28 – Critical Principles (Part 3)

Critical Principles

Pierre GuillaumePierre Guillaume completes his series on critical principles governing cost systems.

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In episode 28

Coming up on Performance Management Edge… Pierre Guillaume continues his series on the principles that should govern a cost system.

Hi, this is Pierre Guillaume one more time, from Beyond EPS Advisors. This is the last segment of a three part series on the principles that should govern a cost system. Today we will cover principles 5, 6, & 7:

5. Considers Behavioral Consequences

6. Achieves Compliance

7. Delivers Value

The first principle we will cover today is consider behavioral consequences.

The way cost information is used to make decisions has behavioral consequences that should be considered in the design of costing practices. Traditionally, managers address the technical considerations of costing, but fail to adequately consider the behavioral needs around costing. If costing processes fail to consider the behaviors desired, the resulting decisions might inadvertently prevent achievement of management’s objectives and sub-optimize organizational resources.

Costing should support the organization’s efforts to encourage interactions between service providers and consumers (internal and external) to maximize the value of these relationships. There may be occasions when the desired business outcome conflicts with the most technically correct cost-assignment method. Let us look at a couple of examples:

Consumption of legal services may be readily identifiable through examination of the time attorneys spend on each issue. While legal costs could be directly charged out, doing so might result in creating the behavior of not seeking legal advice on a timely basis. This delay can often result in much greater legal risks and higher costs than if legal advice was sought earlier. By keeping legal costs as part of a corporate tax and not allocating them on a use basis, managers are encouraged to utilize the legal expertise available when needed. Use of legal may avoid potential liability for the company, saving the organization’s costs long-term.

Conversely, if the organization chooses to assign legal costs to the lines of business utilizing the legal services, charging directly would be appropriate when the legal costs being incurred are directly related to the applicable lines of business, rather than the result of a random process. Legal expenses incurred when verifying compliance with state regulators for a new service should be reflected in that line of business profitability: the inerrant nature of that business led to the costs being incurred. On the other hand, legal costs related to a sexual harassment law suit are best not directly traced when they are incurred: in most cases, it is best to assume that the incident in any given part of the organization is random and not linked to the nature of that part of the organization.

The second example I will use is that of an Employee Tuition Reimbursement Program. To encourage its employees’ continuing education, one of our clients allocates its employee-tuition reimbursement as an employee benefit across all cost centers. This is in lieu of charging employee-tuition reimbursement costs to the actual units with employees pursuing their education. If tuition reimbursement was charged directly, it could result in managers discouraging employees from using the program to avoid the additional costs.

Let’s move on to our next principle: achieve compliance.

Compliance with all legal and regulatory requirements is vital to any organization’s success. The organization should uphold all requirements outlined by the governing authorities. Your costing information will adequately comply with applicable legal and regulatory requirements and convey its financial standing to stakeholders, analysts, credit agencies, governments and investors. In short, to keep this principle simple, nobody wants to go to jail.

Finally, our last principle: deliver value.

One should keep in mind that the system should be kept as simple and cost effective as possible, or as Einstein said, “Everything should be made as simple as possible, but not one bit simpler”.

The principle of value ensures that time and effort spent gathering and evaluating cost information should result in significant organizational benefits. In developing your cost system, one should focus efforts on areas that offer opportunity for significant returns. The focus should be on material items i.e. elements that, if changed, impact the outcome of a decision. In financial terms, the net present value of the future cash flow derived from better decision making should exceed the cost of providing that information.

For example, a more detailed study of customer-segment profitability could be performed. Before investing in that analysis, management should weigh its costs against the value of any changes it would make as a result, decisions such as changing prices, altering services, or lowering the costs to serve. The analysis costs could be one-time costs for a simple analysis or a major cost to acquire, install and maintain an ongoing costing system. In either case, the costs should be weighed against the expected benefits to determine materiality. If changes could not be made, there might be little need to perform the analysis.

By focusing our efforts on significant decisions and cost benefits, we can thus better optimize our resources. Resources can then be deployed to value-added activities, producing greater value for the entire organization.

This concludes this series on the principles beyond successful costing systems and processes. I hope you found it thought-provoking. As always, do not hesitate to come back to us with questions. We will gladly cover them in our question-and-answer section.

Thank you Pierre. This is Alan Stratton your host. Until next time on Performance Management Edge.

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