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Kaplan, R. S. 1990. The Four-Stage Model of Cost Systems Design. Management Accounting (February): 22-26.

Summary by Jeff Hackman
Master of Accountancy Program
University of South Florida, Summer 2001

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This paper was written to extend Kaplan’s thoughts expressed in an earlier article, "One Cost System Isn’t Enough." In that paper Kaplan advocated that companies develop new cost systems to produce useful information for operational control and for profitability analysis. The earlier article also suggested that these systems should be kept separate from the financial reporting system. After receiving feedback from financial executives about the undesirability of multiple cost systems, Kaplan asserted that his main thought was that multiple cost systems are not the ultimate objective but an intermediate and sensible stage on a path to a more effective set of integrated management information systems. To this Kaplan suggests a four-stage model described below. In addition, the reader will find it useful to reference the figure below that was recreated from his article on the four-stage model.

Cost Systems Go Through Four Stages of Development
of Cost System
Stage 1:
Poor Data
Stage 2:
Focus on
Stage 3:
Stage 4:
Cost Systems
Data Quality

Data Errors
Math Errors
Large Variances
Post-closing adjustments

No surprises
Fast monthly Closings
Meets External Audit standards

Shared databases
Stand-alone Systems
Reporting frequency varies by systems

Linked databases and systems
Inadequate Tailored to financial reporting needs Keep Stage 2 system Expanded ABC system: Supports financial reporting as well as product cost management.
Product Costs Inadequate Inaccurate product cost Develop ABC system
Inadequate Limited feedback Develop operational performance measurement system Operational Control System

Stage 1. Stage 1 systems possess a general lack of integrity and auditability of the financial system. In addition to the before mentioned problems, the data problems presented in the above diagram arise because Stage 1 systems don’t do one of two things: capture material, labor, or operating expense transactions accurately or it doesn’t count all the outputs produced by the manufacturing process. These systems are commonly found in small or newly organized businesses that have not paid adequate attention to system design or internal controls.

Stage 2. The majority of companies have stage 2 cost systems and are generally viewed as having adequate data integrity and internal controls. The general belief of the company is that the system produces reliable financial statements, however, these systems are shown to have serious limitations for operational control, accurate product costing, and profitability analysis. Operational control is limited by four attributes of a stage 2 system:

1. They are not timely.
2. Results are highly aggregated making it difficult to continuously improve and learn.
3. The systems focus on aggregated results and not the activities that produced the results. This provides inadequate feedback to a company about the progress of implementing operating improvements, such as just-in-time.
4. Many operating reports are flooded with extensive allocations of costs.

Stage 2 systems are also inadequate for product costing and profitability analysis because they rely on only a few allocation bases for assigning indirect costs, namely: direct labor hours, machine time, and material quantities. These bases all vary proportionately with the number of units produced, or sold. This introduces considerable distortion when also used to assign costs that do not vary with the volume of products produced or sold.

In order to overcome this inadequacy, the article suggests that companies retain their current system for external financial reporting and develop customized systems for profitability analysis and operational control.

Stage 3. This stage is characterized by the need to retain the existing external reporting system from Stage 2. In addition, companies should begin to develop an activity-based system and an operational performance measurement system. Stage 3 systems would produce financial summaries of a company’s short-run performance. This would provide employees with, depending on the information, hourly, daily, or even batch-by-batch information to guide their learning and continuous improvement activities. The ABC system would more accurately assign the indirect and support expenses of the organization’s resources to the products, product lines, divisions, and customers that create the demand for or benefit from these resources. This would facilitate decisions about product design, manufacturing processes, and pricing and product mix. The need for separate systems is evidenced by the different assumptions about expense variability, frequency of reporting and updating, accuracy requirements, and on the scope of the system. The article suggests that the information needed by the localized systems may be downloaded from existing financial accounting, marketing, and sales systems.

Stage 4. Integrated cost systems will derive information from the activity based and operational control systems to prepare external financial statements. The article mentions that companies can begin to replace the financial reporting system from Stage 2 with reconciliation modules that prepare GAAP external reporting statements from data that is already being collected for the managerial systems. Financial statements would then be prepared from systems designed to provide managerially relevant information instead of the Stage 2 philosophy of trying to obtain managerially relevant information from systems that primarily satisfy external reporting. Stage 4 systems would also integrate information between the operational control and activity-based systems. The activity-based expense analysis system would prepare budgets for different departments based on product volume and mix forecasts. The operational control system could compare actual spending to the expense forecasts prepared by the activity-based system. Stage 4 systems would then have two integrated managerial systems - one for product and customer profitability analysis, and one for on-line feedback and performance measurement.

Some attempts have been made at Stage 4 systems; however, these systems provide poor estimates of product costs, and little to no information on the profitability of product lines, customers, and distribution channels.

The author suggests that the best cost system designs will come from organizations that allow local, customized systems to be developed as prototypes.


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