Kaplans phases for developing cost management systems

This paper was written to extend Kaplans thoughts expressed in an earlier article,
"One Cost System Isnt Enough." In that paper Kaplan advocated that companies
develop new cost systems to produce useful information for operational control and
for profitability analysis. The earlier article also suggested that these systems should
be kept separate from the financial reporting system. After receiving feedback from
financial executives about the undesirability of multiple cost systems, Kaplan asserted
that his main thought was that multiple cost systems are not the ultimate objective but
an intermediate and sensible stage on a path to a more effective set of integrated
management information systems. To this Kaplan suggests a four-stage model
described below. In addition, the reader will find it useful to reference the figure
below that was recreated from his article on the four-stage model.

Cost Systems Go Through Four Stages of Development

Stage 2: Stage 3:
Aspects Stage 1: Stage 4:
Focus on Innovation:
of Cost Poor Data Integrated
External Managerial
System Quality Cost Systems
Reporting Relevance

Data Errors
Math Errors No surprises
Shared databases
Large Fast monthly
Stand-alone Systems
Data Quality Variances Closings Linked databases and sys
Reporting frequency
Write-downs Meets External
varies by systems
Post-closing Audit standards
adjustments

External Tailored to
(Financial) Inadequate financial Keep Stage 2 system
Expanded ABC system:
Reporting reporting needs
Supports financial reporti
well as product cost
management.
Product Inaccurate
Inadequate Develop ABC system
Costs product cost

Develop operational
Operational Limited
Inadequate performance Operational Control Syste
Control feedback
measurement system
Stage 1. Stage 1 systems possess a general lack of integrity and auditability of the
financial system. In addition to the before mentioned problems, the data problems
presented in the above diagram arise because Stage 1 systems dont do one of two
things: capture material, labor, or operating expense transactions accurately or it
doesnt count all the outputs produced by the manufacturing process. These systems
are commonly found in small or newly organized businesses that have not paid
adequate attention to system design or internal controls.

Stage 2. The majority of companies have stage 2 cost systems and are generally
viewed as having adequate data integrity and internal controls. The general belief of
the company is that the system produces reliable financial statements, however, these
systems are shown to have serious limitations for operational control, accurate
product costing, and profitability analysis. Operational control is limited by four
attributes of a stage 2 system:

1. They are not timely.

2. Results are highly aggregated making it difficult to continuously improve and
learn.
3. The systems focus on aggregated results and not the activities that produced
the results. This provides inadequate feedback to a company about the progress
of implementing operating improvements, such as just-in-time.
4. Many operating reports are flooded with extensive allocations of costs.

Stage 2 systems are also inadequate for product costing and profitability analysis
because they rely on only a few allocation bases for assigning indirect costs, namely:
direct labor hours, machine time, and material quantities. These bases all vary
proportionately with the number of units produced, or sold. This introduces
considerable distortion when also used to assign costs that do not vary with the
volume of products produced or sold.

In order to overcome this inadequacy, the article suggests that companies retain their
current system for external financial reporting and develop customized systems for
profitability analysis and operational control.

Stage 3. This stage is characterized by the need to retain the existing external
reporting system from Stage 2. In addition, companies should begin to develop an
activity-based system and an operational performance measurement system. Stage 3
systems would produce financial summaries of a companys short-run performance.
This would provide employees with, depending on the information, hourly, daily, or
even batch-by-batch information to guide their learning and continuous improvement
activities. The ABC system would more accurately assign the indirect and support
expenses of the organizations resources to the products, product lines, divisions, and
customers that create the demand for or benefit from these resources. This would
facilitate decisions about product design, manufacturing processes, and pricing and
product mix. The need for separate systems is evidenced by the different assumptions
about expense variability, frequency of reporting and updating, accuracy
requirements, and on the scope of the system. The article suggests that the information
needed by the localized systems may be downloaded from existing financial
accounting, marketing, and sales systems.

Stage 4. Integrated cost systems will derive information from the activity based and
operational control systems to prepare external financial statements. The article
mentions that companies can begin to replace the financial reporting system from
Stage 2 with reconciliation modules that prepare GAAP external reporting statements
from data that is already being collected for the managerial systems. Financial
statements would then be prepared from systems designed to provide managerially
relevant information instead of the Stage 2 philosophy of trying to obtain
managerially relevant information from systems that primarily satisfy external
reporting. Stage 4 systems would also integrate information between the operational
control and activity-based systems. The activity-based expense analysis system would
prepare budgets for different departments based on product volume and mix forecasts.
The operational control system could compare actual spending to the expense
forecasts prepared by the activity-based system. Stage 4 systems would then have two
integrated managerial systems - one for product and customer profitability analysis,
and one for on-line feedback and performance measurement.

Some attempts have been made at Stage 4 systems; however, these systems provide
poor estimates of product costs, and little to no information on the profitability of
product lines, customers, and distribution channels.

The author suggests that the best cost system designs will come from organizations
that allow local, customized systems to be developed as prototypes.