concept, identification of relevant costs has apparently proven more difficult in practice than had been anticipated. Perhaps this difficulty results from the apparent simplicity of the concept. In my own experience with attempting to demonstrate its subtleties to students, colleagues and clients, there seem to be three stages of understanding—acceptance, confusion with other well-known cost concepts and ultimately, ability to apply it in diverse situations.
A previous familiarity with direct costing seems to facilitate immediate acceptance of the relevant cost concept as demonstrated by the ability to apply it to operations improvement projects involving production volume changes. Yet, this same familiarity appears to sometimes inhibit understanding of how relevant costing applies to changes in rates of resource utilization unaccompanied by production volume changes. Unfortunately this is the level of understanding which must be achieved for project costing since so many operations improvements involve changes in rates of resource utilization rather than in production volumes.
Project Costing Errors
Even if we make the assumption that all project analysts and accountants understand and can apply the relevant costing concept, there is still plenty of room for errors in the project costing process. Probably the most common flaw is the improper use of secondary sources of cost information by project analysts. Introduction of errors into project cost estimates is further facilitated by faulty communication between the analyst and secondary sources, and in some cases, between the analyst and an accountant. The extended example which follows attempts to illustrate both of these concepts within an appropriate context.
Consider a situation where an analyst is examining the cost consequences of an operations improvement affecting the production of product y, a joint product. Suppose that the operations improvement involves splitting off product y one step earlier in the joint process and that the analyst has correctly identified all other cost changes that will accompany implementation of the proposed improvement. At this point, the analyst is interested solely in estimating the cost reduction that will result if product y does not have to be processed through cost center 21, currently the final step in the joint process. Where does the analyst obtain that information?
All too frequently, the analyst telephones or visits a friend in the affected cost center seeking the infortmation he thinks he needs. In this particular case, such a call or visit might lead to a dialogue like this imaginary one:
|Analyst:||“Say, Herb, you work in cost center 21 don’t you?”|
|Friend:||“Sure. What about it?”|
|Analyst:||“Oh, just looking for some cost information for this project I’m working on.”|
|Friend:||“You mean the one where we’re not going to run product y through here any more?”|
|Analyst:||“Yeah, that’s the one and what I need to know is what does it cost to run product y through there now?”|
|Friend:||“Gee, I dunno but I’ll look it up.”|
At this point, the analyst’s friend rummages through his files until he locates an accounting report that shows last year’s cost allocation for that unit. It would probably be no surprise if it looked something like this:
|Cost center 21|
|x||1000||1/6 x $30,000||$ 5,000|
|y||2000||1/3 x $30,000||$ 10,000|
|z||3000||1/2 x $30,000||$ 15,000|
Based on this report, the analyst is told that it costs five dollars to process one product y through cost center 21.3 Thus the conversation ends with both parties blissfully unaware that they have not addressed the real issue at hand—an estimate of the incremental cost reduction, if any, expected to result from the decrease in utilization of cost center 21 accompanying the one-step earlier split-off of product y from its joint products.
In other cases, the analyst may contact accounting directly. Unfortunately, he may still get an answer to his question based on an external information report unless he words his questions much more carefully.
Costing Error Impact
It is quite conceivable that a project like the one described in this example would also involve cost or benefit estimates for other areas and over more extended time periods. Suppose that all other costs and benefits were exactly offsetting. Then the acceptance of this particular project might well hinge on the magnitude of cost reduction expected in cost center 21 next year. Based on the information described previously, the analyst would probably estimate that the one-step earlier split-off of product y in the production process would save the firm $10,000 next year, assuming no change in production volumes from this year. No doubt, acceptance of the project would not be long delayed.
What happens when costs are allocated next year? Recognize that last year’s allocation was based arbitrarily on production volumes of the final products since all cost center 21 costs were assumed to be non-separable and non-traceable. Stretching this example to the limit, let’s assume even further that the costs of operating cost center 21 were one hundred percent fixed and that the volumes of x and z did not change next year.4 Naturally, next year’s total cost will again be $30,000, disallowing any inflation or other time associated changes. Given the extent of the assumptions in this example, next year’s cost allocation might well look like this:
|Cost center 21|
|x||1000||1/4 x $30,000||$ 7,500|
|z||3000||3/4 x $30,000||$ 22,500|
It is entirely possible that this situation will go unnoticed. Whether or not it does probably depends on how much fanfare and emotional upheaval accompanied project implementation. If opposition hardened during the process, it is quite likely that someone will point out to “the power that be” that the anticipated $10,000 savings in cost center 21 failed to materialize. From that revelation to the moment when the finger of blame is pointed at faulty cost information supplied by accounting is a short step. Certainly, accounting will be able to defend itself on the basis of the inappropriate use of its report, but some credibility residue is likely to remain.
It is true that this example is so ludicrously simple that one wonders how such a mistake could occur. It is also true that given all the stipulations of this example, the organization would experience no real financial damage as a result of the implementation decision based on faulty information. It does not require a great deal of imagination, however, to conceive of circumstances where this would not be the case and where such practices could lead to serious damage to organizational welfare.
An Ounce of Prevention
Unfortunately, recognition of the problem is the easiest part. Prevention requires liberal doses of three measures. The first of these is formalization of interaction between the accounting area and operations improvement staffs. This requires identification of all those staffs within an organization involved in operations improvement activities; no small task. Once that has been accomplished, it is probably desirable to standardize information request/supply procedures. This might well involve channeling all requests for cost information to a single accounting employee or unit whose primary task is to furnish appropriate cost information to other organizational units upon demand. A sign-off procedure whereby mangement refuses to act on a project evaluation report unless it has the official seal of approval of the accounting unit or employee responsible for furnishing cost information should be very helpful in eliminating the accidental or intentional misuse of accounting information. Naturally such a procedure would also encourage the conscientious performance of the information supply task within accounting.
The second measure is twofold and may be adopted in conjunction with the former one or alone. It consists of an attempt to exert control over the usage of accounting information after it has been released into other hands. Control can be accomplished in two ways—distribution and labeling. Different authors have subdivided accounting reports into many different categories over the years. For purposes of this discussion, grouping them into external, internal status and planning reports is quite helpful. Guidelines for distribution of the reports from each category are easily determined by applying the need-to-know criterion to each group. Obviously external reports should go to those external groups for whom they were prepared and to those internal personnel who have the responsibility of defending the contents. Each internal status report needs to be distributed to the manager of the units reviewed in the reports as well as to the immediate supervisor of each of those managers. Likewise, planning reports should be distributed to those managers responsible for the particular planning activity and to those managers whose counsel is to be sought during the planning process.
The other part of the second measure is the clear and distinct labeling of each report as to the category to which it belongs. From some uses of external and internal status reports, it appears that they should carry an additional label:
WARNING: COST FIGURES IN THIS REPORT CONTAIN ALLOCATIONS WHICH MAY BE DANGEROUS TO THE HEALTH OF THE FIRM IF TAKEN INTERNALLY FOR PLANNING PURPOSES.
Another preventive measure would involve taking the labeling concept one step further. That is, it would be very helpful if individual files of information maintained by accounting were labeled as to their ultimate use, i.e., for external report preparation only, for planning report and internal status report generation, etc. While simplistic in nature, these suggestions are certainly conceptually sound and should reduce project costing mistakes when implemented.
The third measure is educational in nature and involves three steps. First, project analyst personnel must be reminded of or introduced to the contrast between historical costing and incremental costing. Not only must they understand the concept but they must be able to relate it to their daily responsibilities and recognize how their understanding can contribute to the avoidance of incidents detrimental to the firm. Secondly, accounting personnel should be introduced to the classification of reports described previously and reminded of a simple truth: when someone from some other area of the firm requests information to assist him with his responsibilities, that person is rarely interested in information of the external report variety. As it relates to project analysis, the basic truth is even stronger since they are almost never interested in information from the external report category. Lastly, attention should be directed to the nature of communications between accounting and project analysts. Irrespective of whether the formalization of interaction suggestion is adopted, certain basic issues should be addressed whenever project cost information requests are received. Some appropriate questions that accountants can ask are:
1. Are you interested in what it costs now, what it cost last year or what it will cost next year?
2. Are you interested in incremental costs or costs given past allocation procedures?
3. Are you sure you have identified all and only those resources whose utilization will change if this operations improvement is adopted?
4. Have you identified all and only those resource utilization changes which will actually result in net cost changes to the firm?
In each situation, the terminology of the questions would probably be different. Nevertheless, these questions should be enough to identify whether the project analyst has really done his “homework.” His inability to provide suitable answers would certainly be justification for denying his information request until he could do so. Adopted as a package, these measures should greatly improve the quality of information requests as well as reduce the number and intensity of recriminations resulting from the real or perceived dispensation of misinformation. The most important consequence, however, would be the increase in accuracy of the operations improvement project adoption or rejection decision process.
The increasing prevalence of operations improvement project groups has highlighted problems faced by accounting departments for some time. One problem is the use of historical accounting rather than incremental costing information for operations improvement project decisions. It appears that this often results from faulty communication between the analyst and the accounting area. It was suggested that these problems could be alleviated by formalization of interaction between project analysts and accounting, better control of information through improved report dissemination and report and information file labeling practices, and education of accounting personnel as to managerial information need categories and in ways to identify the types of information needed by an analyst regardless of the nature of his initial request.
1. Stanford L. Optner, Systems Analysis for Business Management, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1975, pp. 171-187.
2. C. T. Horngren, Cost Accounting: A Managerial Emphasis, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1972, p. 809.
3. The author recently encountered a similar situation in one of the top 200 banks. The EDP section was using such a report to quote supposedly incremental costs to the bank of new EDP applications even though the particular resources were underutilized.
4. An obviously ridiculous assumption of the type we academicians frequently use in the classroom to underscore our points.