Johnson, H. T. and R. S. Kaplan. 1987. Relevance Lost: The Rise and Fall of Management Accounting. Boston: Harvard Business School Press.
Summary by James R. Martin
Relevance Lost Main Page | Short list of Discussion Questions | Multiple Choice Questions
CHAPTER 2 (1812-1880) - NINETEENTH-CENTURY COST MANAGEMENT SYSTEMS
1. Which came first, management accounting or financial accounting? Management accounting.
2. Why Did Management Accounting Develop? Management accounting developed because of a need for evaluating the internalized linked processes of single activity firms such as manufacturers, (textile mills & steel mills) railroads and large distribution firms (retail chain stores). (See the Johnson 83 summary).
3. Management accounting preceded and may have facilitated the growth of large scale business firms. How? By focusing attention on the potential gains from internalizing processes (p.21)
4. Prior to 1812, textile production involved a domestic system. What was this system like? The various processes (spinning, weaving and assembling) were performed by independent contractors. They were paid according to the prices that were set in the free market. Thus, these prices provided the cost needed for internal decisions and control. Note the efficiency of the workers was not important to the business man since the price of a unit of work was set.
5. What do J/K mean by internalized processes? The textile mills stopped subcontracting and internalized these processes in a centralized environment. The spinners and weavers became employees. (See the Johnson 83).
6. How was early management accounting (1812-1880) relevant? The information was developed for management, not for external reporting.
7. How did firms use management accounting during 1812-1880? (See the Johnson 83).
8. Was accounting information used for inventory valuation, control, both or neither? Explain. Labor costs were compiled monthly and unit costs were determined every six months. Emphasis was on efficiency, labor time, pounds of cotton converted to cloth etc. The purpose was to determine the cost of internalizing the various processes involved in textile production. This information was used for cost control and general product pricing as well as special order pricing, but not for inventory and financial reporting purposes.
9. Did these textile mills use the matching concept? No. The matching concept had not been developed.
10. With no matching concept, how did they value inventory? Inventory was valued at market prices (p.28).
11. How did they treat the costs of plant and equipment. They charged plant and equipment costs off against revenue. Depreciation was not recorded (p.28)
12. How did they treat indirect manufacturing costs or overhead? Overhead costs were not capitalized, i.e., were treated as period costs (p.28).
13. How did they prepare statements for external reporting? Apparently they did not prepare statements as we know them today. They prepared unaudited semiannual balance sheets in the annual reports to stockholders. The emphasis was on cost control, efficiency, and potential productivity gains, not inventory valuation for external reporting which came 50 years later (p.31).
14. Did the nineteenth-century steel mills use the matching concept? No. The Carnegie Steel mill placed emphasis on controlling direct cost to pursue a strategy of becoming the lowest cost producer. Carnegie did not account for long lived assets (p.34). The strategy was to minimize the direct cost of production, so that prices could be cut to drive out the competition.
15. Why or how did railroads create a greater need for accounting information? Railroads provide an example of a more complex business than any that had existed until the 1840's. The complexity created an even greater need for accounting information. Railroads developed special record keeping systems for transactions, such as cash collections, deposits and disbursements using a voucher system. Albert Fink also developed four categories of cost according to cost behavior, i.e., how the cost varied with output. The emphasis was on the cost per ton mile. American railroads were the first firms to have managers managing other managers, thus cost accounting became a tool for evaluating managers as well as internal processes (p.37). A useful measurement was the operating ratio, i.e., ratio of operating expenses to revenue.
16. Did the railroads use the matching concept? No. Railroad management did not use accounting to measure return on investment. They did not record depreciation and equipment stayed on the balance sheet at cost (p.37). Once the railroad was built, they were only concerned with operating efficiency, using cost per ton mile and the operating ratio (p.38).
17. What provided the potential for mass retail distribution systems? The development of mass production manufacturers, railroads for efficient transportation and telegraph for efficient communication (p.39).
18. What provided the motivation for mass retail distribution systems? Potential economies of scale provided the motivation (p.39). (See economies of scale note).
19. What were the two key accounting measurements for these wholesalers and retailers? Departmental gross margins and inventory turnover were the two key measurements used. The emphasis on low margins and high turnover placed importance on inventory turnover (p.41).
20. Did these wholesalers and retailers use the matching concept? No. The reason for internal accounting was to evaluate internal processes. There were no ROI calculations and a lack of concern for depreciation and fixed asset accounting (p.41).
21. What is the key idea in chapter 2? (Same answer as question 2) Internalizing processes was the key element that caused a need for internal accounting information. Management accounting developed to allow managers to evaluate internalized processes that had previously been performed by external independent contractors.
22. Why do J&K place so much emphasis on the idea in question 21? Because historians have attributed the development of management accounting to the need for external reporting, i.e., to value inventory for matching purposes. But there was no matching concept between 1812 and 1880 and little external reporting. On page 28 J&K mention semi-annual balance sheets in annual reports to stockholders, but inventory was valued at market prices. Also see page 131 in (Chapter 6) on this point where they mention that early financial reports did not separate period costs from inventory values.
CHAPTER 3 - EFFICIENCY, PROFIT AND SCIENTIFIC MANAGEMENT 1880-1910
23. How did firms keep management accounting relevant after 1880? For a few years they were able to keep management accounting relevant with a centralized form of organization and emphasis on using engineers' standards to measure efficiency (Chapters 3 and 4). The various divisions of the company were treated as profit centers. Later a decentralized form of organization was used to manage diversified companies (Chapter 5).
24. What new problem developed between 1880 and 1910 that caused an additional need for accounting information and the motivation for the scientific management era? Companies began to produce heterogeneous products with complex processes (p.47).
25. Until 1880 managers were frequently inside contractors. What was an inside contractor? Managers that hired their own employees, produced products and then sold the products to the company (p.48). By the 1870's, inside contracting became less prominent and owners needed more accounting information about production processes.
26. After 1880, predetermined standard rates were developed using time and motion study for labor and a bill of materials for raw materials. Was this done by accountants? No. Standards were used by engineers (Frederick W. Taylor) to measure potential efficiency, not to measure cost.
27. How did the engineers use the standards? For evaluating internal process, not for measuring overall profits. This is consistent with the uses of accounting by the nineteenth century textile and steel mills. (See the Cooper 2000, Johnson 1983, Gantt, and Church summaries).
28. How did accountants use the standards? Variance analysis developed around 1900. The first published equations were by Harrison and Emerson in 1918. Although the idea of cost control was developed about this time, (p.50 Percy Longmuir) the accounting emphasis was on inventory valuation and how to dispose of the variances in the financial statements (p.51). Accountants developed the idea of using standards to simplify inventory valuation.
29. Summarize the three uses or purposes of standards that developed between 1900-1910. 1. To Measure efficiency, 2. To control costs and 3. To value inventory.
30. What new goal or purpose for cost accounting was developed by Hamilton Church and others around 1910? Using accounting to evaluate the overall profitability of the firm (p.52). Church's idea was to trace cost to individual products. This meant linking overhead cost to individual products.
31. Does overall profit measurement require accurate product costs? Explain. Generally no. Church understood this (p.53). (Note: See MAAW's ABC section for more on this point. There are potential situations where overall profit could be distorted by inaccurate product costs.)
32. When did Church say accurate tracing was needed? When different products use factory resources at different rates or in different proportions. Church said that overhead allocations are valueless and even dangerous in such cases (p.54). According to Church, the difficulty of dealing adequately with overhead cost is in proportion to the heterogeneity of the business. Ideally, each type of overhead cost should be traced separately to products (p.55). He thought the distinction between direct and indirect product cost should be abandoned (p.55). Although he kept manufacturing and selling expenses separate (because they are not caused by the same activities), he included both when he calculated product cost to identify profits by product. (See the Church summary).
33. Who was G. P. Norton? Norton developed a textile accounting system that used standards to compare actual performance with the results that would have occurred using the older system of internal contractors.
34. What is the Key Idea in Chapter 3? Church and managers of other firms in the early 1900's faced a different problem than managers before that time. This was the development of heterogeneous product lines and complex processes. These developments caused a need for managers to measure the cost of different products. However, engineer standards and the centralized form of organization helped keep management accounting relevant.
CHAPTER 4 - CONTROLLING THE VERTICALLY INTEGRATED FIRM: THE DU PONT POWDER COMPANY TO 1914
35. The mergers around 1900 created companies that were very different from previous firms. How were they different? Companies like Du Pont, General Electric, American Tobacco conducted multiple activities including purchasing, manufacturing, transportation and distribution (p.61).
36. What was the motivation for these mergers and integration of activities? Profit potential provided the basic motivation for mergers and vertical integration of manufacturing and distribution functions around 1900. Manufacturing firms began to create and in some cases acquire their own distribution channels and sources of raw materials to provide more control over these functions, to reduce risk and to increase profits (p.62).
37. But these vertically integrated firms needed a way to avoid bureaucratic inefficiencies. How did they do this? They developed the unitary or centralized form of organization where the central office directs the activities of departments (p.62). Department managers concentrate on efficiency and effectiveness.
38. Why did these companies need management accounting systems? To promote harmony of managers' and owners' goals (i.e., goal congruence) and to measure the overall profitability, in addition to measuring efficiency (the standards and variances used by single activity firms). p.64 Integrated firms could have used Church's ideas to develop better resource cost tracing systems, but instead they modified older systems.
39. The multi-activity
firms developed two new tools or techniques for control and
motivation. What were these tools?
1. Budgets for planning and coordinating resource flows and
2. ROI to compare the performance of the diverse parts with the performance of the whole.
Together, these techniques were used to promote goal congruence. (See the Dupont ROI graphic).
40. What was the main competitive strategy of these integrated firm's? To mass produce and mass distribute products that provided the greatest potential. Two main strategies are cost minimization and product innovation. Cost minimization was the main strategy for these firms. (See Porter 96 and MAAW's strategy section for a lot more depth on strategy).
41. What information did this require? It required a system for determining which products were the most profitable.
42. How did Du Pont use ROI? Dupont used a centralized system with emphasis on ROI to allocate new investment (working capital and new capital requirements) among competing activities. A key idea in this regard is that multi-activity firms began to ration and allocate capital (p.68). A new key development was to use ROI as the true test of profitability, instead of the percentage of markup on operating cost (p.68). (See the Dupont ROI graphic).
43. What was the innovation that allowed Du Pont to use ROI? Dupont's Asset Accounting System was the innovation that allowed ROI to be used. Prior to 1900 few firms kept detailed records of investment in plant and equipment. Dupont also placed emphasis on cash flows and contribution margin by product (pp.68-69).
44. In summary, what two key developments allowed management to delegate responsibility to department managers? Budgets and ROI.
45. Why didn't single activity firms need ROI? Because they only performed one main activity. Capital rationing was performed by the capital markets (p.68).
46. What evidence indicates that the performance emphasis at the mill level was on efficiency and low cost not NI or ROI? Two Monthly Reports (p.71): 1. Works Cost Report - Used by mill management. Compared actual material usage to standards and to other mills and 2. Profit and Lost Sheet - Used by top management. P&L showed NI and ROI by mill and product line.
47. What is the difference between profit centers and investment centers? Profit center managers generate revenue and costs, but do not make investment decisions. Investment center managers make investment decisions as well. (See MAAW's responsibility accounting section for more information).
48. Were Du Pont's mills treated as profit centers or investments centers? The mills were treated as profit centers, (almost cost centers) not investment centers (p.73).
49. How did Du Pont avoid short run dysfunctional behavior that managers might engage in to improve the ROI measurement? For example, withholding needed investments in new plant and equipment to keep the denominator low to maximize the ROI. ROI was used to evaluate alternative uses of capital, not to evaluate management. Since department managers did not use ROI, there was no problem with short run oriented behavior that might distract from the long run performance. Managers were also owners.
50. How did Du Pont
ROI = (Turnover)(Earnings as a percentage of sales)
= (Sales ÷ Total Investment)(Earnings ÷ Sales) p.85. (See the Dupont ROI graphic).
51. What is the main problem with using net book value as a basis for total investment, i.e., the denominator of the turnover (or capital turnover) ratio? Since net book value is historical cost less depreciation, the ROI tends to increase automatically as the assets get older. This may cause managers to keep assets too long, i.e., where the disposal value is greater than the present value of the expected future net cash inflows. (See MAAW's Chapter 14 summary).
52. How did Du Pont avoid this problem. They didn't use ROI to evaluate managers and they used gross book value as the denominator for ROI calculations starting around 1920.
53. What problem has been
associated with using gross book value as the denominator? Since the denominator is static, managers might be motivated
to dispose of assets too soon. Both methods (i.e., gross and net book
value) favor older divisions because of inflation.
(See MAAW's Chapter 14 summary).
54. What two cost allocation problems did Du Pont's management recognize? 1. The problem of how to allocate cost for make or buy decisions. 2. The transfer pricing problem (p.74).
55. What two alternative
viewpoints on transfer prices were debated by Du Pont's managers?
1. Operating managers wanted to use market prices to evaluate departments (p.75). 2. Top managers wanted transfers to be at cost to evaluate the overall company profitability. Dupont started with 2 and later changed to 1 (p.75).
56. The Dupont Sales Accounting System included several documents and reports that contributed to centralized control, but encouraged decentralized decisions. Briefly describe this system. The reports included: 1) sales orders and invoices, 2) shipping orders and 3) daily sales reports. The sales reports were generated by using punch cards and a system for sorting developed by the U.S. bureau of the Census around 1890. The daily reports included a) monthly sales quantities, b) average unit prices by region, type of product and type of customer, c) sales cost and d) inventory data (pp.76-77).
57. How did Du Pont use ROI for pricing purposes and what was their pricing strategy? Dupont's prices were based on a target ROI. Their pricing strategy was to set prices 1. low enough to prevent new firms from entering the market, but 2. high enough to keep enough competitors to provide a buffer against recession (p.78).
58. Du Pont's salesmen were allowed a certain amount of freedom to set prices. How did Du Pont encourage salesmen to weigh both price and sales volume? A salesman's salary was based on the relationship between actual sales dollars with his base sales dollars (Normal volume X base price). If actual sales = base sales, then actual salary = base salary. If actual sales > base sales, then actual salary > base salary. Base prices were adjusted by management to motivate salesmen to push certain products.
59. How did Du Pont control inventory? Inventory control was obtained by using the ratio of sales cost to gross sales to evaluate managers. Sales costs included 5% of average inventory and receivables, as well as the general office expenses (p.80). Prescribed stock levels were developed based on sales projections to control raw materials inventory (p.82).
60. How did Du Pont control cash? Centralized purchasing used a voucher system to control cash disbursements (p.81).
61. How was ROI used by Du Pont in decisions to integrate backwards, i.e., acquire ownership of, or control over, supply sources? The procedure used to consider the ownership of a supply source (p.83):
Estimate of ROI from investment in raw material source:
Estimate of ROI = Market price - estimate of cost to produce
Estimate of required Investment in facilities
The procedure used to consider controlling a supply source (p.83):
Estimate of ROI = Estimate of
savings from buying direct without middleman
Additional Investment in Inventory required to buy direct
62. What two key aspects
of profitability are emphasized in Du Pont's ROI
1. Capital turnover, i.e., (Sales ÷ Investment) and
2. Profit Margin, i.e., (Operating income ÷ Sales).
(See MAAW's Chapter 14 for more on these relationships.)
63. What is the key idea in Chapter 4? Since ROI was used only by top management, lower level managers were not motivated to make decisions to enhance ROI at the expense of long run performance. Management accounting was still relevant.
Need a break? Take a look at the du Pont Estates.
CHAPTER 5 - CONTROLLING THE MULTI DIVISIONAL ORGANIZATION
64. What are the two major
obstacles to the success of the integrated firm?
1. Complexity - or the bureaucratic paralysis caused by complexity.
2. Management indifference to the owner's goals (p.94). This potential problem resulted when managers replaced owners in performing the managerial functions.
65. How did the integrated firms cope with these problems? Multi divisional firms might have developed better accounting systems, (e.g., using Church's ideas) but instead they coped with these obstacles using decentralization (p.94-96). In decentralized firms, top management plans strategy, while subordinate managers coordinate and control operating activities (p.97).
66. What was the New Use Developed For ROI? J&K indicate that ROI was used to delegate responsibility and allocate funds, i.e., capital (p.98). (Note: Technically, responsibility can be assigned, but not delegated. The authority to act on one's behalf can be delegated as when someone is hired to do a tax return, but the taxpayer is still responsible.)
67. Success of multi divisional firms depends on the management accounting system to perform three task better than the capital markets. What are they? 1. Provide strong profit incentives for managers. 2. Internal audits that link performance to causes. 3. Develop monitoring and measuring procedures to help allocate cash flows to high yield uses, i.e., measure the effectiveness of capital rationing choices (p.99).Thus, the management accounting system provided a mechanism to evaluate general managers and to channel their self interest towards the owner's interest in profits (p.99).
68. Why did the founder of GM fail? The founder of GM (William C. Durant) failed because of his centralized organization - there was too much detail for centralized management to handle.
69. What new techniques did Pierre du Pont and Alfred Sloan use when they took control of GM? They developed a multi divisional structure for GM and Donaldson Brown used Dupont's management accounting control techniques to perform 3 tasks. These tasks involved centralized control over decentralized responsibility. They used: 1. Annual operating forecasts. 2. Sales Reports and Flexible budgets and 3. A management accounting system that allocated resources and rewards on a uniform basis of performance criteria (p.102).
70. What was the annual "Price Study" and why was it used? To deal with seasonal and cyclical trends that were difficult to predict, Brown designed a technique referred to as the Annual "Price Study" that had three elements: (p.103ff.). 1. Forecast of operations by division based on expected volume. 2. Forecast of operations by division based on standard volume (80% of capacity). 3. Developing a standard price for each product. This was the factory delivered price needed to generate a 20% ROI at the standard volume.
71. What two management accounting procedures were viewed as even more important than the forecasts? 1. Sales Reports and 2. Flexible budgets - used to develop separate information about sales volume effects and the effects of operation efficiency (p.108). These techniques helped them improve inventory turnover (p.112). Few flexible budgets were used prior to the 1920's. Brown did not use the term flexible budget, but he did use the technique in 1923. (p.110). In addition, Brown developed market share data (p.109).
72. What was the management accounting system's major contribution? It was used to promote goal congruence (p.113).
73. How did GM deal with the problems of ROI (e.g., under investment), i.e., promote goal congruence? GM used three approaches to promote goal congruence: (pp.114-116). 1. To prevent managers from under investing to improve ROI, corporate staff were included in the planning process (p.114). This tended to prevent a division manager's bias from having too much influence on the planning process. (Note: This meant that divisional managers did not have complete autonomy, i.e., the divisions were profit centers rather than investment centers. 2. To offset another deficiency of ROI - that it does not measure the performance of the mangers, GM used different ROI targets for different divisions (p.115). 3. GM also used a stock bonus plan that vested after 5 years. Prior to the bonus plans, management incentive plans were based on division profits which caused some division managers to behave in a manner inconsistent with the firm's overall goals (p.116).
74. What do you think is the key idea in this chapter? A key idea in this chapter is that although the Strategic Product Costing system advocated by Church offers an alternative to managing diversity without decentralization, the multi activity firms of this era chose to use the divisional form of organization instead. They used this approach to keep management accounting useful to managers. In other words, it is still relevant for management's needs.
CHAPTER 6 - FROM COST MANAGEMENT TO COST ACCOUNTING: RELEVANCE LOST
75. How did management accounting lose relevance? The demand for external information caused the emphasis to shift from management's needs to inventory valuation for external reporting.
76. According to J&K, what development occurred after 1925 that caused management accounting to lose relevance? Emphasis shifted from the information about the processes underlying the financial data to the financial data. By the 1960's and 1970's, external financial reports were used to "manage by the numbers" (pp.125-126).
77. What problem occurred for product costing and decisions related to products such as pricing, product mix and make or buy? The inventory valuation methods developed for external reporting provided misleading and irrelevant information for strategic product decisions (p.126).
78. How did this problem occur? Early single activity firms, prior to 1880, did not need separate product cost information because they produced homogeneous products that consumed resources at uniform rates (p.127). After 1880 metal working firms did need separate product cost because they produced different products that consumed resources at varying rates. That's what Church wrote about. But accurate tracing of product cost disappeared after 1910 (p.127). Probable reason: High cost of information processing (p.128). Church's system was unmanageable because it was not supported by the necessary information technology. Evidence indicates that the machine tools industry used aggregate cost pools after World War I. Vertically integrated firms used the divisionalized form of organization to cope with product diversity.
79. To what do J&K attribute the disappearance of managerial product costing after 1914? The development of Product cost accounting for financial reporting
80. Why did product cost
accounting for financial reporting develop? Because of the
demand for external financial information by: (p.129ff)
1. Capital markets - After 1900, the need to raise capital caused a need for audited
2. Regulatory bodies and
3. Federal taxation.
81. What new development occurred for accounting? The Matching Concept was developed. Separate information for the balance sheet and income statement was stressed. This data was based on the "cost attach" idea that allows the separation of the cost assigned to goods sold and ending inventory (p.130). Other new concepts included the cost concept and the concepts of objectivity and conservatism (p.131).
82. What evidence do they provide that the matching concept was new? Few firms used financial reports prior to 1900. Cost was not used to value inventory. Instead, inventory was valued at market prices. Inventory costing developed when accountants began to emphasize integration (later referred to as articulation) of the financial and cost accounts. Data on the financial reports had to be traceable to the cost records.
83. What were the auditors mainly concerned with? Auditors insisted that inventories be valued at objective, auditable, conservative amounts (p.131). Auditors were concerned only with separating the cost of the period from the cost in the inventory (p.132). A key idea is that accurate product costs were not needed for financial reporting.
84. What distinction do J&K make between engineer product costing and auditors inventory costing? Engineers traced costs to activities that caused the costs and treated all costs as direct costs of products. The auditor's method aggregated "oncost", or burden (overhead) and applied it to products on the basis of labor. Thus, profitable and non profitable products could not be identified (p.132). J&K note that the engineers' method probably would have been dropped even if audited statements had not been developed because it failed the cost/benefit test (p.133). Audited statements might not have developed without the demand for capital and subsequent development of capital markets, but government regulation (e.g., antitrust and SEC) and tax requirements were also important.
85. What do J&K say is The Ultimate Question? Why do rational managers voluntarily use non managerial cost information in settings where it is clearly irrelevant? (p.134)
86. What do they provide as a possible answer to the ultimate question? 1. Academic accountants may have been the main cause. After World War I the purpose of cost accounting became inventory costing for financial reporting (pp.134-135). Paton and Sanders developed and advocated the "cost attach" idea as the cost accountants chief activity (p.136). 2. Also there was no academic link with practice. Cost textbooks in the 1920's did not mention actual management accounting practices. Standard costing was included, but only as a method to simplify inventory costing (p.137).
87. What evidence do they provide that after World War II, academic accountants rediscovered management accounting for decision making, i.e., a "Rediscovery" took place? In the 1940's and 1950's accountants began to write about the deficiencies of financial accounting, but their concern was how to make financial accounting better for management decision purposes. Accountants debated which cost to attach to products. Non manufacturing cost were not charged to inventory and were essentially dropped from cost accounting. The reason is that they wanted to avoid anticipating income (p.139). Later (in 1970) even Paton recognized that the "cost attach" idea was at odds with the actual process of free market valuation. (The customer pays for value not cost. This idea may have provided the roots for the concepts of value added cost and non value added cost that we will see later.)
88. The auditor's inventory cost approach falls between two extremes, i.e., two ways to treat costs. Explain. 1. One extreme might be called "the all cost are period cost approach" used by the early textile mills. No cost flowed into inventory. 2. The other extreme might be referred to as "the all cost are direct product cost approach" advocated by Church. No cost are period cost (p.140). Church's pre 1914 ideas seemed dead in the 1980's. They provide examples of many current accounting textbooks (including Kaplan's advanced text) that all indicate their belief that management accounting is new, developed after financial accounting.
89. What is the main point J&K are trying to convey? Management accounting was developed first and then forgotten (p.141).
90. In the section comparing U.S. and U.K. Cost Management they indicate that British firms did not need management accounting. Explain why? British systems were based on a single process. Market prices provided the necessary cost information.
91. How did the economic model of the firm play a roll in aggravating the problems discussed in this chapter? The academic model of a simple firm producing a homogeneous line of products was used to illustrate contrived production problems. But the inventory information generated by such systems is irrelevant for actual management decisions, as well as the new emphasis on financial reporting for external users driven by capital markets, government regulation and tax requirements (p.145).
92. What is the book's cumulative message at the end Chapter 6? Management accounting developed prior to financial accounting for external reporting as a result of management's demand for information. Management accounting remained relevant for managements' needs for over one hundred years before it finally became subservient to financial accounting after 1925 and lost relevance.
CHAPTER 7 - COST ACCOUNTING AND DECISION MAKING: ACADEMICS STRIVE FOR RELEVANCE
93. What developments were made in management accounting between 1920 and 1960? The answer to this question includes the contributions by J. M. Clark, the London School of Economics, William Vatter and others.
94. According to J&K what dominated cost accounting practice and textbooks during the 1920's? Both were dominated by the "financial accounting mentality" (p.153).
95. However, J. M. Clark argued for managerial cost systems. What were Clark's main contributions to accounting literature? The basic problem was too much cost aggregation. In 1923 an academic researcher, J. M. Clark (University of Chicago) wrote about separating fixed and variable cost using statistical analysis. He developed the idea of "different cost for different purposes" and identified ten functions of cost accounting. These included providing information for determining: (p.155). 1. Satisfactory prices, 2. Minimum prices, 3. Which products were profitable, 4. Inventory control, 5. Inventory values (one of ten, as opposed to the only one), 6. Process efficiency, 7. Department efficiency, 8. Losses, wastes & pilfering, 9. Product cost separate from idle capacity cost and 10. Tie in with financial accounts. Clark argued against having the concepts of consistency, objectivity and auditability control cost management information. He recommended a separate system for cost management (p.155). (See the Frank summary for more on Clark).
96. What contributions were made by the London School of Economics? In the 1930's the LSE recognized that accountants' product costs were useless for decision making and indicated a need for opportunity cost and avoidable cost (p.156).
97. What do J&K refer to as the Conventional Wisdom in the 1940's? The same emphasis on arbitrary allocations based on the "cost attach" idea (pp158-159).
98. What was Vatter's contribution to accounting thought? In 1950 William Vatter's (University of Chicago) managerial accounting textbook, published in paperback, provided some light. Vatter emphasized providing relevant information for management. He had six chapters on budgeting and control. Vatter strongly advocated different cost for different purposes following the ideas of J. M. Clark (p.160). He recognized that management needed more timely information. Financial statements were too late. Timely information was more important than complete information (p.161). Vatter recommended two systems since the needs of internal and external users are different. He emphasized a key idea: Management accounting had to serve management, not accountants (p.162).
99. What were the analytic tools and other advances developed in the 1950's and 1960's? 1. Capital Budgeting - The discounted cash flow approach. Joel Dean's book on Capital Budgeting was published in 1951 and was the main innovation of the 50's (p.163). 2. Residual Income - Developed in the 1960's, apparently by General Electric, to overcome the behavioral problem attributed to ROI of management under investment (p.165). They note that GE dropped it around 1980. 3. Management Control - New interest in studying decentralization and transfer pricing (p.166). 4. Robert Anthony developed a framework for understanding the planning and control functions: (p.178) Strategic Planning - establishing overall objectives and policies. Management Control - monitoring overall efficiency and effectiveness. Operational Control - monitoring specific process efficiency and effectiveness. (See Anthony 64 summary). 5. Herbert Simon identified three functions of managerial accounting information: Score keeping, attention directing and problem solving. 6. Academic operations Researchers developed techniques for solving a variety of problems, such as the product mix decision using linear programming and when to investigate variances using dynamic programming (pp.169-171). 7. Information Economics - Formalized cost/benefit analysis. Represented a new approach for analyzing the content and value of accounting information. The emphasis is on the demand for accounting information based on the utility provided to the decision maker. These formal models have not been applied in practice (173). 8. Agency Theory - Deals with the relationships between principals and agents. So far, no practical uses have been obtained (p.174).
100. What do you think is the main point J&K are trying to convey in this chapter? The simple models of academics have mislead rather than enlightened users since actual businesses are much more complex (p.176). Scientific management techniques were developed by practicing engineers and managers. However, Operations Research techniques were developed by academics and their literature is devoid of references to actual systems. Their models were not tested (pp.172&177). Practicing accountants apparently did not develop any important innovations between 1925 and 1980 unless they were kept secret, except for the discounted cash flow techniques (p.176). Thus, management accounting remained irrelevant between 1925 and 1960.
CHAPTER 8 - THE 1980'S: THE OBSOLESCENCE OF MANAGEMENT ACCOUNTING SYSTEMS
101. How did management accounting systems become even more irrelevant between 1960 and 1980? Older systems were computerized, but not improved. Managers continued to place emphasis on financial results rather than processes. Textbooks illustrated simple models that were inadequate and misleading. Financial information continued to be too late and too aggregated for managements' needs. GAAP became even more influential.
102. How did accountants use computer technology when it became available after 1960? They automated the manual systems that included: 1. Large aggregated cost pools, 2. Stage I allocations from (service) cost pools to cost centers using a variety of measurements, e.g., floor space, square footage and 3. Stage II allocations of overhead to products were made using direct labor cost, or hours, as the allocation basis and planned activity as the denominator for the rate calculations. Overhead rates were sometimes 15 to 20 times the direct labor rate. J&K provide an example where unit cost are calculated using 5 digits and 4 decimal places, although the first digit is probably incorrect (p.185). Many firms combine labor, material and overhead when transferring cost from one stage, or process, to the next, thus special studies would be needed to determine value added. These systems can be traced back to the "cost attach" idea illustrated in all cost accounting textbooks. Some firms (as shown in their Exhibit 8-1 example p.185) do not even attempt to separate fixed and variable costs.
103. What are seven adverse consequences of Direct Labor Allocation Systems identified by J&K? 1. Industrial Engineers' time is used to save small amounts of direct labor time (p.188). 2. Little attention is given to actual overhead (p.188). 3. Managers emphasize reducing allocated overhead costs rather than actual overhead costs (p.188). 4. Managers may misuse high paid workers, such as engineers, to perform production operations to reduce overhead allocations (p.188). 5. Allocations based on direct labor provide the wrong signals (p.189). For example, it motivates managers to subcontract parts that require a large labor content, but since direct labor does not drive many overhead costs, subcontracting causes more overhead, (e.g., purchasing, receiving, inspection, materials handling, storage, accounts payable) not less. 6. Product costs are distorted by cross subsidies. Overhead costs are shifted from less labor intensive products to more labor intensive products and from small volume products to high volume products. Many of these costs are not driven by direct labor, but by other activities such as machine hours, setups, inspection, and materials handling (pp.189-190). 7. Inhibits planning and cost control (p.191). (They mention an unsolved mystery variance that results from product mix changes and indicate that it is impossible to explain.)
104. What did J&K say was wrong with current textbooks (1980's). Textbooks present simple models that can not be used to illustrate the problems caused by using direct labor as the single allocation basis (p.191). Textbooks need to illustrate the two stage process (p.192). They indicate this is not in current cost text. (Note: Most textbooks show a two stage process, i.e., 1) allocating service department cost to producing departments which become overhead in the producing departments, then 2) allocating overhead cost to products. They are referring to what we now call the ABC two stage process.)
105. What are some other
problems J&K identify with typical 1980's cost accounting
1. Traditional cost accounting systems do not provide timely information. Most systems are on a monthly cycle that produces information too late and too aggregated for process control over labor, material, machine utilization, quality, inventory levels, utilities and output (p.193). 2. Production managers have developed their own "back-of-an-envelope" control systems. Some have even hired their own accountants (p.194). 3. The purpose of the official cost accounting system appears to be providing top management with monthly P&L summaries, but it is not helpful for product costing or process control (p.194). 4. Promotes a narrow short run outlook where managers engage in nonproductive activities to enhance short run performance such as: changing accounting alternatives, reducing discretionary spending and adjusting the timing of revenue and expense recognition (pp.195-197). ("Cooking the books." p.207 note 7). 5. The profit center concept is distorted by placing emphasis on financial, as opposed to operating management. This motivates managers to use financial transactions to generate earnings, e.g., mergers and acquisitions, spin-offs, leveraged buy-outs, and sale lease backs (p.197).
106. What problem do J&K identify with GAAP? GAAP encourages a "financial accounting mentality". Only one set of books (two if you include tax.) Some problems mentioned include: (pp.197-198). 1. Expensing investments in the future, e.g., R & D, process improvements, advertising and sales promotion, employee training, quality improvements. 2. Allocating corporate interest expense, rather than charging for the use of capital. 3. Allocating pension prior service cost (sunk cost) to divisions.
107. What do J&K view as the most damaging influence of the financial accounting mentality, i.e., the fundamental flaw in the financial accounting model? The incentive to reduce spending on discretionary intangible investments (e.g., investments in R&D, quality, human resources and customer relations) to enhance short run performance (p.201). That companies can increase short term performance by sacrificing their long term economic health is the fundamental flaw in the financial accounting model. Short term profit cannot measure a company's economic value because the value of intangible assets is ignored. These intangibles include such things as stock of innovative products, knowledge of processes, employee talent and moral, customers loyalty, product awareness, reliable suppliers and efficient distribution networks. A basic defect is that the traditional systems provide no way to measure these intangibles (pp.201-202).
108. Why didn't problems with ROI appear before the 1970's and 1980's? 1. There was less pressure for short term financial performance in the 1920-1930 period than in the 1970-1980 period (p.203). 2. Managers were promoted less often in the past. 3. With smaller organizations of the past, management actions to achieve short term profit at the expense of long run performance were more obvious to top management (p.203). 4. Current managers lack production experience and are less knowledgeable about how to create value (p.204). 5. Executive Bonus plans based on accounting measures. 6. The competitive environment is very different now. (This is the topic of chapter 9.)
CHAPTER 9 - THE NEW GLOBAL COMPETITION
109. According to J&K the competitive environment completely changed during the 1980's. What changes do they identify? 1. Disinflation reversed the previous inflation psychology so that cost increases could no longer be recovered with higher prices (p.209). 2. The value of the U.S. dollar increased making foreign goods relatively less expensive to U.S. consumers (p.210). 3. The Japanese began to use innovative practices such as total quality control (TQC), just-in-time inventory systems (JIT) and computer integrated manufacturing (CIM). 4. Product Life cycles became much shorter. 5. Deregulation.
110. What conflict do they identify between Total Quality Control and the traditional optimization theory. TQC pursues zero defects and emphasizes quality at the design stage, i.e. "build quality in" while the traditional policy, based on the optimizing theory, (i.e., that there is some optimum level of defects) led to high levels of inventory, rejects, rework, scrap and warranty expense. The traditional idea was to "inspect quality in" (pp.210-211). Companies found that total manufacturing costs declined as the incidence of defects decreased.
111. What is the relationship between Just-In-Time (JIT) Systems and the optimization methods such as EOQ? The two approaches are conflicting. The Japanese did not accept the economic order quantity (EOQ) and economic lot size models that attempt to minimize setup, ordering, storage, holding and stock out cost. The JIT approach emphasizes eliminating inventory, not optimizing inventory levels (p.212). A Key Idea is that Inventory hides problems.
112. What are the reasons for holding inventory? 1. To protect against shortages caused by defects, i.e., poor quality. 2. To provide buffers to offset long setup times. 3. To protect against the uncertainty of supply delivery times. 4. To protect against a bad factory layout.
113. How do the Japanese avoid these problems? 1. The Japanese reduced setup times and 2. developed long term relationships with suppliers 3. (who deliver where the materials are needed in the factory) and 4. developed better plant layouts (pp. 214-215).
114. What gains are identified from using JIT? 1. Provides lower inventory carrying cost. 2. Frees up floor space for other purposes. 3. Reveals problems that need to be corrected, not hidden by the inventory, e.g., problems with quality, bottlenecks, lack of coordination, shrinkage, and unreliable suppliers (p.215). The most important benefit from JIT is derived from identifying and correcting these problems which leads to improvements in productivity.
115. What is CIM? CIM refers to Computer Integrated Manufacturing. CIM may include one or more of the following for a particular firm: 1. Numerically controlled machines. 2. Robots. 3. Computer aided manufacturing (CAM). 4. Flexible manufacturing systems (FMS).
116. What tends to occur when CIM is used? CIM results include: 1. Lower direct labor cost. 2. Higher overhead cost. 3. More fixed (sunk) cost as a proportion of total factory cost. 4. More indirect cost and less direct cost. 5. Better quality and manufacturing flexibility allowing firms to compete on the basis of economies of scope (pp.216-217).
117. What do Shorter Product Life Cycles have to do with competitive strategy? Many Companies have begun to compete on the basis of a product innovation strategy rather than the traditional mass production low cost strategy. This involves producing high performance customized products and timely delivery which requires a great deal of manufacturing flexibility. Since these products become obsolete rapidly, price is related more to the value to the customer than to cost, but high gross margins are needed to recover high sunk cost (pp.217-218).
118. What are some of the effects of deregulation? The deregulation of service industries has forced firms in these industries to become far more competitive. Examples include: Banks, Hospitals, Airlines, Railroads and Phone Companies. Accurate costing of services in more important (pp.218-219).
119. What are the implications of all of these changes in the competitive environment for cost management? The following are more important than ever: (p.221) 1. Accurate knowledge of product cost regardless of the firm's strategy. 2. Excellent cost control. 3. Coherent performance measurement. Current systems are of little use, although they may have been useful when developed. ROI was sensible for the cost structures at the time it was developed. Most costs were variable at the time. The consequences of short run performance measurements were less severe in the past, but now: direct labor is decreasing and becoming fixed and overhead is increasing as a fraction of total factory costs. There is less need to keep track of work in process inventory in a JIT system. Previous efficiency measures confuse rather than help workers and management. Now more current cash outlays benefit the future. Expensing these investments in the future (e.g., Telecommunication, & information processing equipment, software development, R&D, improved marketing, distribution, logistics and human capital) distorts short term profits.
120. What do you think is the main point of Chapter 9? The realization that the competitive environment has changed resulting in a need for more flexible approaches to cost accounting, management control and performance measurement systems. J&K say that is "the challenge" (p.224).
CHAPTERS 10 - NEW SYSTEMS FOR PROCESS CONTROL AND PRODUCT COSTING
121. What types of systems are recommended to create relevance for management accounting? Separate systems to serve the various functions and audiences for management accounting information.
122. What are the four functions of a Cost System identified in Chapter 10? 1. Allocate costs for periodic financial statements. 2. Facilitate process control. 3. Compute product cost. 4. Support special studies, e.g., capacity expansion, equipment replacement. Disaggregated data are needed to support these studies when the need arises.
123. What are the steps in designing a process control system? 1. Defining the cost center boundaries (p.229-230). 2. Define or estimate the time period needed to generate measurable units of output. (This could be per hourly, daily, monthly, semiannually etc.) Must be specific about how we define short term. The relevant period depends on the type of cost center, e.g., long for R&D, short for a machine center producing multiple parts per second. Need to take advantage of the computer technology that makes it possible to produce variance reports in milliseconds. 3. Determine the cost drivers, i.e., the activities that cause the costs to vary. (Examples include: D.L. hours, machine hours, number of orders received, number of orders processed, number of parts, number of inspections, number of engineering change orders, number of orders shipped, number of setups, pounds of materials moved etc.) 4. Prepare flexible budgets for each cost center.
124. Are allocations from outside the cost center relevant for process control? Allocations from outside the cost center that are not directly affected by the center's activities (uncontrollable at the center level) are of no value for process control purposes. In other words specific tracing is useful, but allocations are not useful (pp.231-232).
125. Do J&K think short term variable costs are useful? Although short term variable costs are useful for some incremental cost decisions there is a danger in using these cost for most product decisions. Thus, long term variable costs are needed for most product cost decisions, including product pricing, product introduction, product abandonment, product mix, order acceptance and make vs. buy (p.233).
126. What do J&K think is the most important goal of a product cost system? Estimating the long run cost for each product. Traditional systems do not provide this information (p.134).
127. Do J&K think the separation of fixed and variable cost is needed for product costing? Nearly all cost are variable for long run product costing. Fixed cost are not relevant. Thus, Direct costing is not relevant (p.234).
128. Are the most significant product costs treated as fixed or variable in traditional systems? Factory overhead cost such as design, development, and engineering applications, plus marketing, selling, distribution and service cost are the fastest growing costs. But these costs are mostly fixed (and some even sunk) with respect to the output level (p.235) The most significant product costs are fixed or sunk, but they are caused by product related decisions.
129. What do good cost systems need to identify that is missing in traditional systems? The causes of the fixed costs within departments. Something besides the physical volume of output explains the growth in departments. The task is to identify the cost drivers by asking questions about why department cost vary, e.g., why are there eight people in this department instead of just one? In traditional cost systems, the causes of overhead are hidden ("the hidden factory"). The primary cost drivers for overhead are transactions, not volume of production (p.235-236).
130. What Four Types of Transactions or Drivers are identified in this chapter? 1. Logistical - Order, execute, confirm materials movement. 2. Balancing - Match inputs with demand. 3. Quality - Validate conformance with specifications. 4. Change - Engineering, scheduling, routing, standards changes (p.237).
131. What are Miller and Vollmann's mechanisms to reduce transactions? JIT, reduced product components, stability, (i.e., fewer engineering change orders) and automation (p.237).
132. Cost tracing involves two stages. Describe Stage I. Cost Tracing starts at the component level to identify and trace costs to a large set of homogeneous cost pools, each having a cost per unit of cost driver. Homogeneous cost pools include cost explained by a single driver (p.238). 1. Estimate the demands on each driver from each component or subassembly, e.g., setups. 2. Sum across all components to obtain an estimate of the total transactions of each type, e.g., total setups. 3. Divide the total number of transactions into the total cost to obtain the cost per transaction, e.g., total cost of setups ÷ number of setups = cost per setup. 4. Determine the number of each cost driver used by each component or subassembly in a given period.
133. Describe Stage II. 1. For each driver, multiply the number of cost driver units for each component by the cost per cost driver unit. 2. Sum by component to obtain fully traced cost for each component. This process is not precise, but it probably gets the first digit correct.
134. What is the main difference between the approach above and the traditional approach to cost allocations? All overhead costs should be considered variable.
135. What is the main advantage of the two stage cost tracing approach described? It avoids shifting costs from one type of product to another. For example, traditional systems shift costs from small-volume frequently setup products, to high-volume mature products (p.240).
136. How can we use these improvements in cost allocations? Once accurate product cost are determined there are many alternatives such as: eliminating, repricing, charging extra fees or redesigning some products (p.240). But we must understand the cost first. We need to eliminate the mentality that fixed cost are necessary for production, but are not influenced by product and production decisions. The system needs to show the cost of product diversity and complexity.
137. What is wrong with the way Costs Outside the Factory are treated by traditional cost systems? Distribution, selling and service cost are treated as period costs, but also need to be understood and traced to products. Cross subsidies and product cost distortions also occur when different distribution channels are used and products are sold to different types, or classes, of customers (p.245). The same kind of process can be used starting with interviews to identify the distribution, selling and service cost drivers.
138. What is wrong with the traditional cost categories? Labor, materials, overhead, selling, distribution, and administration, conceal the underlying cost structure and produces misguided decisions (p.247).
139. What is the main point of Chapter 10? Typically, one system is used for all four cost functions. One comprehensive system would be nice, but is not necessary. Three systems may be needed for the first three functions of a cost system because these functions have different characteristics including: time periods, requirements for fixed and variable costs, degree of traceability and allocation, sets of relevant costs and audiences. While these systems may use information from a common data base, it seems unlikely that a single system can be designed to achieve these diverse functions. (I developed a table to summarize these ideas. See MAAW's Chapter 2, Exhibit 2-4).
CHAPTER 11 - PERFORMANCE MEASUREMENT SYSTEMS FOR THE FUTURE
140. What do performance measurements have to do with accounting relevance? The old saying, you get what you measure. Measure the irrelevant or less relevant and that will be emphasized.
141. Do J&K think it is possible to obtain a valid measure of performance from existing accounting systems? Why? No. Existing systems are not useful for process control and product costing. In addition, existing systems provide short term financial measures that are invalid indicators of performance. The problem is that it is impossible to obtain a valid measure because of the combined effects of three things: increased capital intensity, the reduction in direct labor content and the contributions from the firm's stock of knowledge and intangible resources.
142. What do J&K think of short term profit measurements? Profits measured over the life of a product are relevant, short term profit measurements based on short term allocations are meaningless.
143. What new types of performance measurements are needed to create relevance for management accounting? Management accounting systems need to measure nonfinancial indicators based on the firm's strategy. 1. Internal failure indicators - Scrap, rework, etc. 2. External failure indicators - Customer complaints etc. 3. Productivity measures for a firm pursuing a low cost strategy. 4. Measures to support JIT - Throughput times, lead times, inventory levels. 5. Measures of flexibility - Number of parts per product, percentage of common to unique parts, design simplification etc. 6. Measures of innovation - Total launch time, accuracy, speed, customer satisfaction, etc.
144. What are the Key ideas in Chapter 11?. Management accounting needs to return to the original purpose of management accounting. Return to the basics and recognize the inadequacy of any single financial measure. Better systems will not insure the firm's success, but will contribute. Its a time of unparalleled opportunity, the technology exists to create the needed systems. Accounting for accountants is wrong. The task is too important to be left to accountants. Engineers and operations managers must help design new management accounting systems.
CHAPTER 1 - INTRODUCTION (USED TO EMPHASIZE SOME KEY IDEAS)
The problem according to J&K is that today's Management Accounting Information, driven by the financial reporting cycle is too late, too aggregated, too distorted and too narrow to be relevant for managements needs.
145. What do J&K mean by too late? The financial information provided in the statements and variance reports is too late for operating managers to monitor and control processes and the work that takes place in the factory.
146. What do J&K mean by too aggregated? There are different types of aggregation. One type of aggregation is where many different categories of indirect costs are combined in plant wide or departmental overhead accounts. Another type is where direct labor, direct material and overhead are lumped together when costs are transferred from one producing department to another. These two types appear to be what J&K are referring to in Chapter 1. There is a third type of aggregation which relates to time. Manufacturing costs are aggregated by months and quarters. Operating managers need disaggregated information to manage processes and work on a daily, hourly, or in some cases a real time basis.
147. What do J&K mean by too distorted? They are referring to the cross subsidies mentioned in Chapter 8, pp. 189-190. For example where costs are shifted from low volume products to high volume products, or from capital intensive products to labor intensive products.
148. What do J&K mean by too narrow? There are several elements of traditional accounting systems that are narrow. The main idea is that traditional accounting systems cannot measure a company's economic value because many important intangibles are ignored. This is the fundamental flaw mentioned in question 99. Narrowness also relates to developing a value chain perspective versus a value added by manufacturing perspective. Considering vendors, distribution and customer service as well as production is more encapsulating. J&K also mention the short term narrow outlook on page 195. This relates to the movement from a short term cost perspective to a life cycle cost perspective.
149. J&K say that accounting information is too late, but that managers have a short term mentality. Is this inconsistent? Explain. No, there are two groups involved. Too late refers to the usefulness of accounting information to production, plant and operating managers for process control and managing work. The phrase short term mentality refers to upper level managers emphasis on short term financial performance.
150. What do you think is the main cause of the problems discussed in Relevance Lost, the structure of the accounting system, the structure of the companies involved, or the structure of the economic system? This is a controversial question. One view is that the economic system is at fault. The short term financial accounting mentality is part of the capital market system which is a subsystem within the American individualistic economic system that places emphasis on short term consumption. Another view is that the structure of the organization is at fault. Solutions are found in reorganizing the company around the concepts of activity based management, just-in-time and the theory of constraints concepts. These relatively new organizational concepts and systems are being developed within the existing American economic system. A third view is that the accounting profession is at fault. The accounting profession is obligated to serve the needs of management regardless of the structure of the organization or the broader economic system. The accounting profession should have recognized and solved the problem long before now. In fact, management accounting should never have lost relevance in the first place.
Relevance Lost - Book Covers Front & Back
DuPont ROI Graphic