Midway upon the journey of our lives as penitent bean counters, we endeavor to move forward by glancing behind to master the most propitious elements of cost accounting. So, our anatomy lesson takes us back to charm school to re-learn our ABCs . . .
The Brain: Financial Accounting System
Despite my previous diatribe against the parochialness of bean counting, I must confess that we owe a great debt to the ABCs of cost accounting. An organizational financial accounting system is the brain of comprehensive IT Service Costing. Reviewing its evolution helps to reinforce our understanding of the fundamental activities needed to associate costs with services.
Climbing the Beanstalk: A Brief History of Cost Accounting
The origins of cost accounting are as dubious as Jack climbing his mythical beanstalk. In all likelihood, since the advent of beans (probably somewhere between 6,750 B.C. and 9,750 B.C., in case you wanted to know), humans have wanted to count (and eat) them. In our brief history below, we will highlight some (but not all) of the important developments.
1500s – Cost Finding
Although there is some evidence that systematic and “cost” accounting existed prior to the 15th century (for example, with soap manufacturing to charge a more “fair” price for soap), many accounting historians trace cost accounting back to Medieval cloth manufacturers in Florence, Italy. At that time, the Florentines (specifically, Medici Industrial partnerships) purchased raw material (wool and silk) and farmed out production work to craftsmen who worked from home. Various stages of production were performed by different craftsmen and different guilds, who charged different prices for their labor and produced different quantities of cloth. In order to obtain a more accurate cost picture, the Florentines needed to record the various quantities and prices charged for cloth woven by different craftsmen and guilds. They did so to calculate what they should charge for a finished cloth item. Although they were conscious to some degree of fixed and variable prices, it is still premature to call this total cost accounting since they did not account for overhead costs. Since the craftsmen used their own tools, the purchasing company was not concerned about how much it cost the laborer to produce.
1772 – Father of Cost Accounting
The next milestone in our history occurs in 1772 in the U.K. when the “Father of Cost Accounting,” Josiah Wedgwood, started to run into tough times. If the surname sounds familiar, that’s because it is. This is the same Wedgwood who started a pottery company that today produces some of the most exclusive china in the world. Josiah Wedgwood also happens to be the grandfather of Charles Darwin. In our cost accounting evolution, the depression of 1772 meant that demand for pottery fell and inventory was growing dusty on the factory shelves. Wedgwood needed to determine whether his company could avoid bankruptcy, so he began to develop a deep understanding of the cost elements involved in producing pottery. In other words, he became a sort of self-taught accountant. Along the way, he discovered that his chief clerk was embezzling. But more germane to our inquiry, Wedgwood learned the cost of materials needed for each stage of production. He also tried to account for the cost of shipping and inevitable breakage – in other words, “overhead.” He realized that some pieces of china were significantly more expensive to produce than others. Some employees were also significantly more experienced and skilled than others, and Wedgwood’s observations ultimately led to differential pay and specialization by skillset. More than anything else, Wedgwood uncovered the tight coupling between supply and demand. By understanding how much different pieces of pottery cost to produce, he could determine how much to charge. In turn, he started to use price as a way to influence demand for two lines of pottery and effectively segment the market into wealthy consumers who wanted high-quality pottery and less affluent customers who could only afford less expensive, lower quality pottery. (ITIL enthusiasts will recognize in this how understanding patterns of business demand helps IT to plan for capacity and influence customer demand through pricing and chargebacks.) Wedgwood was one of only about 10% of firms during the Industrial Revolution that survived through at least the 1840s.
1830s, 1840s, 1850s – Enter the USA
In the United States from the 1830s through the 1850s, similar cost account developments were taking place. Notably, the Lowell cotton textile mills managed to consolidate and integrate all the means of production. Due to falling prices and foreign competition, Lowell refined cost accounting procedures to determine appropriate market prices. They also relied on cost accounting data to make operational decisions. Mill overseers acted as foremen and were responsible for day-to-day operations. This included understanding profitable and wasteful aspects of mill processes.
In the 1830s and 1840s, the Springfield Armory is often considered to have had the most advanced accounting system up to that time. Initially, Springfield’s accounting was architected as a way to summarize financial transactions, track inventory flows, and install individual employee accountability for the work they performed. They used “chart and discharge” accounting, which meant maintaining detailed records of the cost and inventory of raw materials, work-in-progress, and completed items. In addition to tracking the cost of raw materials and value-added/processed inventory, their accounting system was critical to payroll. On a monthly basis, they tracked workers by name, the piece-rate for each task performed (early on, workers set their own piece-rate), and the type and quality of work. They used “piece rates” as a way of incentivizing individual workers to produce greater quantities. The flaw in the Springfield system had less to do with their approach to cost accounting and more to do with organizational and cultural factors. In the early days, despite piece rate incentives, the Armory was plagued by workers who would drink alcohol on the job and spend significant time socializing and not working (Can you only imagine if Facebook existed back then!). Civilian control was not effective in altering employee behavior. After 1840, Springfield placed governance of the factory under military control and benefitted from an influx of Westpoint graduates who understood cost accounting but were also able to exercise a greater degree of discipline over laborers.
In the United States, the Railroad industry contributed greatly to cost accounting. As late as the mid-1800s, corporate financial reporting and auditing were immature, so railway companies needed to devise their own best practices for operating their business. The accounting principles and formulas they created later served as the basis for accounting in other industries despite flaws or “accounting errors.” In particular, early on, railroads did not appropriately account for depreciation and noncash expenses. Even so, companies like the Baltimore and Ohio railroad were early thought leaders and practitioners of governance and auditing.
Around the same time, in the U.K., the Regulation of Railways Act of 1868, required British railroads to use the double account method. This method splits the balance sheet into current long-term asset categories. In the case of the latter, if an asset was maintained and kept in working order, it was considered a long-term asset and no depreciation was charged. Instead, replacements and maintenance costs were expensed (i.e. Replacement Accounting).
Back in the U.S., the Pacific Railway Act of 1862 authorized the construction of the Transcontinental Railroad and as early as the 1870s, railroad construction took off. However, post-bellum railroads were not very profitable largely because they did not understand the relationship between short-term profits and long-term costs. Railroads and equipment need to be maintained constantly and over the long-term, and this amounts to no small expense. Enter Albert Fink, a German-born engineer and superintendent of the Louisville and Nashville Railroad. Fink introduced a cost-analysis system to measure railroad operations efficiency and profitability. At the time, his thoughts on fixed and variable costs and costs assigned to multiple account periods were innovative. He also devised a version of what we would today call “unit costs” by calculating profitability and expense per ton-mile and by passenger-mile. In short, Fink’s cost management techniques led to the management axiom of “control through statistics” and earned him the moniker, “Father of Railroad Economics.”
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1890s – “Scientific Management” and Frederick Taylor
Frederick Winslow Taylor earned his reputation as the father of “Scientific Management” largely due to his studies of efficiency and task standardization. But his contribution to the history of accounting is no less monumental. Taylor borrowed many of his accounting concepts from the railroads and improved upon them. Taylor’s main focus was on providing accounting information useful in management decision-making. As such, he was concerned with obtaining copious amounts of information about items important to making business decisions. At the same time, he strongly advocated eliminating items that were not useful in decision-making, the nineteenth century version of what we call “noise.”
Taylor used several journals and ledgers to gather and consolidate cost information into the smallest number or headings or categories possible without compromising understanding of what the expense items actually meant. These individual ledgers were then posted to the general ledger on a monthly basis. At the risk of oversimplifying, Taylor’s work led to the introduction or improvement of concepts such as: chart of accounts, general ledger, tracking of Sales expenses, general shop expenses, open accounts, depreciation, valuation of work-in-progress or inventory, and register of accounts. Perhaps more important, Taylor’s focus on “useful” information encouraged Planning department activities to become more closely integrated with General Accounting. It also supported an “interlocking system” where costing is integrated with general accounting systems. Ultimately, “Taylorism” represented something of a transition from an era of incomplete cost accounting and evolved into what we might call “managerial accounting,” where the emphasis is placed on tracking information to support decisions.
1920s – “Modern Industrial Cost Accounting”
Building upon Taylor’s insights, the 1920s saw a substantial increase in the professionalism of accounting and the “Modern Industrial Cost Accounting” era began. Significantly, in 1921, a CPA from Chicago, J.O. McKinsey wrote a series of nine articles describing the benefits of creating a master budget and “business budgeting.” He described what we now know as governance by promoting the importance of having a budget committee along with associated roles and responsibilities.
For his part, Alfred Sloan worked his way up the corporate ladder to become the president of General Motors in 1923. He introduced the idea of “annual styling changes” to the automobile industry. In essence, he introduced slight cosmetic changes to automobiles on an annual basis to highlight the newness (or oldness) of an automobile and thus encourage people to update their car just as they would update their clothing based on changing fashions. Another way to say this is “planned obsolescence.” He relied heavily on uniform accounting procedures to manage a decentralized company. His goal, which he called “the ladder of success,” was to create a suite of auto brands under GM, each successively more luxurious than the last, to encourage customers to stay within the GM family but purchase increasingly more expensive cars. He needed accurate and highly-detailed cost accounting information to facilitate this brand segmentation since it was based on alternating pricing based on cost and sales predictions.
1950s, 1960s, Absolute Costing v. Direct Costing
The only thing more ferocious than a battle between academics is a war between accountants. Thus, the proponents of absolute costing parried against the janissaries of direct costing.
In absolute costing, both variable and fixed production costs are considered product costs. Product unit cost includes direct materials, direct labor, and variable and fixed overhead. Fixed and overhead costs associated with manufacturing are allocated proportionally to the cost of each unit.
In Direct costing (also known as marginal costing), costs that vary depending on the output are considered as part of the product cost, whereas fixed manufacturing cost is not.
Absolute costing advocates contended that excluding fixed manufacturing costs would artificially undervalue inventory. Direct costing supporters believed that absolute costers allocated fixed manufacturing costs on an arbitrary basis to product costs and therefore did not arrive at a true product cost.
As with most arguments, over time, the reasons for the quarrel often disappear. In today’s world, computers and accounting systems allow companies to effortlessly maintain both absolute and direct costing systems.
1970s, 1980s, “Activity-Based Accounting” and George Staubus
Activity-Based Accounting or costing (ABC) is largely based on the work of George Staubus, who researched Activity Costing and Input-Output Accounting. ABC became popular in the manufacturing sector based on a recognition that knowing the cost of simple components or inputs does not provide an accurate overall cost picture. Instead, ABC “identifies activities and allocates the cost of each activity with resources to all products and services according to the actual consumption by each.” The ABC model is an advancement over conventional costing because it accounts for indirect or overhead costs and associates these with direct costs to gain a more comprehensive cost picture. ABC can be applied to both products and services and help managers understand profitability. It also helps managers determine ineffective processes used to deliver products or services.
1980s – “Value Chain Model” and “Activity Based Costing”
In 1985, famed professor, Michael Porter, introduced the idea of the value chain model in his book, “Competitive Advantage.” The value chain is made up of all the activities that an organization undertakes to deliver outcome or value to the customer. (Notice how suspiciously close this sounds to ITIL’s definition of value, especially when you consider a shift towards understanding value from the customer’s perspective.) Porter divided these activities into Primary and Support. Primary activities include inbound logistics, outbound logistics, operations, marketing and sales, and service. Support activities include Procurement, Human Resources, Technology Development, and Infrastructure.
Meanwhile, activity-based costing remained popular throughout the 1980s.
Figure 1: Generic Porter Value Chain
1990s and Beyond – “Service-Based Costing”
In the 1990s, Activity-Based Accounting started to fall out of favor, largely because companies found it too difficult or expensive to implement. Likewise, Kaplan’s Balanced Scorecard started to gain momentum and then waned. Although Balanced Scorecard takes a holistic approach, it, too can be difficult and time-consuming to implement.
Figure 2: Balanced Scorecard
Service-Based costing emerged as a viable alternative to both of these. In Service-Based costing, services are defined first based on desired customer outcome. Then, all activities, components, resources, and overhead are valued and taken into account.
Although Accounting has changed over time, throughout its entire history, the general trend is towards a more holistic approach to understanding the full cost to produce a product or provide a service.
The first early breakthroughs in cost accounting attempted to inventory and value all components of production. But there was a recognition that total cost is more than the sum of the components. Driven by necessity and propelled by crisis, the best businesses found ways to navigate financial depressions, outwit competition, and adjust to rising material prices. Key to all success stories is the impulse to count anything you wish you control and eliminate anything that is wasteful. For example, large “other” categories should be eliminated to the extent possible when performing service costing.
Figure 3: Comprehensive IT Costing
Does all of this sound familiar? The trend towards outsourced IT and managed service providers is reason enough to want to improve our ability to cost services. Although the history of accounting may be more appealing at a party attended by Cliff Clavin, Amy Farrah Fowler, and Velma Dinkley (Scooby Doo), the stakes are all too real to us. Doesn’t the history of IT parallel the history of the venerable industries described in the preceding section?
But why is comprehensive costing so important to us and what do we need financial accounting systems to do for us? At a minimum, we need our financial accounting systems to do three things for us: Accounting, Budgeting and Charging.
Accounting is concerned with historical information. It lets us know how much we spent on something. In the ITIL publications, it is defined as “The Process responsible for identifying actuals Costs of delivering IT Services, comparing these with budgeted costs, and managing variance from the Budget.” Without good accounting, we cannot budget accurately nor can we charge fairly or profitably.
Accounting involves at least two basic (but not simple) activities: Costing Typing and Cost Classifying.
Costing Typing means grouping types of costs into categories, putting the beans in the right buckets. For example, a few common IT cost types include: Hardware, Software, and Salaries.
Cost Classifying addresses the end purpose of the cost. Typical cost classifications are: capital, operating, direct costs, indirect costs, fixed costs, and variable costs.
For comprehensive IT Service Costing to work, before performing cost typing or classifying, service recording should be done. That is, what a service is (and what it is not) and all of the aspects (people, process, and technology) should be identified before allocating costs.
Budgeting enables an organization to plan future IT expenditures based on knowledge of actual costs and information we have on likely increases or decreases in future cost. Effective budgeting helps reduce the risk of over-spending. It also helps prevent the organization from “penny pinching” too much and approaching spending too conservatively. Formally, ITIL defines budgeting as, “The Activity of predicting and controlling the spending of money. Consists of a periodic negotiation cycle to set future Budgets (usually annual) and the day-to-day monitoring and adjusting of current Budgets.”
Charging is the third component of IT Financial Management. Charging is simply recovering the cost of delivering IT services. Not surprisingly, when an organization does not really understand what services it is providing or how much they cost, charging becomes a mystery; reach into the top hat and pull out a price tag and hope that the customer is willing to pay. The reality is that many organizations treat IT as an internal or shared service provider. In other words, IT is a cost center that the business funds at a high level; in turn, IT does not charge back for services. Even if this is the case in your organization, the inability to describe costs in terms customers can understand (i.e. valuable services) makes it difficult to justify IT budgets. Some savvy IT shops do something called “notational charging.” Essentially, no real funds change hands between the business and IT. However, IT provides a dummy invoice to the business detailing how much it would have cost had the business been an external customer. I am personally not a fan of “notational charging” per se. It sounds too much like saying “I told you so.” On the other hand, I strongly support close communications between IT and the business; and in budget conversations IT should have concrete evidence to demonstrate how much it costs to offer various services.
For managed service providers, knowing comprehensive IT service cost is even more critical. It is the only basis to know how much to charge for a service and to still remain profitable
The Ecosystem of Financial Management Systems
No discussion of IT Financial Management is complete without addressing financial accounting systems. Although there are many robust systems on the market, not all financial accounting systems are created equal. There are basically two types of systems on the market: Enterprise Resource Planning (ERP) systems and IT Financial Management Systems.
Most sizeable organizations are likely to have an ERP system (e.g., SAP, PeopleSoft, etc.). The range of functionality offered by ERP systems is large. At a basic level, ERP systems integrate back-office processes and act as big relational databases that aggregate information from various business processes so they can be recombined and repurposed. For example, an invoice processing/Account Payable module of an ERP system allows you to code and record invoices from vendors and have checks issued. The information from recording the invoice can then be used as inputs for specific departmental budgets, reports on expenses by vendor, or by category. A big benefit of ERP systems is that they make managerial reporting easier and more timely and they help make accounting more accurate. Since the scope of ERP systems is large, they tend to focus on basic accounting and not service accounting.
By contrast, IT Financial Management Systems tend to be narrower in scope and focus on running IT as a business. Many of them support accounting, budgeting, and charging processes. Some even help to reconcile and process vendor invoices. The best of the IT Financial Management Systems help to define lines of business. For example, a hospital may be interested in how much IT is dedicated to supporting in-patient care. At the service level, a good IT Financial Management system could also tell how much IT is supporting Clinical Applications Services.
ERP systems are not better than IT Financial Management Systems nor vice versa. Both systems simply have different scopes and different goals. Quite often, both systems work together. In fact, this is an ideal situation.
What to Look for in Good IT Financial Management Systems
If you are a medium to large organization, the likelihood is that you already have an ERP system. But ERP systems are usually configured to perform cost item or component costing; not service costing.
By contrast, a good IT financial management system interfaces with your ERP system or makes it easy for you to manually input data from your ERP system. More importantly, a good IT financial management system is built around service recording and service taxonomy concepts. In other words, the system understands that components and even cost items are just the tip of the iceberg when it comes to services. A good system is structured around a comprehensive understanding of services.
Figure 4: Comprehensive IT Service Costing Iceberg
Good IT financial systems also provide multiple views and dashboards. For example, maybe your CIO is interested in knowing how much you are spending on the Information Security Management Services; but she also is concerned about how much IT is spending in aggregate on software, licenses, hardware, personnel, etc.
If your IT financial management system is at all integrated with your IT Service Management tool (e.g., Cherwell), so much the better. Comprehensive IT service costing is greatly supported when you have an up-to-date asset register to track component inventory and when Service Asset and Configuration Management is being performed and maintained. In other words, if you know which physical assets you have and how they relate to each other, to the services they support, and to the people who maintain them, performing comprehensive IT service costing is much easier and more accurate.
A final note on IT financial management systems – if you do not already have a service catalogue, it is good practice to combine or run parallel campaigns to create an IT service catalog and implement IT service costing. If you already have an IT service catalogue and are beginning to implement service costing, be sure to involve both IT and Finance staff. Ideally, service in the service catalogue and Financial Accounting for services should be the same. If a one-to-one relationship is not practical, then strive to get as close as possible.
Finally, hiring a consultant to help perform IT service costing can be beneficial. Costing initiatives can be complex and take a long time. Often, a consultant is in a better position to focus on the work that needs to be done without being interrupted by daily operations and other IT projects. Hire a consultant who has the ability to work seamlessly between the business, Finance, and technical IT. The consultant should be able to sort through financial reports and even invoices (if necessary). Be cautious, however, that the consultant really understands service costing and doesn’t simply count beans and putting them in different buckets.
Dear Reader, intrepid wanderers, we near the end of our journey. But what do we do when things do not fit so neatly together? What do we do with that deplorable bucket of IT costing “other?” How do we bring it all together and keep the momentum going? Join me again for our final installments, the sixth and seventh partitions.
Be sure to check out our free IT Costing Guide!