Cost management system at JSC Russian Railways

In the business world, the rearview mirror is always clearer than the windshield
Warren Buffett, American investor, businessman and philanthropist

Introduction Recently, corporations have been applying end-product management and supply chain management to increase the profitability of each product, which enables prices to be kept low while raising profits. An activity-based costing method is the key to success in these critical management strategies. ABC is a costing model that identifies the cost pools and activity centers in an organization. It assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or a service. As a result, ABC management can support managers to see how shareholder value can be maximized and how corporate performance can be improved. Specifically for monopolies it is greatly important to pursue a price policy based on product costs, while for other corporations it is imposed by market prices. In addition, cost management systems in large state-owned holdings have their own special features, including a very high share of indirect expenses in the consolidated corporate expenses. The process of cost allocation with respect to different business units (BU) and subunits usually has high potential for improvement. Based on the situation described above plus a framework of reform, the national railway monopoly, JSC Russian Railways, started a process to restructure the management accounting system by implementing an activity-based costing method in order to increase efficiency and reduce costs without sacrificing the value for the customers.

The company JSC Russian Railways (hereinafter RZD) is one of the biggest railway companies in the world. RZD has a complicated multi-level structure that includes company branches and representation offices, subsidiaries and associates. As of December 2006, the company had a total of 120 subsidiaries and associates. Some of the fields in which RZD operates are: Freight traffic Long-distance passenger traffic Suburban passenger traffic Infrastructure services Locomotive power services Rolling stock repair services Capital construction Research and development Maintenance of public property Large-scale production, functional diversification and the complicated organizational structure of RZD result in differences between the units reporting standards, use of the wrong consolidation principles and the undefined corporate policies, which entail misleading decisionmaking processes for management. These imperfections in the management reporting can damage corporate strategy. Therefore, we were engaged in the project of reengineering RZDs management accounting system. The improvement project for the cost management system of RZD was implemented in three phases.

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Phase 1 A specific characteristic of RZD is that general indirect expenses and overheads are rather high as a percentage of total expenses. Indirect expenses, related to the maintenance of the railways infrastructure, account for 40% of the total general costs and 30% of handling costs. Overhead costs, which are proportional to the labor compensation fund in recent years, also accounted for approximately 30% of total handling costs. Consequently, some 60% of the total expenses of railway transportation are distributable, and the structure of traffic handling costs depends sharply on the accuracy level of allocation of these distributable expenses. Therefore, in order to define profit- and loss-making activities facilitating the development and maintenance of an effective cost management system and increasing profitability of the whole company, an activity-based analysis of expenses and functions (marketing, legal services, human resources, finance and accounting, etc.) was carried out. The analysis conducted during the diagnostic phase of the project allowed the identification of existing accounting methodology and cost allocation methodology deficiencies. They could be classified into two main areas: data gathering and cost allocation method.

Figure 1: Cost allocation Cost data

Expenses consolidated

Direct costs

BU 1

Allocation coefcients

Products/ services

BU n

Overheads

Regarding the data gathering process for costs, the following problems were identified: Incorrect consolidation structure Failure to break down expenses on cost accounts and cost items by filling out the form Incorrect cost allocation to general and administration expenses in the consolidated balance sheet In the area of cost allocation method, the following problems were identified: Application of outdated coefficients for distribution Application of labor compensation fund as a basis for cost allocation Allocation of overhead expenses on the upper level (some expenses, e.g., general and administration expenses could be allocated at the level of business units)

Phase 2 To increase the accuracy of cost allocation and create an effective management system, an activity-based costing analysis of the types of activities was carried out. The development of a new accounting methodology requested improvements and adjustments to the previous format, providing detailed data gathering for more accurate cost allocation using the activity-based costing analysis. The challenge was to create separate cost accounting frameworks for the different types of activities. The detailed analysis of the activities of every business unit and their inclusion in the strategic corporate scheme allowed them to derive the new accounting format showing costs of single business units. As the new accounting format is more flexible, it enables the conduction of cost structure operating analysis and operating budget planning based on cost groups; including a breakdown of costs to cost items.
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Figure 2: Cost accounting of different types of activities Cost data Function 1 BU 1 Additional function n BU 2 Product 2 Function 2 BU 3 Additional function n Function n Direct allocation Product n In proportion to the statistics coefcents

The main advantages of the new accounting format were as follows: Structuring costs by types of activity Indication of physical measures and number of employees by cost items Product 1 Specification of company expenses and all physical measures enabling planning and cost items accounting The new cost allocation methodology involved the implementation of an activity-based costing model. As a result of the implementation of the new cost allocation methodology, it was possible to carry out a structural analysis of costs by type of activity. Some characteristics of the new method of cost allocation were as follows: Adding definition of function as an object of cost accounting Allocation of production costs and general and administration costs to production function

BU n

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 Allocation of general and administration costs and costs of service departments to production functions of production departments, and not to types of activities, which increased the accuracy of cost allocation Allocation of general and administration costs at lower levels Implementation of a new cost allocation scheme for selected items Implementation of a cross-costing method Phase 3 During this phase, a pilot project to make the cost management system more effective was executed in the Moscow section of RZD. An electronic model, which enables separate accounting by type of activity and type of rail transportation, was created. The high level of satisfaction with the results of the pilot made the management decide to develop the activity-based costing model and apply it to the whole company.

Conclusions The first benefits of implementing the activity-based costing method were realized in the management reporting system. Data gathering systems are the basis for management reporting. Improvement of the formats and processes of data gathering lead to successful optimization of the management reporting system, avoiding the creation and implementation of additional systems for similar purposes. Critical redesign of the formats and standards of data gathering brings a higher level of efficiency and even motivates employees. Beyond that, implementing activitybased management makes profit- and loss-making activities more visible to RZD, facilitating the elimination of loss or taking reform measures to promote profitability. It enables an increase in the effectiveness of budgeting by identifying

a cost/performance relationship in the different fields of activities of the Russian railways, links corporate strategy to operational decision-making and helps improve decisions about tariffs that are based on the cost of activities. It also encourages continuous improvement and total quality control because planning and control are directed at the process level. Therefore, the ABC method is the key to the improved performance of the Russian railway in several respects and supports taking measures to promote profitable business development.

Authors Sergey Zaborov is a Senior Manager in the Advisory Practice, Ernst & Young, Russia. Liani Asatiani is a Senior Consultant in the Advisory Practice, Ernst & Young, Russia.

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