What Do Activity Based Costing and Enron
Have in Common?
by Tom Pryor

"Not long ago, accounting was boring", said the front page of the February 6, 2002 Wall Street Journal. "With the profession facing a credibility crisis, a wide array of critics - from members of Congress to small investors to officials of the big accounting firms themselves - have begun calling for a major overhaul of the accounting system." Enron has brought accounting practices into the spotlight, an unfamiliar position for most accountants.

If the spotlight was pointed at you, what would you do in the following situation?

You're a college graduate, passed the CPA exam and have a new job in the accounting department of a well known, publicly traded manufacturing company. After a few months on the job you suspect that the legacy cost accounting system is significantly overcosting high volume products and undercosting low volume products. You're tipped off to this issue when you analyze cost trends of the past ten years in preparation for the upcoming budget. You have found that: Overhead costs have been growing for the past five years at a rate twice that of material or labor; 80% of the products represent 20% of the sales; Accounting policy and practice for the past twenty years has been to allocate overhead to products based on direct labor content, even though labor is now only 5% of product cost. The overhead rate (overhead divided by direct labor) is 1000%, e.g. $10 of overhead for $1 of labor. Overhead expenses below gross margin, most of which is not included in product cost, have grown at a rate of 10% per year for the past five years. You are not totally sure of the full implications of your findings. You pull out your cost accounting textbook. The authors list inventory valuation, pricing, strategic planning, budgets, make/buy decisions, marketing plans, compliance reporting and sales commissions as some of the compliance and cost management issues impacted by the product cost system. You become concerned that your employer's legacy costing method may be misleading management and stockholders. Your concerns move from the potential P&L impact of inaccurate costing to the balance sheet. The majority of finished goods inventory is comprised of high volume products. If those products are in fact overcosted by the legacy cost system, assets on the balance sheet are significantly overstated. Your favorite professor told you, "Never bring your boss a problem without also offering a potential solution." Therefore, after additional reading, calls to friends and much thought, you come to the conclusion that Activity Based Costing (ABC) would be a logical method to improve the legacy cost system. You feel ABC would address your concerns. Feeling confident and prepared, you bring your findings, concerns and recommendation to the attention of your boss. "You may be right, but rule number one of accounting is consistency is more important that accuracy", replies your boss. "That rule has served me well during the past fifteen years. Senior management expects our accounting department to be consistent and conservative but not change agents. If we admit we've been doing something wrong, we're likely to get our heads cut-off. But if we consistently do something wrong, we won't be severely scolded by the auditors or senior management." You are surprised and confused by your boss's response, but thank them for their time. Returning to your desk, you ponder the following questions: The manager did not disavow my findings. Therefore, am I confronted with a potential legal issue, management issue, ethical issue or no issue at all? If an ethical issue exists, where should I go for guidance? Am I an accomplice in a crime if the cost system is inaccurate but goes unchanged? Are their other implications if I stay and the product cost system goes unchanged? What is it "costing" the business not to change the cost management system? How could I build a business case to improve the cost system, possibly using the principles of Activity Based Costing (ABC)? What could I do to encourage change? If my boss is not inclined to change, should I go around them and look for support from auditors, top management or possibly the internal customers of cost accounting, i.e. Marketing, Sales, Design Engineering, Bid & Quote, Purchasing and Manufacturing?

One of the activities my wife and I used to raise our daughter was periodically ask questions like, "If you have a flat tire, what will you do?" Or, "If you're at a party where kids begin smoking dope, what would you do?" We wanted Valerie to know what to do before something unexpected happened. It appears to me that Enron vice president Sherron Watkins was prepared for the unexpected. She boldly sent a letter to Chairman Ken Lay questioning the company's accounting practices and recommending change.

I believe the product cost scenario bears some similarity to the story at Enron … the legacy cost system may be legal but it's not accurate. Do you agree? Are you in that situation? Are you prepared? I look forward to your thoughts and opinions.

Send your comments to Tom Pryor at TomPryor@icms.net.
Or call 817-475-2945 to talk to Tom or another ABM expert about your ABM needs.

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