Management And Accounting Web

Edersheim, E. H., and B. Vanderbosch. 1991. How to make accounting count: Causal-based accounting. Journal of Cost Management (Winter): 5-17.

Summary by David Montgomery
Master of Accountancy Program
University of South Florida, Summer 2003

ABC Main Page | ABM Main Page | Cost Management Main Page

The purpose of the article is to introduce causal-based accounting, an alternative to the traditional cost accounting system. The authors achieve this by describing the problems with the traditional system, including comparisons to the new causal-based system. They proceed to provide a detailed description of the design and implementation process of the new system, including examples from different industries. Finally, the authors go on to describe the post-implementation process including what is needed to maintain a good working system and the opportunities it provides.

Out with the old, In with the new

Traditional accounting systems pose several problems when it comes to managing a business effectively. Traditional systems were designed specifically for the operating environment of the past. Today’s operating environment is drastically different from that of the past and accounting systems must reflect these differences. The authors point out overhead costs as an area of concern. According to the Edersheim and Vanderbosch, “Most accounting systems allocate overhead across operations on the basis of some arbitrary measurement of activity (e.g., labor hours or machine hours)”. However, this does not lead to accurate costs and overhead is critical to understanding the intrinsic cost of the various parts of an operation. Thus, traditional accounting systems can lead to a “betrayal by numbers.”

Increased global competition is also changing the shape of today’s operating environment. Traditional systems are unable to detect the changes in international asset bases and therefore, do not provide a meaningful picture for management. It can be viewed as cutting off management from their operating floors. This has lead to the development of “Causal-Based Accounting.”

Causal-based accounting is comparable to activity-based accounting, only it places emphasis on the cost drivers and on allocating traditional cost elements for each activity center by causal factor. Meanwhile, activity-based costing emphasizes defining activity centers. If implemented correctly, causal-based accounting can be a very powerful and a valuable tool for management.

Causal-based accounting contains three underlying concepts:

1. Costs generally increase in a step-like fashion, not in a smooth progression,

2. The staircase itself is not static, and

3. It is not necessary to be concerned about the details of every cost staircase.

Costs in the business world tend to occur in increments. They can be viewed as a “staircase” in which a given cost purchases a certain amount of capability and the purchase of an additional amount of capability incurs another increment of cost. The traditional system fails to recognize this staircase effect. Instead, the traditional system classifies costs as either fixed or variable and dependent on volume. Causal-based accounting on the other hand identifies four factors that increase costs:

1. Number of products,

2. Number (or variety) of components and suppliers,

3. Capacity, and

4.Volume.

The shape of this staircase provides a cost-benefit analysis for managers; however, it is important for them to note that the shape of the staircase differs by type of company as well as by cost element. It is also important for managers to note the second underlying concept that the staircase itself is not static. This infers that the shape of the staircase is in flux and it makes it hard to make an accurate assessment at times of what things actually cost. Lastly, managers must realize that it is not necessary to be concerned with the details of every cost staircase. By implying these three concepts managers are better able to understand and control the costs surrounding their operating environment.

Designing a Causal-Based System

The development of a causal-based accounting system is composed of three steps:

1. Tailor and focus,

2. Structure the system architecture,

3. Execute, detail, and test.

The first step involves determining the major cost and time elements of the operation and to determine the investment decisions management struggles with the most. Typically a review of the income statement is performed to identify major cost elements, and then to reallocate these costs more accurately. However, problems may arise with regards to major versus minor costs. Sometimes costs are assumed to be major costs, but then are later determined to be minor costs. Techniques such as sampling may be implemented to help uncover these discrepancies. In determining the investment decisions management struggles with, it is useful to limit the number of broad issues to a few and to combine these issues with the major time and cost elements to create the backdrop for structuring the causal-based system architecture in Step 2 (page 9).

The second step is to structure the architecture of the system. This involves three major activities:

1. Regrouping activities into activity centers,

2. Redefining line items from the existing system to each activity center and,

3. Identifying the causal factors that drive the shape of the various cost staircases.

When regrouping activities into activity centers the nature of activities should be similar, and the associated costs should respond similarly to changes in the operating environment. It may be useful to examine each operating facility to include reviewing and comparing facility budgets and operations. When redefining line items it is useful to perform systematic reviews across activity centers, apply judgment, and conduct interviews with accounting personnel as well as those close to the operations. The final activity involves identifying causal factors, which are things that drive how much capability a company gets and at what cost. The number of actual causal factors usually ranges between five or six; however, it should be kept below ten. Once this step is complete, the architecture of the new accounting system is determined.

The third and final step involves execution, detail, and test work. According to the authors, “It is a matter of establishing more precisely how the various causal factors affect each of the redefined line items, building up the base cost structure for each of the activity centers, allocating the costs in the nonproductive centers back to the productive centers, calculating product costs, and then testing and fine-tuning the system” (page 11). It is also at this point that a cost matrix should be completed for each activity center. The end result is a complete and functional causal-based accounting system.

Post-Implementation

A causal-based accounting system is not perfect. It involves a great deal of judgment, intuition, and questioning. Therefore, selecting the right core team is the glue that holds the system together. An ideal team is small, approximately three to four people. The core team should be composed of those with a complete understanding of the accounting system, as well as those with a thorough knowledge of the business operations. Most importantly, members should recognize the need for change. Activities of team members should include careful observations, extensive interviews, and documentation of all decisions behind the building of the system.

From management’s perspective it is critical to release and sustain the new causal-based system’s power. Management is more likely to recognize problems and opportunities and to address them more quickly. It is also critical for management to thoroughly understand the opportunities provided by the new system. These include:

Opportunities to better utilize existing capabilities;

Opportunities to alter the shape of the staircase to avoid or postpone having to incur the larger cost of a setup and;

Opportunities to change prices to more accurately reflect product cost.

As far as sustaining the new system’s power it must be institutionalized. This involves frequent updates, incorporating the system into routine business operations, regular reviews and reports on costs, highlighting opportunities, and flagging changes in the underlying cost staircases.

The authors conclude the article by emphasizing an addition to the old Chinese saying of that a man cannot make a fortune until he knows how to make a profit. Their experience suggests adding: “And a man cannot make a profit until he knows what his product really costs.”

__________________________________________

Related summaries:

Anderson, S. W., J. W. Hesford and S. M. Young. 2002. Factors influencing the performance of activity based costing teams: A field study of ABC model development time in the automobile industry. Accounting, Organizations and Society 27(3): 195-211. (Summary).

Argyris, C. and R. S. Kaplan. 1994. Implementing new knowledge: The case of activity-based costing. Accounting Horizons (September): 83-105. (Summary).

Brimson, J. A. 1998. Feature costing: Beyond ABC. Journal of Cost Management (January/February): 6-12. (Summary).

Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Reprint of Church, A. H. 1931. Overhead: The cost of production preparedness. Factory and Industrial Management (January): 38-41. (Summary).

Cokins, G. 1999. Using ABC to become ABM. Journal of Cost Management (January/February): 29-35. (Summary).

Cooper, R. 1990. Implementing an activity-based cost system. Journal of Cost Management (Spring): 33-42. (Summary).

Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).

Cooper, R., and R. S. Kaplan. 1998. The promise - and peril - of integrated cost systems. Harvard Business Review (July-August): 109-119. (Summary 1, (Summary 2).

Gaiser, B. 1997. German cost management systems. Journal of Cost Management (September/October): 35-41. (Summary).

Gosselin, M. 1997. The effect of strategy and organizational structure on the adoption and implementation of activity-based costing. Accounting, Organizations and Society 22(2): 105-122. (Summary).

Hughes, S. B. and K. A. Paulson Gjerde. 2003. Do different cost systems make a difference? Management Accounting Quarterly (Fall): 22-30. (Summary).

Jones, T. C. and D. Dugdale. 2002. The ABC bandwagon and the juggernaut of modernity. Accounting, Organizations and Society 27(1-2): 121-163. (Summary).

Kaplan, R. S. 1990. The four stage model of cost systems design. Management Accounting (February): 22-26. (Summary).

Krumwiede, K. R. 1998. ABC: Why it's tried and how it succeeds. Management Accounting (April): 32-34, 36, 38. (Summary).

Landry, S. P., L. M. Wood and T. M. Lindquist. 1997. Can ABC bring mixed results? Management Accounting (March): 28-30, 32-33. (Summary).

Lee, J. Y., R. Jacob and M. Ulinski. 1994. Activity-based costing and Japanese cost management techniques: A comparison. Advances In Management Accounting (3): 179-196. (Summary).

Mangan, T. N. 1995. Integrating an activity-based cost system. Journal of Cost Management (Winter): 5-13. (Summary).

Martin, J. R. Not dated. Chapter 2: Cost Accounting Systems and Manufacturing Statements. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter 2

Martin, J. R. Not dated. Chapter 7: Activity Based Product Costing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter 7

Mecimore, C. D. and A. T. Bell. 1995. Are we ready for fourth-generation ABC? Management Accounting (January): 22-26. (Summary).

Miller, J. G. and T. E. Vollmann. 1985. The hidden factory. Harvard Business Review (September-October): 142-150. (Summary).

Palmer, R. J. and M. Vied. 1998. Could ABC threaten the survival of your company? Management Accounting (November): 33-36. (Summary).

Roberts, M. W. and K.J. Silvester. 1996. Why ABC failed and how it may yet succeed. Journal of Cost Management (Winter): 23-35. (Summary).

Turney, P. B. B. 1990. Ten myths about implementing an activity-based costing system. Journal of Cost Management (Spring): 24-32. (Summary).