The Use of System Dynamics as a Cost Management Tool

Amir H. Khataie
Mechanical and Industrial Engineering Department, Concordia University
1515 Saint Catherine Street West, Montréal, Québec, Canada

Juan J. Segovia
John Molson School of Business, Concordia University
1450 Guy Street, Montréal, Québec, Canada

Akif A. Bulgak
Mechanical and Industrial Engineering Department, Concordia University
1515 Saint Catherine Street West, Montréal, Québec, Canada

1. INTRODUCTION
ABSTRACT
Activity-Based Costing (ABC) is an accounting
In today’s business world whose characteristics
system which represents a different perspective
include limited financial resources it is critical to
to assign, instead of allocating; Manufacturing
identify and monitor where and how these
Overhead (MOH) costs. MOH costs are assigned
resources need to be invested in the company.
to the cost objects by estimating the cost object
The Master Budget represents a plan of action
activities consumption.
which specifies how financial resources will be
acquired and invested during a particular time
Johnson and Kaplan (1987) state that using
period. Activity-Based Budgeting (ABB) is a
Traditional Cost Allocation (TCA) systems
budgeting approach that integrates Activity-
decrease the accuracy of product costing,
Based Costing (ABC) into the budgeting
especially when accountants focus on the
process. ABB’s approach forecasts the products
allocation of MOH costs to estimate the value of
to be produced and the customers to be served in
inventories [3]. Cooper and Kaplan introduced
order to determine the activities, which will be
ABC costing in the late 1980s as a means to
required, and therefore, identify the required
minimize this cost allocation deficiency. ABC
resources. ABB leads to a better control of the
costing can significantly decrease the cost
firm’s indirect costs. Systems Dynamics
allocation effect, but it does not completely
represents a simulation approach with the ability
eliminate it. In the mid 90s the use of ABC
to provide decisions based on the feedback that
costing led to the management of the activities
it receives from the process. SD analyzes the
required in the products manufacturing
system status changes that correspond to the
processes; thus, Activity-Based Management
system variables’ changes and/or the interactions
(ABM). ABM is particularly effective in
amongst them. This research presents an
determining products and customers
innovative preliminary application of System
profitability.
Dynamics as a Cost Management model based
on the detailed cost information provided by According to ABM philosophy, ABC has been
ABC. The model can analyze and foresee the viewed as an indispensable step to implement
effect of each decision or policy implemented on other operational improvement approaches such
the firm’s budget and financial performance. as Just-in-Time (JIT), Business Process
Reengineering (BPR), and Total Quality
Keywords: System Dynamics, Cost
Management (TQM). Even though ABC
Management, Activity-Based Costing, Cash
implementation as cost accounting system is
Flow Analysis
expensive and complicated, its managerial
benefits and its impact on financial success are
the main reasons for its popularity. model. The relevant summary and conclusion
are discussed in the last section.
Cooper [6] addresses the issue of the supporting
role of ABC in the transition of a company to a 2. MODELING APPROACH
lean enterprise. He identifies a lean enterprise as
the one that has specific characteristics such as The modeling approach used in this study is
the adoption of JIT production system, the System Dynamics. SD is a simulation approach
implementation of TQM, team-based work with the ability to continuously update the
environment, supportive supplier relations, and system status through feedback loops. In SD
high customer satisfaction. Similarly, Novićević simulation, each run will be based on the
and Antić [10] discuss ABC as an ‘enabler’ to updated variables from the previous run. The
sustain improvement initiatives (e.g. JIT, TQM), two main reasons for SD’s popularity are the
which optimize their effectiveness. Furthermore, ability to model complex problems and the
some studies evaluate the ABC constructive role possibility of integrating qualitative factors e.g.
on a firm’s financial indicators such as Return human factors into the model.
on Investment (ROI) and Return on Assets
(ROA); for example, [4] and [5]. Forrester [7] originally defines SD as “the study
of the information feedback characteristics of
The information provided by ABC costing can industrial activity to show how organizational
also be used for budgetary purposes. Activity- structure, amplification (in policies), and time
Based Budgeting (ABB) incorporates the delays (in decision and actions) interact to
information from ABC costing in order to influence the success of the enterprise. It treats
determine financial objectives and to monitor the interactions between the flows of
the daily operations of a company. It also information, money, orders, materials,
provides information on the results derived from personnel, and capital equipment in a company,
improvement projects. ABB links the resource an industry, or a national economy.”
consumption with the actual activity
consumption because it uses the information According to [12], there are differences between
from ABC. Thus, ABB provides a better Discrete Event Simulation (DES) models and
evaluation of the system efficiency as compared SD models. In DES models, specific entities can
to the conventional budget system [2]. In order be followed throughout the system, system state
to increase business efficiency, we need to changes occur at discrete points of time. DES
control the costs. There is a significant models are stochastic in nature; their structure
difference between cost reduction and cost consists of a network of queues and activities.
control; companies can reduce their costs DES models are actually applied for tactical
without necessarily controlling them. Cost level situations. On the other hand, in SD
control normally requires an intelligent and models specific entities cannot be followed
systematic cost reduction approach such as Lean throughout the system, system state and
Manufacturing (LM). variables can change continuously at small
segments of time. Stochastic features are rarely
This study presents a preliminary research in the used in the SD models; the structure of SD
interdisciplinary area of Managerial Accounting models consists of a system of stocks and flows.
and Operations Management. It applies System SD models are mostly applied for strategic level
Dynamics (SD) to present a novel simulation- situations.
based cost management model. The reliability of
the model is also enhanced by integrating the The SD simulation approach has normally been
detailed cost information from ABC costing. The utilized at the strategic level in service and
remainder of this article is organized as follows: Resource Management situations. Few studies
section 2 elucidates the applied modeling have used SD as a cost analysis and cost
approach and the relevant literature. Section 3 management tool. Abdel Hamid and Madnick
presents the preliminary SD cost monitoring [1] used SD to evaluate the consequences of
multi-variables changes on the software → product (i) inventory value → product (i) cost
development process costs, considering some of goods sold → product (i) selling price →
managerial qualitative functions, e.g., planning, product (i) demand → product (i) production
staffing, and controlling. SD has also been used rate.
to analyze and measure the importance of
quality cost factors, e.g., preventive costs and The second part of CLD, Figure 2, shows how
external/internal failure costs in [8]. MOH costs are estimated based on ABC. The
CLD only shows the batch-level MOH cost
Macedo et al. [9] developed an ABC-based cost estimation. The model can update the activity
management model for the reengineering pool rates in each run, based on the actual
process of manufacturing a laboratory product. activity consumption and costs from the
The model does not contain any feedback loops previous runs. The activity consumption is a
and works as a preliminary real-time cost function of the production rate. The activity cost
calculator rather than as a cost management tool. is a function of the activity consumption and
A novel SD cost management model presented activity pool rates. Accordingly, the feedback
in this study contains feedback loops. The loops of Batch-level activity pool rate →
feedback loops shifted the budgeting and cost product (i) batch-level activity pool rate →
allocations process from a static process to a product (i) total cost of batch-level activity →
more dynamic process. total cost of batch-level activity → batch-level
activity pool rate for batch-level costs are
3. PRELIMINARY MODEL defined. The similar approach can be applied to
the other MOH costs.
According to Sterman [11], the Causal Loop
Diagram (CLD) should be developed as the first The third part of CLD, Figure 3, shows how the
step in SD modeling. CLD can facilitate the manufacturing costs calculated in the previous
modeling process by indentifying the main stage are incorporated into the budget. The
variables and feedback loops. “A CLD consists arrow crossed by a vertical line indicates a delay
of variables by arrows denoting the causal in the process. For example, receiving money
influences among the variables [11].” At this after selling the item normally incorporates
stage of modeling, it is not necessary to define some unwilling delays which have an effect on
the type of variables, e.g., auxiliary, stuck, and the company’s account receivables and cash
flow. The developed CLD has been created in availability. The variables estimated in this part
four different parts. The positive and negative of the model will be used later to calculate the
signs are defining the effect that the linked financial indicators.
variables have on each other.
The fourth part of CLD includes the financial
The first part of the CLD, Figure 1, shows how indicators calculations. Figure 4, shows five
the manufacturing costs -including direct labor, financial indicators that the model can estimate.
direct material and relevant MOH- are estimated The current structure can estimate Gross Profit
based on the production demand and production Margin and Net Profit Margin amongst the
rate. The main feedback loops are; product (i) Profitability Financial Indicators. From the
production rate → product (i) direct labor hour Liquidity Financial Indicators, the model can
→ product (i) direct labor cost → product (i) estimate Current Ratio, Inventory Turn Over,
cost of goods manufactured → product (i) cost and Collection Period. More financial indicators
of goods sold → product (i) selling price → such as, Working Capital, Days to Sell
product (i) demand → product (i) production Inventory, and Account Payable Turn Over can
rate. Similar loops can be established for each also be incorporated to the current model
product’s direct material costs and MOH costs. structure.
The other main loops are defined according to
the inventory level and inventory value; product
(i) production rate → product (i) inventory level
 4. CONCLUSION Management, Vol. 10, No. 4, 1997, pp. 7-
18.
The presented preliminary SD cost management [3] L. Boyd & J. Cox, “Optimal decision
modeling approach elaborates a new application making using cost accounting information”,
of SD as a simulation technique. The SD International Journal of Production
feedback loops help the model to update the Research, Vol. 40, No. 8, 2002, pp. 1879-
variables. The cost management model can link 1898.
the activity resource consumption to the [4] D. Cagwin & M.J. Bouwman, “The
company’s budget by using ABC. It can also association between activity-based costing
monitor and analyze the flow of costs and and improvement in financial
update the company’s budget and financial performance”, Management Accounting
indicators continuously. The model assists Research, Vol. 13, No. 1, 2002, pp. 1-39.
management to foresee the effect of each [5] D. Cagwin & D. Ortiz, “The context-
decision taken on the company’s budget and specific benefit of use of activity-based
financial performance. costing with supply chain management and
technology integration”, Journal of the
In order to show the advantages of the model Academy of Accounting and Financial
and as a future work, the model will be applied Studies, Vol. 9, No. 2, 2005, pp. 47-70.
to an ABB case study. Moreover, financial [6] R. Cooper, “Activity-based management
indicators will be added to the model structure. and the lean enterprise”, Journal of Cost
For example, by incorporating the shareholders’ Management, winter 1996, pp. 6-14.
equity relevant variables, it will be possible to [7] J.W. Forrester, Industrial Dynamics,
add Solvency Financial Indicators such as Waltham, MA: Pegasus Communications,
Financial Leverage Index and Financial 1961.
Leverage Ratio into the model. [8] B. Kiani, H. Shirouyehzad, F.K. Bafti &
H. Fouladgar, “System dynamics approach
Another future work is to validate the cost to analysing the cost factors effects on cost
management model output by using the Monte- of quality”, International Journal of
Carlo simulation approach. In this case the Quality & Reliability Management, Vol.
model will be applied to a different combination 26, No. 7, 2009, pp. 685-698.
of products and the profitability will be [9] J. Macedo, R. Ruiz Usano & J. Framinan
measured after a desirable period of time. By Torres, “A real time cost monitoring
changing the products’ price elasticity randomly, system for business process reengineering”,
different product combinations could be Proceedings from IFAC Workshop,
generated and applied to the model. In addition, 1997, pp. 411-416.
a random number will be used to represent the [10] B. Novićević & L. Antić, “Total quality
delay between the time cash is received from the management and activity-based costing”,
customers and the time it’s incorporated in the Economics and Organization, Vol. 1, No.
accounts receivable. This characteristic is useful 7, 1999, pp. 1-8.
to analyze the average cash availability of the [11] J.D. Sterman, Business Dynamics:
company. Systems Thinking and Modeling for a
Complex World, 1st ed., Irwin, CF:
5. REFERENCES McGraw-Hill, 2000.
[12] A.A. Tako & S. Robinson, “Comparing
[1] T. K. Abdel-Hamid, & S. E. Madnick, “On model development in discrete event
the portability of quantitative software simulation and system dynamics”,
estimation models”, Information and Proceedings of the 2009 Winter
Management, Vol. 13, No. 1, 1987, pp. 1- Simulation Conference (WSC 2009),
10. 2009, pp. 979-991.
[2] S. Borjesson, “A Case Study on Activity-
Based Budgeting”, Journal of Cost
Figure 1 - Manufacturing Costs Estimation

Figure 2 - Pool Rates Adjustment

Figure 4 - Financial Indicators Estimation