Accounting for Management Decisions - Research Paper Example

?Accounting for Management Decisions I. Executive summary Today many organisations are going out of business as a result of the mounting cut- throat market competition across the globe. Even though a company has a better range of well recognised product lines and brand names, it cannot confront with modern business situation unless the firm possesses potential management level strategies and decision making capabilities. In order to be highly competitive in the market, an organisation must be able to forecast future changes in customer needs and market trends. Organisations normally predict possible future market changes by assessing past and current market flows. For this purpose, an organisation deploys a number of business evaluation tools. Activity based costing, value chain analysis, and customer profitability are the three major frameworks that assist an organisation to evaluate its business flow. This paper conducts a detailed research to identify the core concepts, objectives, pros and cons, and applicability of each of these business evaluation methodologies. The paper includes an extensive literature review section and an analysis section. The major findings reflect that: Cost centre and cost driver are two core concepts of activity based costing Governance, innovation and upgradation, benchmarking, and product positioning are the key ideas of value chain analysis Cash flow, customer capital/equity, and customer as a real option constitute the core concepts of customer profitability The ABC approach greatly assists users to better identify their overheads with regard to activities and resources. The most advantageous feature value chain analysis is that this methodology assists its users to get a clear view of their core competencies The concept of customer profitability aids an organisation to identify its profitable customer groups and secure them from competitors. II. Introduction Today, organisations are widely using business evaluation tools like ABC, value chain analysis, and customer profitability analysis to evaluate their (organisations’) business feasibility and secure future profitability. Application of these tools assists firms to identify their pitfalls in supply chain activities, their potential strengths and weaknesses, and most profitable customer segments. Although all these three techniques are complex and time consuming, they are the best available tools to accurately evaluate a business concern. The ABC approach is mainly concerned with allocation of cost to various supply chain activities along with the firm’s resources whereas the value chain analysis explores activities that create value for the organisation and those do not create. The former method specifically focuses on profitability of each activity and process while the latter tries to define the organisation’s core competencies over its rivals. In contrast, the concept of customer profitability aids a firm to identify profits generated by its individual customers. All the three approaches are based on some core accounting and management concepts. The following sessions critically analyse these three business evaluation tools in detail. III. Literature review 1. Activity based costing Activity based costing (ABC) can be simply referred to a special costing approach that clearly identifies and defines activities in an organisation and allocates costs of each activity among all products and services based on actual consumption by each activity. According to the Consortium for Advanced Manufacturing-International (CAM-I), activity based costing is a costing model “that assigns cost activities based on their use of resources, and assigns costs to cost objects, such as products or customers, based on their use of activities” (Lewis, 1995, p.114). The ABC is a valuable accounting tool as it provides an organisation with more clear view of the product and process costs. This concept can be effectively employed to improve management decision making process and thereby promote the firm’s long term sustainability. This model gives specific focus on the allocation of resource costs to activities and subsequently activity costs to cost objectives including commodities, geographical locations, and customers. It can be considered as a potential source for data and information. Since the ABC model emphasises on activities rather than departments or conventional cost centres, it facilitates activity based management and thereby enhances continuous product quality improvement and business process reengineering (ibid). Core concepts Cost centre and cost driver are two core concepts of activity based costing and they form the basic framework for distributing total costs incurred along with resources to various activities. Cost centre indicates an organisational unit that contributes to the total costs of an organisation, but does not add to its profit directly. Marketing, customer service, and research and development are some of the typical examples of cost centres. The concept of cost centre greatly benefits an organisation to identify revenues and expenses associated with individual processes. Scholars maintain that activity based costing is an effective measure to precisely make out cost centres related with each product or service offered by a business firm and integrate those identified costs into the particular product’s or service’s price. To illustrate, consider a manufacturing producing two products that are not identical. In addition, marketing efforts required for the promotion of the sale of each product would not be the same. Therefore, it is clear that costs related with the manufacture of these products may be different and hence the firm’s management has to clearly identify the individual costs to effectively price the products separately. Here, the application of activity based costing helps a firm to price its products in accordance with their actual cost of production. Similarly, a cost driver reflects unit of an activity which leads to a change in the activity cost. Examples of cost drivers include direct labour hours, number of purchase orders, and machine hours. The ABC technique is used to allocate indirect cost to concerned activities. Objectives Activity based costing is one of the most powerful techniques for management accounting. Elimination of wastage is another key objective of the ABC approach. The ABC approach helps organisations identify hidden waste contained in overheads. It is clear that wastage elimination is one of the most effective strategies to improve profitability. The major objective of the ABC tool is to develop a system “the effectively captures, allocates, and distributes costs by area of responsibility” (Ziesel, 1997). This may be beneficial for an organisation to encourage its employees to bear the challenge of responsibility accounting and thereby improve the firm’s overall profitability. Since the ABC approach can go hand in hand with modern management paradigms, organisations can avoid accounting as well as managerial complexities to a great extent. From the view point of Blanchard (2009, p. 306), the key objective of this methodology is to facilitate traceability of all applicable costs to different products or processes that cause to generate such costs. He adds that this approach is useful to make possible initial cost allocation and its subsequent assessment by function. Another objective of the activity based costing is to address the pitfalls of conventional management accounting framework, where overhead components are allocated and distributed to all units of the enterprise regardless of whether or not such costs directly apply (ibid). Comparison with traditional systems While comparing activity based costing with other traditional costing systems, it seems that the former has a range of competitive advantages over the latter. Under an ABC approach, cost of raw materials plus the sum total of all value contributory activities involved in production constitute the total cost of a product. As Akyol et al (2005) points out, this approach links the costs of activities performed to model the usage of organisational resources to various outputs including products, services, and customers. As discussed earlier, concepts like cost centres and cost drivers under ABC approach would assist the organisation to accurately identify costs relating to various processes, procedures, and products and thereby effectively price a product or service in a way the set price would bring costs involved in production plus a desired level of profit. In contrast, under traditional cost accounting systems, costs such as direct materials and labour only can be directly linked to a product. In other words, a range of other direct and indirect costs associated with the production activity is not considered under traditional costing systems. In short, it is not possible to accurately understand total cost of production using traditional cost accounting system and this worse situation makes the organisation’s product pricing ineffective. Unlike ABC costing system, traditional systems cannot be used to categorise activities into value added and non-value added. In contrast to traditional costing systems, the ABC technique is capable of eliminating non-value added activities to improve overall performance of the system. Advantages and disadvantages The idea of activity based costing assists organisations to more accurately deal with processes like costing of products, services, SKUs and distribution channels. The most advantageous feature of ABC approach is that it aids users to better understand their overheads with respect to activities and resources. This method takes unit cost into account rather than considering just total cost for accounting purposes. Another advantage of this approach is that it can well integrate with continuous improvement programs like Six Sigma. ABC is an effective framework to bring waste and non-value added activities to the notice of top level management. It also supports scorecards and performance management and therefore this technique aids the organisation to avoid complexities of using several accounting procedures. The ABC tool can be better employed to cost processes, value streams, and supply chains. Furthermore, activity based costing facilitates benchmarking and hence organisations can easily identify its areas of improvement. In short, ABC approach benefits an organisation to scrutinise its each unit of activity in terms of profitability. The most potential disadvantage of ABC method is that it consumes longer time to collect data. As a result, firms often cannot complete their cost accounting processes by the end of a fiscal period and this situation would cause dissatisfaction among stockholders. In addition, installation and establishment of an ABC system would be a difficult task, specifically if the organisation is employing more conventional cost accounting methodologies. 2. Value chain analysis Value chain analysis is a complex management concept that simply assists an organisation distinguish between its operations that create value and those do not. Value chain analysis is described as a “theory used to define a framework that focuses on the interfaces between functions-specifically, those that affect the customer’s value” (Ferrand et al, 2006, p. 131)). This understanding is of significant importance in business because an organisation earns above average returns on its investment only when the value it creates exceeds the costs realised to create that value. The process of value chain analysis greatly assists a firm to identify its cost position and implement a business level strategy effectively. In today’s competitive business environment, firms analyse their value chains in global rather than domestic context. Generally, an organisation’s value chain is categorised into primary and support activities. Primary activities are concerned with a product’s physical development, its sale, distribution, and after sales services whereas support activities represent the assistance required for facilitating the primary activities. Value chain analysis aids a business manager to scrutinise how a particular product moves from the raw material phase to the end customer. Core concepts Governance, innovation and upgradation, benchmarking, and product positioning are some of the core concepts of value chain analysis. Governance is the way an organisation deals with its strategic management activities. Effectiveness of governance policy plays a crucial role in determining an organisation’s long term sustainability. Hence, value chain analysis gives specific focus on the firm’s governance tactics. In other words; value chain analysis of a firm is centred on the concern’s governance policy. It is clear that frequent innovation and upgradation are necessary for an organisation to be up to date with changing business environments and market trends. Therefore, the process of innovation and upgradation adds value to a firm’s operational efficiency and competitiveness. Value chain analysis pays specific attention to how frequently and effectively a business concern makes product/service innovation and business upgradation. Similarly, benchmarking is the search for best business practices by comparing an organisation with the industry’s top performing one. This process assists an organisation to gain competitive advantages over its rivals. Benchmarking is also a key concept of value chain analysis as it contributes to improvement of value chain performance. Finally, the concept of product positioning is also an integral component of value chain analysis. Product positioning can be referred to the process by which an organisation creates an image of its products/services in the minds of customers. An organisation’s market competitiveness very much depends on how effectively it (organisation) has dealt with the product positioning process. Therefore, product positioning is one of the most important tools of value chain analysis. Objectives The main objective of value chain analysis is to identify key actors in the value chain from input providers to producer, trader, retailer, and final customer. This process also aims to evaluate how well an organisation’s marketing chain is performing. Scholars opine that large organisations perform value chain analysis with the objective of identifying areas where collaborative bargaining power can have a positive influence on benefits to small firms operating in the value chain. One of the key objectives of value chain analysis is to properly identify potentialities and constraints along the value chain. The process also intends to analyse various contextual issues concerning policy, economy, technology, and environment. Through an effective value chain analysis, it is possible to assess business development services and identify effective intervention strategies. With the process of value chain analysis, a firm aims to get a detailed view of the costs in its chain that could be influenced by proper changes in the chain’s processes. Value chain analysis aids an organisation to compare its value chain with that of competitors and this practice may assist the firm to identify crucial areas of improvement and thereby form appropriate strategic solutions immediately. Comparison with traditional systems In olden days, business houses followed the traditional management accounting approach to assess their operational efficiency and this practice was replaced by value chain analysis. As Drury (2008) points out, the concept of value chain analysis is entirely different from traditional management accounting. The traditional management accounting is concerned with cost reduction in value added process whereas the value chain analysis focuses on competitive advantages based on the whole interconnected activities form suppliers to end users. Under traditional management accounting system, a single cost driver is considered and cost is dependent on volume of production and sales (ibid). In contrast to this, multiple cost drivers including technology, experience, and complexity are adopted in value chain analysis. The traditional system is applied at the overall firm level and deals with cost-volume-profit analysis. In case of value chain analysis, a set of unique cost drivers is assigned for each value activity. The traditional management accounting targets adhoc cost reduction measures by giving focus on variance analysis and performance evaluation whereas value chain analysis considers as a function of various cost drivers controlling individual value activity (ibid). The former method gives emphasis on control of manufacturing costs while the latter focuses on gaining competitive advantages. While the traditional approach takes internal information only into account, the value chain analysis method considers both internal as well as external information. The process of benchmarking has less scope under traditional management accounting and it is mainly restricted to cost. In contrast, benchmarking has a broader scope in value chain analysis as this approach focuses on full-fledged benchmarking. Advantages and disadvantages In the fast changing modern business environment, the concept of value chain analysis has a range of advantages. The most potential advantage of this process is that it assists an organisation to accurately identify its core competencies (Needles, 2010, p. 805). By focusing on its key strengths, a company may get an edge over its market competitors. Value chain analysis aids a business concern to effectively deal with outsourcing process, which can be very beneficial to organisation lacking sufficient resources, skills, or experience (ibid). Another potential benefit of value chain analysis is that it can effectively define information needs and flows that are necessary to identify how the business actually performs. This concept considers information systems/information technology as a value adding process rather than a mere cost. An effectively structured value chain analysis can reflect an organisation’s operational pitfalls and quickly make necessary changes to what the firm is currently doing in the marketplace. This method reflects the significance of interrelationships within the organisation and, between the organisation and its external partners such as suppliers, intermediaries, and competitors. Even though value chain analysis may aid a firm to distinguish its core competencies from those of its competitors, it is a very complex process and takes longer time to complete. Evidences suggest that many managerial personnel are still unfamiliar with the effective use of value chain analysis. This idea is very old and hence its relevance in today’s internet age is still debated. Finally, ordinary people may not easily understand this idea. 3. Customer profitability Customer profitability can be simply referred to the profit earned by an organisation from customer relationship during a specific period of time. Customer profitability is defined as “a snapshot of the profit or contribution from a customer (or group of customers) during a previous period, usually a year” (Ryals, 2008, p.41). It must be noted that customer profitability is historical like any other profit measure. The concept of customer profitability assists an organisation to evaluate financial efficiency in a previous period. Hence, this idea is greatly beneficial for an organisation to identify unprofitable relationships in the past and formulate strategies to convert such relationships into profitable in the future. The net present value of the cash flows derived by serving a customer is called customer lifetime value. High customer lifetime value is identified with unprofitable customers whereas profitable customers can have low customer lifetime values. There are several methods employed to find out customer profitability in terms of monetary values. The Balanced Scorecard approach would be an effective tool to measure customer profitability. A detailed view of the customer profitability would assist organisations to frame strategies to ensure greater level of customer satisfaction. Finally, customer profitability analysis may benefit business concerns to adopt measures for improving their operational efficiency. Core concepts Major concepts of customer profitability include cash flow, customer capital/equity, and customer as a real option (Murphy, 2005). Cash is lifeblood of any business and therefore cash flow must be a crucial determinant of customer profitability (ibid). The author adds that an organisation can improve its customer profitability by maintaining an effective balance between inflow and outflow of cash. Some companies consider the impact of cash flow on working capital or net working capital as part of customer profitability analysis. Customer equity is also a key concept of customer profitability. Customer equity refers to the value of future revenues raised by an organisation’s customers in lifetime. In accounting practices, a company with increased customer equity is valued greater than a company with lower customer equity (ibid). Hence, customer equity can have a direct impact on customer profitability. While performing a customer profitability analysis, organisations give prime significance on the level of customer capital they possess (ibid). Nowadays, firms consider customer as a real option to improve their profitability. The marketer has an opportunity to make a profit when an individual customer completes a business transaction. However, the level of opportunity seized or amount of profit generated may depend on systems that are in effect for dealing customers. An organisation’s long term customer profitability would very much depend on the firm’s ability to retain its profitable customers. Since all customer relationships are based on a series of options, an organisation can improve its customer profitability by thoughtful exercise of different options. Objectives The major objective of the customer profitability concept is to perform customer profitability analysis and thereby properly identify effective and ineffective activities and services relating to customer. This approach can be used to identify highly profitable customers; hence, organisations can develop strategies to provide better services to those customers and thereby retain them. Another major objective of this concept is to set prices in accordance with cost to serve. By the application of this tool, firms aim to furnish necessary data for future negotiations with customers. Transformation of unprofitable customers into profitable customers is one of the key goals of this accounting tool. With the performance of a customer profitability analysis, an organisation tries to discover permanent loss customers and stop spending further money on them. This methodology assists the organisation to avoid waste spending. By executing customer profitability analysis, an organisation aims to identify common characteristics of profitable customers and thereby spread its target audience coverage. Finally, timely and effective meeting of customer needs is another objective of customer profitability analysis. Comparison with traditional systems While comparing traditional profitability analysis methods with customer profitability system, it seems that latter method is a more comprehensive one. In traditional systems, only a firm’s total profitability was considered. As a result, managements could not accurately identify amounts of profits generated by individual organisational units. This situation led to the existence of unprofitable organisational units, processes, and practices at the expense of other profitable ones. In short, traditional profitability analysis measures were not potential to discover factors that diminish the level of an organisation’s profitability. In other words, traditional systems were just used to measure total profitability and thereby make necessary changes to operational strategies. In contrast to traditional profitability analysis tools, customer profitability method focuses on profits generated by individual customers. This strategy is assistable for organisations to identify weaknesses in its each unit, process, or activity if any. Through an effective customer profitability analysis, an organisation can eliminate unprofitable market operations and thereby reduce operating costs to a great extent. The customer profitability concept is more complex while compared to other traditional profitability analysis methods. However, the customer profitability idea provides the firm with extensive customer information and thereby aids the management to effectively meet actual customer needs. Advantages and disadvantages The concept of customer profitability is a realistic approach as it does not involve too many assumptions. Customer profitability is calculated by giving focus on actual historic data pertaining to customer revenues and costs rather than forecasts. Consequently, reliability of the customer profitability analysis would be high. Hence, the organisation would get a fair view of the customer potentiality which in turn would aid the firm to improve its profitability status. One of the potential advantages of customer profitability concept is that it may help an organisation to secure its highly profitable customers from competitors. The concept of customer profitability is of great importance in budgeting activities as this approach may benefit the organisation to accurately point out future customer needs. In addition, a company can trim down its operating costs to a large extent if it practices customer profitability approach. More precisely, an effective customer profitability analysis would aid the company to curtail spending on unprofitable customer segments. However, customer profitability analysis is a time consuming process and high level of skill and efficiency are necessary to obtain reliable results. Even a minute error in customer profitability estimation would significantly affect the firm’s market competitiveness. Since the customer profitability is dependent on a number of factors including customer income and family background, the estimated profitability may be subjected to fluctuations in future. Under such circumstances, organisation may not get much benefit from performing a customer profitability analysis. IV. Analysis of the Literature Review Applicability of activity based costing Beyond academic discussions, activity based costing has proved its applicability to the business world. ABC is a modelling process and its applicability for full scope and partial views has been well proven. One of the most useful applications of this approach is that it helps identify unprofitable products, departments, and operations. Therefore, this methodology assists an organisation to improve those weaker areas and thereby increase profitability. ABC can be applied to allocate additional resources on profitable products, processes, departments, and operation. This practice would benefits firms to identify potential business areas and invest more on them. Business houses may adopt this technique to cut down their costs at any pre-product-level and often on a departmental level. In addition, ABC approach is helpful for organisations to point out unnecessary costs that can be eliminated to improve profitability. Another application of this costing method is that it can be deployed to price a product or service with any desired analytical resolution. Similarly, better management, effective budgeting, and performance measurement are some of the well proven applications of activity based costing. This method aids firms to make cost calculations more accurate. Hence, this tool would be beneficial for marketers to make some effective forecasts and frame future business policies. Since this method has the potential to cost each activity associated with production, its helps firms ensue product/customer profitability. Evaluation and justification of investment potential in new technologies is another key application of ABC methodology. By applying this costing strategy, firms can effectively manage their product and process design in order to improve product quality. This costing policy can be also applied to manage increased pressure from regulators. ABC technique also supports recent management innovations including JIT and TQM systems and this situation assists firms to notably reduce their costs. Applicability of value chain analysis Value chain analysis has a number of applications in the today’s competitive business environment. The most significant application of this framework is that it can be deployed to identify and promote a company’s level of competitive advantage. As Dahlstrom et al (2004) believes, the value chain analysis scrutinises an organisation’s strategic activities or value activities, examine their costs, and effectively coordinates linkage of those activities within the value chain. The authors continue that this model can be applied to promote efficiency of an organisation’s international operations, efficiency of several actors’ operations in an industry based value chain, evaluate decisions relating to investments and business expansions. This tool is nowadays widely applied in studies of international trade as it constitutes a fundamental framework for business feasibility analysis. The value chain analysis checks a firm’ activities and learn how they interact with one another and influence each other’s cost and performance. It is also a crucial tool to evaluate various economic benefits derived by an organisation. Value chain analysis is a better strategy to discover customers’ strategic needs. It is obvious that modern business is customer focused one and hence exploration of customers’ strategic needs is of great importance in determining an organisation’s long term sustainability. Nowadays, many organisations apply this tool to get a clear understanding of their various strengths and weaknesses. Firms can use this technique as a measure to intervene in its value chain activities and thereby eliminate chances of business failure. Today, vast majority of organisations, regardless of their nature and size, are following this framework to identify their core competencies and improve supply chain efficiency. In short, the value chain analysis is being used by modern organisations and regulators for a wide variety of applications. Applicability of customer profitability Like two other models discussed above, applicability of customer profitability in business has been well recognised and proved. Customer profitability models are used to evaluate some key profit drivers including cost profiles and customer behaviours and this process in turn aids an organisation to identify the potential areas of opportunity and inefficiency. One of the most promising applications of customer profitability concept is that it greatly supports benchmarking process. Hence, a business concern can effectively identify its areas of improvement and core competencies over its market rivals. Many firms are currently using this framework as a tool to assess processes that are most troublesome to customers. Evidences suggest that customer profitability analysis can be effectively employed to increase value through cost reduction, revenue increases, and customer satisfaction improvement. In the words of Ryals (2008, p. 79), evaluation of customer dependency is a potential application of customer profitability analysis. The author says that firms can consider this approach as a tool to establish an effective balance between customer acquisition and customer retention. He continues that customer profitability analysis is an effective technique in ‘understanding the payback to customer acquisition’ (ibid). To conclude, this framework can be better applied to identity profitable customers and ensure their retention. V. Conclusion All the three concepts like activity based costing, value chain analysis, and customer profitability are of great significance in modern business organisations. By using activity based costing method, an organisation can measure costs associated with its each unit of activity. Hence, the company can allocate total incurred costs among various activities along with resources. This situation facilitates effective decision making. Similarly, value chain analysis helps an organisation identify its core strengths and potential weaknesses as compared to its competitors. This framework would be beneficial for organisations to frame operational strategies that best suit their future needs. Furthermore, value chain analysis may aid an organisation to distinguish between activities that create value and those do not. Finally, customer profitability is also a business evaluation tool that enables firms to identify their profitable and non-profitable customers. Therefore, organisations can design effective policies to retain their profitable customers. Through a customer profitability analysis, companies can identify what approaches are necessary to meet customer needs and requirements. Applicability of all the three concepts to the business world has been well proven. Identification of unprofitable products, departments, and activities is one of the major applications of activity based costing. This method is also applied in future business forecasting. At the same time, value chain analysis is used to explore and promote a firm’s core competencies. In contrast, evaluation of customer dependency and balancing between customer acquisition and customer retention are the major application of customer profitability framework. References Akyol, DE, Tuncel, G & Bayhan, GM.,2005. A comparative analysis of activity-based costing and traditional costing, World Academy of Science, Engineering and Technology, 3, pp. 44-47, [Online] Available at: [Accessed 18 May 2012]. Blanchard, B., 2009. Cost management. In: AP. Sage & WB. Rouse, Eds. Handbook of Systems Engineering and Management. USA: John Wiley & Sons. Drury, C., 2008. Management and Cost Accounting. London: Cengage Learning EMEA. Dahlstrom, K, Ekins, P, He, J, Davis, J & Clift, R., 2004. Iron, steel and aluminium in the UK: Material flows and their economic dimensions, Center for Environmental Strategy, pp. 1-233, [Online] Available at: [Accessed 18 May 2012]. Ferrand, B, Xu, M & Roberts, M., 2006. Unattended delivery for online shopping: An exploratory study from consumers perspectives. In: M. Khosprow-Pour, Ed. Emerging Trends and Challenges in Information Technology Management. USA: Idea Group Inc. Lewis, RJ., 1995. Activity-Based Models for Cost Management Systems. USA: Greenwood Publishing Group. Murphy, JA., 2005. The customer profit conundrum, pp. 1-41, [Online] Available at: [Accessed 18 May 2012]. Needles, BE, Powers, M & Crosson, SV., 2010. Principles of Accounting, USA: Cengage Learning. Ryals, L., 2008. Managing Customers Profitably. England: John Wiley & Sons. Zeisel, DW., 1997. The importance of activity based costing in managing a turnaround, Turnaround Management Association, [Online] Available at: [Accessed 18 May 2012]. Read More