During the last 15 years a revolution in the practice of cost management has occurred. First, activity-based costing (ABC) emerged in the 1980s as a replacement for the traditional standard cost systems that had remained essentially unchanged since the tum of century. Second, activity-based management (ABM)— the operational improvements and strategic actions taken with ABC information— became integrated with other cost-management techniques, such as kaizen and target costing, to produce new ways to reduce costs both across the value chain and over the life of the product. At the same time, the importance of nonfinancial measures to inform and motivate performance improvements became apparent. This book illustrates the conceptual leap from feedback to feedforward cost management, leading to powerful programs for strategic cost management.
This book provides a comprehensive treatment of the various innovations in cost and performance management. Students will learn the individual concepts and, more importantly, how they fit together, enabling companies to reduce costs while maintaining or increasing revenues. Underlying this integration are two powerful concepts: first, the accurate measurement of activity costs; and second, the reduction of costs by continuous and discontinuous improvements. As the organizational integrator, the finance function shifts from being the passive reporter of the past to a proactive influencer of the future. This migration enables cost and performance measurement systems to become embedded in the formulation and implementation of strategies and operational improvements.
We identify three primary functions of cost management systems:
1. measure cost of goods sold and value inventory for the financial report
2. estimate costs of activities, products, services, and customers
3. provide economic feedback to employees and operators about process
Using a four-stage model of cost system evolution, we document the evolution of cost-management systems for these three functions. We start with stage I
systems. These systems cannot perform any of the three primary functions well. Next, we explore stage II systems that can perform the first function, financial reporting, effectively but not the two managerial functions. Third, we explore the use of multiple stand-alone stage HI systems, each capable of performing one function effectively. Finally, we introduce the concept of stage IV, where new enterprise resource planning (ERP) systems integrate the capabilities of the stand-alone stage III cost systems into a single system capable of performing all three primary functions. We conclude by documenting the application of activity-based management to budgeting and transfer pricing. These final applications demand such intense information exchanges between the ABC system and other organizational systems that they require the integration capabilities of an ERP-based stage IV system.
Textual material at the beginning of each chapter presents the themes and general principles that will emerge from the study of the cases in the chapter. The cases, written from actual company experience, explore the properties of cost systems. They reveal how the design of cost systems determines the type of information management receives about the costs of its product, production processes, customers, suppliers, and other organizational units. More than 50 percent of the cases are new to this second edition.
The book has been written primarily for classroom use. For MBA and undergraduate courses, we believe the study of multiple cases with each chapter allows the concepts to be learned inductively. Our companion book, Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance (Boston: Harvard Business School Press, 1998), was written for executives and practitioners, and contains more illustrative examples and in-depth discussion. For executive programs, with fewer sessions per course, the two books can be combined by having the students read the textual chapters of Cost and Effect while analyzing representative cases from this book.
Even beyond classroom use, practitioners including financial and operational managers, management accountants, and consultants should find much useful material in the second edition. The innovative approaches to cost management have evolved so rapidly and recently that the cases in this book represent the most available and comprehensive presentation of how these emerging concepts are applied in practice. Practitioners who study the cases carefully will learn much about the sources of failure in existing systems and the opportunities for innovative approaches in their own organizations.
The cases have been selected to explore the evolution of cost systems from the stage I systems, that were surprisingly common only 20 years ago, all the way to stage IV systems that are only now beginning to emerge. Chapter 1 introduces the concepts of cost and performance measurement and presents the four-stage model of cost system evolution. The cases for this chapter deal specifically with the failures from stage I and stage II systems that fail to perform all three primary functions of cost measurement systems. Several of the cases show the rudiments of emerging stage III cost systems.
In chapter 2, we learn in more detail about the specific limitations of traditional costing systems for serving managerial purposes. From this start, we can see how innovative systems can provide adopting companies with more responsive, more accurate, and more relevant information for making operational improvements and strategic decisions. The cases in this chapter illustrate effective stage II systems that can accurately value inventory and measure cost of goods sold for financial reporting purposes but provide poor or only limited support for the two managerial functions of cost management systems. The last two cases in the chapter describe how standard costing systems
have been made more timely and responsive for providing feedback on financial expenses.
Chapter 3 illustrates how Japanese and US companies are using new financial and nonfinancial measurement systems to drive employees' learning and improvement activities. The chapter shows innovating Japanese and US companies using kaizen costing and pseudo profit centers for their continuous improvement efforts.
Chapters 4-9 provide a comprehensive treatment of activity-based costing and activity-based management (ABM). Chapter 4 describes the foundations of activity-based costing. The cases involve relatively simple ABC systems, most designed at the very beginning of the ABC movement. Chapter 5 treats the measurement of capacity costs comprehensively, and it illustrates how ABC can switch from being an historic to a prospective costing system. The cases explore the various issues that surround costing unused capacity. Some of the cases deal with traditional systems whereas others explore capacity-adjusted ABC, including the integration of ABC with the theory of constraints.
Chapter 6 and its associated cases explore ABM, both operational ABM, where managers use the ABC information to make better decisions about improving activity and process efficiency, and strategic ABM, which focuses on decisions about product pricing and mix. In addition to the managerial uses of ABC information, the cases in this chapter provide a marvelous learning experience about the implementation issues that arise when installing ABC systems in actual organizations. Chapter 7 extends ABC and ABM out of the factory to encompass the economics of customer and supplier relationships. Students will learn how companies are using ABC information to manage their total value and supply chain more effectively. Chapter 8 and its associated cases illustrate how cost information can be used productively during the product design and development process. The cases show product engineers using both target costing and activity-based cost information to make better product design and development decisions.
Chapter 9 extends the application of ABM principles to nonmanufacturing settings, such as banks and hospitals. By the end of chapter 9, we have documented the current state of the art in operational control and activity-based cost systems. Chapter 10 provides the ultimate destination for the book. It describes the vision for the future: cost and performance measurement systems, tightly integrated together to provide managers with valid, timely information for managerial purposes, as well as for external reporting. The cases in this chapter illustrate the risks of attempting such integration before the principles of stage IV systems are fully understood, and they help to identify the design characteristics for effective stage IV systems.
Chapter 11 builds upon this vision to describe how the ABC system can be used as the foundation for budgeting, on a rational, analytic basis, the organization's future expenses and resource supply. In addition, it explores the application of activity-based principles to transfer pricing. Since stage IV systems are just now emerging at this time, we do not have cases to illustrate these applications.
In developing the ideas in this book, we are obviously indebted to the many individuals and organizations in North America, Europe, and Japan with whom we have worked during the past 15 years. We were fortunate in receiving permission to present many of these cases in undisguised form. The several dozen case studies, drawn from innovative companies willing to share their experiences in implementing new cost management systems, required the cooperation of hundreds of people. We have learned from each of them, and rather than list them individually, we wish to thank them collectively for allowing us to enhance our research by studying their experiences.
We also have benefited from support of the Harvard Business School and the Claremont Graduate University. A combination of teaching assignments and support for the extensive fieldwork and case studies enabled us to learn from and influence practice. With this book, we can leverage this support to share the knowledge with faculty, students, and practitioners around the world. We also appreciate the permission from Harvard Business School Press, and its president, Carol Franco, to use text from our trade book, Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance (Boston: Harvard Business School Press, 1998) in preparing the second edition.
Jenica Flores at Harvard Business School gave us great administrative assistance in the preparation of the book. We appreciate the contributions of Professor V. G. Narayanan for use of three of his newest cases. At Prentice-Hall, P. J. Board man provided continual encouragement to share our latest work in a second edition of the book; Annie Todd, as editor, coordinated our contributions and kept us moving forward, and Susan Rifkin gave careful attention to the quality and speed of the production process. We profited from the reviews of William D. J. Cotton, SUNY at Geneseo; Susan S. Hamlen, SUNY at Buffalo; Monte R. Swain, Brigham Young University; and Y. Robert Lin, California State University, Hayward.
In summary, the material in this book presents a state-of-the-art view of the emerging principles of cost management system design. We have observed, after teaching this material, that our students and executives are capable of leading the change in their organizations to redesign their cost management systems. Thus, we feel confident that the material is actionable and practical. However, the material is not a cookbook that can be followed unthinkingly. Students must master the underlying design principles for cost management systems and learn how to apply these principles sensibly and in a cost-effective fashion, recognizing the competitive environment, product and customer mix, process and information technology, and organizational situation in their individual companies.
Robin Cooper Atlanta
Robert S. Kaplan Boston