Cost Measurement and Analysis-A Necessary Part of Industrial Engineering Education & TrainingBalbinder S. Deo and Doug Strong
Balbinder S. Deo, Assistant Professor, Department of Finance & Management Science,
College of Commerce, University of Saskatchewan, 25 Campus Drive, Saskatoon, SK,
Canada S7N 5A7.
Doug Strong, Professor in the Department of Industrial Engineering, University of Manitoba,
Winnipeg, Manitoba, Canada R3T 5V6.
Some Important Points made in the paper.
One of the basic duties of Industrial Engineering professionals is to make improvements in operations, and systems of operations, to reduce the cost of operations.
Two assumptions play a major role in promoting the use of physical measures of productivity.
1. There exists an inverse relationship between physical measures of productivity and cost.
2. Increasing the physical productivity of resources used in production operations can reduce the cost of production of a manufactured product or service.
These relationships may hold true provided reduction in the physical quantity of one resource in one operation does not increase the consumption of other resources in the same operation and / or in other operations of the production system. Gain in the physical productivity of one resource may cause loss in others. For example, increase in the productivity of labor by employing high production capacity machines may cause loss in the productivity of machinery employed
or vice versa. In a similar fashion, within a production system, gain in physical productivity measure of one functional area may cause loss in productivity of other related functional areas.
Improvement in productivity at the firm level, not just at the functional level, can be helpful in reducing the cost of production.
Cost Measurement in Engineering Profession - An Historical Perspective
Increasing sales and reducing cost of production by productive use of resources in operations can achieve increase in profit. The use of cost as a measure of productivity is not new among engineering professionals. Literature describing the history of engineering provides significant evidence of its use and promotion among engineers by the pioneers of the profession.
Henry C. Metcalf (1885), as a superintendent of ordnance depots, realized the importance of cost measurement and analysis in manufacturing. He proposed to measure costs to the minutest detail possible within the organization to measure the efficiency of manufacturing and administration operations and also to create plan of cost of operations by knowing the detailed elements of cost involved for each operation performed on a product during manufacturing process. He published his thoughts in a book titled “The Cost of Manufactures and the administration of Workshops, Public and Private” in 1885, for providing guidance to other engineering professionals in the field.
Henry Towne (1886), another engineering professional, wrote a paper titled ‘Engineer as an Economist’ for one of the meetings of The American Society of Mechanical Engineers. According to him, determination of cost was one of the important duties of an engineer. To achieve this end he proposed the establishment of a separate shop accounting section at each workshop level to collect cost related information to meet the cost information needs of engineering professionals.
Hugo Diemer (1910), is the first faculty member of Industrial Engineering subject at Pennsylvania State College, quoted F.W. Taylor's appeal to engineering professionals to take up the responsibility of cost related data collection and analysis as part of profession.
Charles Buxton Going published a book titled, "Principles of Industrial Engineering" in 1911.
He called industrial engineering, “New branch of engineering grown out of the rise of, and enormous expansion of the manufacturing system.” This branch of engineering, according to him, “Has drawn upon mechanical engineering, economics, sociology, psychology, philosophy and
accountancy to form a distinct body of science of its own”. In this definition of industrial engineering, inclusion of the subjects of economics and accountancy testify to the fact that the cost measurement and analysis was regarded as part of industrial engineering theory and practice at that time.
Howell, in his presentation at the 1995 International Industrial Engineering Conference, advised industrial engineers to reclaim their traditional industrial engineering responsibilities, such as, measurements of labor costs, manufacturing methods, and productivity improvement, along with other responsibilities so that their demand in industry, job title and functional identity remains intact. According to him, cost estimation should be one of the areas for which an industrial engineer should also be responsible and accountable.
Recent studies by Barnes (1991), Dhavale (1992), and Eaglesham (1998), found in the Industrial Engineering literature on Activity Based Costing technique, broadly point out that some industrial engineers take interest in cost measurement.
Lenz and Neitzel (1995) developed their own methodology to develop a cost simulation model. In this model, they have used a cost equation that consists of eight components, such as station cost; labor cost; overhead cost; inventory cost; automation cost; capacity cost; material cost; and
indirect cost. In this type of modeling, they claimed, all performance measures can be translated into costs by applying cost equations to the results of factory model.
Deo (2001)14 developed an Operation Based Costing model to measure cost of each resource in each operation, and the cost of each operation in a production system. In this model, an operation is considered as the basic unit of production system. The structure of the model matches the typical structure of an operation.
It is observed by the authors that cost measurement and analysis is slowly becoming one of the basic requirements for various job openings related to industrial and manufacturing engineering area. Education and training of industrial engineers in cost measurement and analysis, can give them an extra advantage in raising productivity and reducing cost in industrial organizations. Industral engineering schools and departments need to introduce the subject as a necessary part of industrial engineering education and training for future generation of industrial engineers.
Role of Costing and Cost Accounting in the Organization
Cost accounting is a separate accounting discipline and in many countries, statutory cost accounting bodies exist that regulate this field. Industrial engineers have to work in close cooperation with this discipline to make sure that costs are measured with a view to providing appropriate cost information to industrial engineering department and to the company regarding unit costs of components and finished products made by the company. The output of the industrial engineering department has to be captured by the cost figures reported by the cost accounting department.
Purposes of Accounting Systems
Accounting is a major means of helping managers of an organization, equity investors of an organization, potential equity investors, creditors and bond holders of an organization, potential creditors and bond holders of an organization, suppliers and customers of an organization and other stake holders to take decisions.
Accounting provides information for three major purposes:
1. External reporting: These reports are used investors, creditors, government authorities, and other outside parties.
2. Routine internal reporting: These reports which are periodically generated are used by managers of the company for their internal decisions.
3. Nonroutine internal reporting: This information or reports are generated to support projects and other decisions that come up as the need arises from them.
While the reports are prepared in different formats and basic data is manipulated or summarized in various ways to facilitate decision making, there is one data base maintained by the accounting system that contains data in the form debits and credits to various accounts maintained in the accounting system. Accountants combine these data items in various ways to provide information to internal or external users.
Distinction Between Financial Accounting, Cost Accounting and Management Accounting
Horngren’s distinction between them is interesting.
Management accounting as a discipline focuses on accounting information that facilitates decision making by managers of the organization. If focuses on routine and nonroutine accounting reports.
Financial accounting measures and records business transactions and provides financial statements that are based on generally accepted accounting principles (GAAP). Executive compensation is tied to profit figures reported in the financial statements and equity share valuation is also based to a large extent on these financial statements.
Cost accounting provides information to facilitate both management accounting and financial accounting. Its focus is measuring and reporting financial and nonfinancial information that is related to the cost of acquiring or consuming resources by an organization.
Cost management is an activity of managers related to planning and control of costs. Managers have to take decisions regarding use of materials, processes, product designs and have to plan costs or expenses to support the operating plan for their department or section. All these activities come under cost management. Information from accounting systems help managers in cost management activities. But the cost accounting system and the reports it generates is not the cost management system. Accounting system can be interpreted as a part of cost management system of an organization.
Cost management is not cost reduction alone. It is much broader. Organization increase advertising expenditure to increase sales, increase research and development expenditures to promote new products. Here the concerned managers are deliberately incurring additional costs in a period (compared to the previous period) as they expect profits from such decisions or expenditures. Cost management system has to ensure that a cost is incurred with the expectation of profit.
The Role of Management Accounting
The role of management accounting is also described as problem solving, score keeping and attention directing.
Problem solving: The role of accounting in problem solving is to provide information useful in evaluating alternatives.
Scorekeeping: Scorekeeping records the results of various actions of the managers and helps in assessing whether the results expected from the various actions are realized or not.
Attention directing: The scorekeeping function in combination with expected results, and comparative analysis of scores of various companies, divisions and departments, comparative analysis of present period scores or results with previous periods show opportunities of focusing attention of managers to improve things.
Value chain is a visualization of complete business as a sequence of activities in which usefulness is added to the products or services produced and sold by an organization. Management accountants provide decision support for managers in each activity of value chain.
Design of Management Accounting System
The design of management accounting system has to take into consideration the decision needs of the managers. Also it has to take into consideration the new themes and challenges that managers face currently.
Horngren identified four such themes in the tenth edition of his book.
1. Customer focus: The challenge for managers it invest sufficient resources to enhance customer satisfaction. But every action of the organization has to result enhanced profitability or maintained profitability for the organization.
2. Key Success Factors: These are nonfinancial factors which have an effect on the economic viability of the organization.
Cost, quality, time and innovation are important key success factors. Management accounting systems need to have provisions for tracking the performance of the organization and its divisions as well as competitors on these success factors.
3. Continuous improvement: Continuous improvement or kaizen is a popular theme. Innovation related to this area in costing is kaizen costing .
4. Value Chain and Supply Chain Analysis: Value chain as a strategic framework for analysis of competitive advantage was promoted by Michael Porter. Management accountants have to become familiar with the framework and provide information to implement the framework by strategic planners.
The term supply chain describes the flow of goods, services and information from cradle (the mines sources of raw materials) to grave (where discarded products or dumped), regardless of whether those activities occur in the same organization or many organizations.
Key Guidelines for Management Accounting System Design
Cost Benefit Approach: In the system design resource allocation decisions are to be made. Examples would be software to buy and associates to employ. A cost-benefit approach should be used for all such decisions. Resources should be spent only when there is profit to the organization due to that expenditure. Each incremental addition to the accounting system must be supported by incremental profit to the organization.
Behavioral and Technical Considerations: Management has human dimension and it has to focus on how to help individuals to do their jobs better. Managing people involves discussion of managers with his associates on improving performance. The behavioral responses of people to reports highlighting their underperformance have to be understood. Management accounting should lead to cordial relations and climate.
Different Costs for Different Purposes: It is to be noted that there are several cost concepts and cost measures can be created for each of these concepts. Cost accountants have to careful to provide appropriate cost to the managers. The accounting system has to have some precautions to make sure that the accountant understands the decision situation of a manager and provides appropriate cost measures.
Like other professionals, accountants also face ethical dilemmas. They need ethical guidelines. Institute of Management Accountants (IMA), USA published guidance note on ethics to be followed by management accountants.
Competence, confidentiality, integrity and objectivity are important themes of the guidance note.
Horngren, Charles T., George Foster, and Srikant Datar, Cost Accounting: Managerial Emphasis, Tenth Edition, Prentice Hall, Inc., Upper Saddle River, New Jersey, USA, 2000
Cost Accounting - Horngren et al., Book Information and Review