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A cost management system is composed of three primary elements: motivational
elements, information elements, and reporting elements. These elements are detailed
in Exhibit 2–10. The elements as a whole must be internally consistent, and
the individually selected elements must be consistent with the strategies and missions
of the subunits. Different aspects of these elements may be used for different
purposes. For example, numerous measures of performance can be specified,
but only certain measures will be appropriate for specific purposes.


Motivational Elements
Performance measurements are chosen so as to be consistent with organizational
goals and objectives and to “drive” managers toward designated achievements.
These measurements, which are discussed in depth in Chapters 20 and 21, may
be quantitative or nonquantitative, financial or nonfinancial, and short-term or longterm.
For example, if a subunit is expected to generate a specified dollar amount

of profit for the year, the performance measure has been set to be quantitative, financial,
and short-term. A longer-term performance measure might be an average
increase in profit or change in stock price over a five-to-ten-year period.
Today, performance measures and rewards are designed not only to motivate
employees and managers to act in the best interest of the organization but also to
help recruit and retain qualified employees. These roles are illustrated in the accompanying
News Note.
The performance measurement system should encourage managers to act in
the best interest of the organization and its subunits and to support organizational
missions and competitive strategies. Once defined, the nature of the criteria used
to measure performance should be linked to the organizational incentive system
because, as implied in the News Note, “you get what you measure.” This linkage
sends the message to managers that they will be rewarded in line with the quality
of their organizational and subunit decisions and, thereby, their contributions to
achieving the organizational missions.
In addition to performance measures, different forms of rewards have different
incentive effects and can reflect different time orientations. In general, longer-term
incentives encourage managers to be more long-term oriented in their decisions,
while short-term incentives encourage managers to be focused on the near future.
To illustrate, cash is the most obvious reward for short-term performance. All
managers receive some compensation in cash for paying living expenses. However,
once a manager receives a cash reward, its value is not dependent on future
performance. In contrast, a stock option that is not exercisable until a future time

provides a manager with an incentive to be more concerned about long-term performance.
The ultimate value of the stock option is determined in the future when
the option is exercised, rather than on the date it is received. Thus, the option’s
value is related more to long-term than to short-term organizational performance.
Performance rewards for top management may consist of both short-term and
long-term incentives. Normally, a major incentive is performance-based pay that is
tied to the firm’s stock price. The rewards for subunit managers should be based on
the specific subunit’s mission. Managers of subunits charged with a “build” mission
should receive long-term incentives. These managers need to be concerned about
long-term success and be willing to make short-term sacrifices for long-term gains.
Alternatively, managers of subunits charged with a “harvest” mission must be
more oriented to the short term. These subunits are expected to squeeze out as much
cash and profit as possible from their operations. Accordingly, incentives should be
in place to encourage these managers to have a short-term focus in decision making.
Profit sharing refers to compensation that is contingent on the level of organizational
profit generated. This type of pay is a powerful incentive and is now
used in virtually every U.S. industry. Today’s companies experiment with a variety
of incentives as a “carrots” to induce employees and managers to act in the best
interest of customers and shareholders. As indicated in the following News Note,
not all of these efforts are successful.
Selection of performance measurements and the reward structure is important
because managers evaluate decision alternatives based on how the outcomes may
impact the selected performance (measurement and reward) criteria. Because higher
performance equals a larger reward, the cost management system must have specified
performance “yardsticks” and provide measurement information to the appropriate
individuals for evaluation purposes. Performance measurement is meaningful
only in a comparative or relative sense. Typically, current performance is
assessed relative to past or expected performance or, as illustrated in the following
News Note, relative to peers.


Informational Elements
The accounting function in an organization is expected to support managers in the
areas of planning, controlling, decision making, and performance evaluation. These
roles converge in a system designed for cost management. Relative to the planning
role, the cost management system should provide a sound foundation for the
financial budgeting process.
Budgets provide both a specification of expected achievement as well as a
benchmark against which to compare actual performance. A CMS, like a traditional
cost accounting system, should be able to provide the financial information needed
for budget preparation. But, in addition, a well designed CMS will disclose the cost
drivers for activities so that more useful simulations of alternative scenarios can be
made. The same system can highlight any activities that have a poor cost-benefit
relationship so that these activities can be reduced or eliminated. This helps reduce
budget preparation time. “By reducing the length of the budgeting cycle and
making the process more efficient, the informational benefit of semiannual or quarterly
budgeting may become practical.”14
As firms find it more difficult to maintain a competitive advantage, they must
place greater emphasis on managing the product life cycle. In such an environment,
firms often use innovative tools, many of which are discussed in later chapters,
to provide information relevant to assessing their competitive positions. As
discussed earlier in this chapter, most actions available to managers to control costs
are concentrated in the earliest stages of the product life cycle. Accordingly, information
relevant to managing costs must be focused on decisions made during
those stages—that information will be provided by a well designed and integrated
cost management system.
The life cycle of many products will become shorter as firms become more
and more adept at duplicating their competitors’ offerings. In the future, managers


Reporting Elements
The reporting elements of a cost management system refer to methods of providing
information to persons in evaluative roles. First and foremost, the CMS must
be effective in generating fundamental financial statement information including inventory
valuation and cost of sales information. This information is not necessarily
the same as that being used for internal planning, control, decision making, or
performance evaluation. But, if the feeder systems to the CMS have been appropriately
integrated and the system itself designed to minimize distortions, there
should be little difficulty generating an “external” product or service cost.
In addition to financial statement valuations, the reporting elements of the cost
management system must address internal needs of a responsibility accounting
system. This system provides information to top management about the performance
of an organizational subunit and its manager.16 For each subunit, the responsibility
accounting system separately tracks costs and, if appropriate, revenues.
Performance reports are useful only to the extent that the measured performance
of a given manager or subunit can be compared to a meaningful baseline. The
normal baseline is a measure of expected performance. Expected performance can
be denoted in financial terms, such as budgetary figures, or in nonfinancial terms,
such as throughput, customer satisfaction measures, lead time, capacity utilization, and
research and development activities. By comparing expected and actual performance,
top managers are able to determine which managers and subunits performed according
to expectations and which exceeded or failed to meet expectations. Using
this information that has been processed and formulated by the cost management
system, top managers link decisions about managerial rewards to performance.
Exhibit 2–12 demonstrates a typical performance measurement system that gathers
data from four perspectives: internal, innovation, customer, and stockholder.