Understanding costs: Part 1 — costing concepts

Editor's note: This article is the first in a two-part series looking at costs. It is an overview of traditional and activity-based costing approaches, to be followed by a detailed look at a new approach — resource-based costing ­— in part two.

An ongoing challenge for management accountants is that operational and strategic managers need to understand costs by cost objects, for instance products, services, customers, or the organisation. However, this split is not one that naturally exists; instead, it needs to be derived through some form of allocation process.

A simplistic but useful way to view organisations is that they incur costs to acquire resources, which are used to complete activities that are required by cost objects. It's necessary to understand costs at all these stages to understand why they have or will be incurred and, hence, to manage them effectively.

Accounting systems can hold a wealth of data on costs that tell you how much, from where, on what, with whom, and when, but not why they were incurred.

Cost insight is required for financial, operational, and strategic management, which have vastly different demands. The information also needs to be viewed by various dimensions relating to the resources acquired, activities completed, and associated cost objects.

This first article in this two-part series looks at current costing systems and their associated benefits and challenges. The second article outlines a more insightful approach that is better suited to the needs of the current and future organisational environment.

Traditional costing systems

For many decades traditional costing systems (actual, normal, and standard costing) have been used to identify the resources associated with direct costs and then relate these to either products or services as the cost objects. The remaining indirect costs are then allocated straight to the cost objects (see the chart "Traditional Costing Approaches").

Traditional costing approaches

Direct costs of labour and material represented the major share of costs and could often be allocated confidently to a specific product. The low level of indirect costs meant that the accuracy of their allocation was not a significant issue for decision-making.

The various traditional costing system approaches differ principally in terms of whether they use actual costs or a predetermined standard cost rate multiplied by the actual number of units. Predetermined standard cost rates work well for standardised products that are being produced from batch or continuous flow processes. Actual costs work best for jobs producing a bespoke product, requiring some form of time-recording system and causing increased volatility in cost rates. The approach adopted is a matter of what is achievable and most appropriate for the organisation.

Over time, the relationships between costs and end products have become more complex as the proportion of indirect or overhead costs increased, processes became cross-functional and shared across product lines, and products and services have tended to become more bespoke.

Whilst these traditional approaches are easily understood and satisfactory for statutory financial reporting purposes, they have been found to be unsuitable for many other applications, such as transfer pricing, process improvement, and product profitability.

Activity-based costing

The emergence of activity-based costing (ABC) in the late 1980s has been the most recent major development in cost analysis. It was initially developed on stand-alone systems separate to the traditional approaches used for financial reporting and used principally in manufacturing businesses.

The treatment of direct costs is basically the same as in traditional accounting systems. However, the key difference is an improved allocation methodology for the indirect costs (see the chart "Activity-Based Costing Approach"). The most common approach to activity-based costing takes costs from the general ledger and allocates them to different "activity cost pools". These cost pools could relate to direct (product and service) and sustaining (relating to a batch, product, service, order, client, brand, channel, or facility) activities at a level of detail determined by the purpose of the model. The activities could be further qualified to indicate qualities such as the processes they relate to and whether they are value-adding or non-value-adding.

Despite the conceptual logic of ABC, the level of adoption by organisations has been lower than may have been expected. Various issues were encountered, including long and expensive implementations, onerous maintenance requirements, and insufficient detail in the information supplied. All of this meant that the benefits gained often did not justify the level of investment required.

In my experience, a key issue is the initial allocation of costs to "activity cost pools". The approach relies on managers having a detailed understanding of the costs, the team's resource usage, and how these vary over time. This may be suited to situations where the resources are homogenous and activities are standard, but it is far more challenging in many real-world situations.

The approach is adequate to inform some high-level organisational decisions. However, it has limitations in the amount of operational and strategic insight it provides to decision-makers on matters such as why costs are at the level they are, how the organisation may change cost levels, and the implications of that.

Continuing relevance

Over the years since the introduction of ABC, there have been numerous changes in the organisational environment that have led to an increase in the proportion of costs that are indirect. Factors increasing indirect costs include:

• Automation and digitalisation.
• Creating bespoke products and services.
• Regulatory demands.
• Recognition of various stakeholder needs; eg, environmental, social, and governance (ESG) and diversity, equity, and inclusion (DEI).
• Sales and marketing efforts.
• Research and development.

The justification for investing time, effort, and cost into developing ABC is most significant when a major proportion of total costs relates to indirect or support resources. Therefore, this should have increased recognition of the need for organisations to have a robust indirect costs allocation methodology to understand why costs have and will be incurred, but this does not seem to have happened.

One thing that has not changed is organisation leaders' desire to better understand financial performance in relation to products, services, and customers. Therefore, it is worth looking in some detail at the various applications of cost insight and then propose how the various needs are best met.

Revisiting the objectives

Cost insight is required to provide insight for management to make a wide variety of financial, operational, and strategic decisions (see the table "Examples of Cost-Related Management Decisions").

To manage costs fully, it is essential to have integrated information from the level of raw costs through resources acquired, activities completed, and then the ultimate cost objects.

There will be some common attributes that apply to all information, including that the constituent data can be traced back to a robust source of actual cost data that meets audit standards. However, there are other demands such as frequency, timeliness, granularity, and accuracy that will vary significantly. Additionally, some users will require an understanding of actual costs whereas others will also require a prediction of future costs (see the table "Potential Information Attributes Required for Different Uses").

Enhanced costing techniques

To meet all the identified organisational needs, any enhanced costing technique needs to have the following qualities:

• Supporting the analysis of historic actual costs and prediction of future costs.
• Showing the interdependencies between costs, resources, activities, and cost objects.
• Providing the levels of detail needed for operational management.
• Mapping the path from the current status to the future vision delivered by the organisational strategy.
• Processing on a regular and timely basis.
• Achieving a suitable level of credibility with organisational management to inform decision-making.

The exact needs that are required will vary depending on the application. If all the various needs are to be adequately met, many organisations will require significant investment in developing their cost-analysis capability.

The second article in this series will consider how these challenging objectives can be met.

— Paul Ashworth, FCMA, CGMA, is a Jersey, British Isles-based practising management accountant providing strategic insight and enabling business intelligence systems in financial and business services, and public-sector organisations. To comment on this article or to suggest an idea for another article, contact Drew Adamek at Andrew.Adamek@aicpa-cima.com.