The last several decades have been a turbulent per
ABCiod for management accounting in the United States. Many U.S. businesses failed in the international market, and the management accounting profession recognized that some of the blame rests upon shortcomings in the information provided to managers. A continuous flow of articles dating back to the mid-1980’s such as Kaplan (1986) or Chalos and Bader (1986) has criticized contemporary management accounting systems. On the other hand, Reider and Saunders (1988) offered a defense of contemporary management accounting methods asserting that the methods are adequate but have not been used appropriately.
Management accounting plays a crucial role in manufacturing competitiveness by supplying relevant information which guides and facilitates management planning and control, decision making, and performance evaluation (Amenkhienan. and Green, 1990). Until recently, management accounting has been heavily criticized for failing to provide timely and accurate information, and for not keeping pace with the new manufacturing environment and technologies (Johnson and Kaplan, 1988). Other criticisms suggest that management accounting reports are of little help to operating managers and that the system fails to provide accurate product costs.
In response, firms have adopted new costing techniques including the most common, Activity-Based-Costing (ABC). Yet even advocates of ABC have criticized its use (Johnson, 1992). The response to the criticism is that individuals do not understand this accounting method and, therefore, misuse its techniques (Kaplan, 1992). This is similar to the defense of the traditional accounting techniques. Both claim that the techniques are appropriate, but incorrectly used. Maybe all of these authors are correct. Management accounting information does have problems, but where do the problems lie?
In academia, new models have found their way into journals and texts. Caution is necessary however, as it is too easy to criticize the traditional models and move quickly away from them rather than reconcile new ideas with old models. Manufacturing firms are adopting Just-In-Time (JIT) systems, and Total Quality Management (TQM) has become the preferred system. These three currently popular business concepts (ABC, JIT, and TQM) will be discussed.
ACTIVITY-BASED COSTING (ABC)
Among the criticisms of management accounting, a troublesome area has been the inaccurate overhead allocation of costs to products. In the past, the bases used for allocating overhead were either volume driven, such as direct labor hours and machine hours, or financial measures, such as direct labor costs and raw materials costs. These allocation bases are simple and easy to use since the information is readily available either from production or accounting reports, but they often result in mis-measurement of costs.
As firms moved from labor driven manufacturing to automated manufacturing, old allocation bases proved even more inaccurate (Horngren et al., 1999). Products were either under- or over-costed because the bases used did not accurately reflect the activities consumed by the product. Another problem was that the bases did not accurately reflect the overhead triggered by either batches or product lines (Johnson, 1988), nor were all the production costs driven by these bases.
Another source of inaccurate costing has been the mis-measurement or exclusion of relevant costs (Weisman, 1991). Since business firms are subject to a multitude of externally mandated accounting and reporting requirements (e.g., pronouncements of the SEC, FASB, GASB, IRS), management accounting has used these same costs to make business decisions. Though these costs satisfy external reporting purposes, they are incomplete for many internal purposes. For example, R;D, distribution, and advertising costs are not considered as product costs for external reporting purposes and are therefore often erroneously excluded from the calculations of product costs for internal uses (Dyckman, Bierman, and Morse, 1994). ABC has been limited as a successful solution to this problem.
Without the restrictions of Generally Accepted Accounting Principles (GAAP), management accountants realized they could use more appropriate bases for allocating product costs and could create more cost centers to accumulate overhead and production support costs (Cooper and Kaplan, 1999). This does not solve all costing problems, as all costs are not easily identified. Difficulty still remains in quantifying numerous costs, and without objectivity and verification, accounting systems often excluded relevant information.
The idea behind ABC is that it is an activity that drives costs. ABC tries to relate the cost of an overhead activity directly to the product that demands that activity (Troxel and Weber, 1990). ABC does not reduce product costs, but merely rearranges the product costs and attracts attention. But, ABC does help identify the costs of activities that are consumed by a product and commitment to changing or eliminating these activities can lead to reduce product costs. ABC assists in focusing on eliminating non-value added activities, such as storage, lead time, and throughput time (Atkinson et al., 1999).
The advantages of ABC are (1) it provides more accurate product costs because the cost drivers include both financial and non-financial measures (e.g., setups and lead time), and (2) it includes more relevant costs. The strategic advantage of ABC is that it helps companies eliminate non-value added activities (e.g., storage and inspection). If ABC is used properly, companies are likely to see a reduction in costs and thereby gain a competitive advantage.
Therefore, ABC offers improvements in three problematic areas: mis-measurement of costs, exclusion of relevant costs, and cost reductions. Though not all firms can use ABC, it is used widely by many companies. With the development of the personal computer, companies are able to analyze large numbers of activities, cost drivers, and products in a convenient, off-line mode (Troxel and Weber, 1990).
ECONOMIC ORDER QUANTITY (EOQ) vs. JUST-IN-TIME (JIT)
Some individuals find the JIT model incompatible with the more dated EOQ model. Is there an issue of incompatibility or is it inaccurate measurement of costs, exclusion of relevant costs, and lack of cost control, the same problems identified in the previous section?
The EOQ model suggests an optimal lot size of inventory that companies should have on hand. The optimal lot size occurs at the point where ordering costs equal carrying costs (See Figure 1, point A). JIT, on the other hand, means supplying a product that is needed (DeLuzio, 1993), when it is needed, and in the quantity that is needed. It stresses minimum sized inventories approaching zero. If the two models, EOQ and JIT, are used correctly, the lot size determined by the EOQ model should closely approximate the demand-driven JIT lot size (Jones, 1991). However, this has not been the case. The lot size inventory under the EOQ model is larger than the JIT lot size.
Due to dependency on GAAP for creation of all accounting information, companies mis-measure costs, do not include all the relevant costs in the computation, and do not apply reasonable cost control to the costs identified by the EOQ model. For example, carrying inventories creates costs that are commonly ignored in the EOQ computation, resulting in higher lot sizes. Some of the costs typically identified as carrying costs include insurance on inventory, interest, property tax, and shrinkage. What is missing are some of the fixed costs such as inspection, audit fees, forecasting and scheduling, and the cost of poor quality. The inclusion of
Figure 2 Increasing carrying costs due
to more accurate measurement.
such costs increases the total carrying cost. Higher measures of carrying costs tend to move the inventory level downward, as illustrated in Figure 2, by shifting the optimal level from point A to point B. Likewise, attention should be paid to controlling identified costs. As has been seen in JIT, ordering (setup) costs can be significantly reduced through cost control (Atkinson et al., 1999). A reduction in ordering costs further lowers the inventory level as demonstrated by the shift from point B to point C in Figure 3. This suggests that management accountants look
Figure 3 Decreasing ordering costs due
to cost control.
beyond the short run variable costs and adopt a more comprehensive view of which costs are relevant. They can then assist management in reducing or eliminating some of the costs identified. Hence, the EOQ model does not need to be replaced by the JIT model. Both models give accurate inventory lot size, provided costs are more accurately captured, all the relevant costs are identified and used in the computation, and management properly controls all the identified costs.
TRADITIONAL QUALITY vs. TOTAL QUALITY MANAGEMENT (TQM)
Concern about quality has been an issue throughout history even though it is often presented like a new development. The new focus on quality began in 1970, when the erosion of American business in the world markets became noticeable (Chatterjee, and Yilmaz, 1993). The objective of a company with regard to quality is to minimize total-quality costs, while producing high-quality products. This objective has not been achieved, however, due to the same problems identified earlier – mis-measurement, exclusion of relevant costs, and lack of control over identified costs.
In the traditional quality cost system, management accountants attempted to use only those quality cost categories that are easy to quantify and that appear on the income statement. Even though satisfying GAAP, these costs are incomplete for internal decision making because of mis-measurement and exclusion of relevant costs. Such quality costs as indirect and intangible failure costs (external failure costs) are ambiguous and much harder to quantify and, therefore, are usually ignored (Carr and Thomas, 1992).
Figure 4 Increasing failure costs due to
more accurate measurement.
Indirect failure costs are existing costs concealed in other cost categories. They include such costs as the costs of producing and storing excess inventories and manufacturing costs resulting from design inefficiencies. Intangible failure costs represent the opportunity costs of lost sales or reduced market share. Exclusion of indirect and intangible failure costs understates total external failure costs, which in turn understates the total quality costs. As a result, a higher defect rate is allowed and companies spend more on warranty or repairs, which increases external failure costs. This might not happen if management accountants do a good job of measuring the various quality cost categories of prevention, appraisal, and internal and external failure costs. In Figure 4, higher failure costs, due to better measurement (increase from old cost curve to new cost curve), shift the optimal defect level downward from point A to point B, suggesting a lower defect rate.
A serious flaw in the traditional quality cost system is minimizing individual quality costs, when in fact the strategy should be to assess any significant relationship that exists among the different cost categories (Godfrey and Pasewark, 1988). For example, companies’ goals maybe to reduce the cost of repairing defective items. Apart from reducing the external failure costs, the companies should also consider increasing prevention and appraisal costs so that fewer defective products are produced. By investing more in prevention and appraisal costs (See Figure 4), companies find that they spend less on failure costs. They realize that building quality into the product is a lot cheaper than having the product inspected at the end of the production line (Chatterjee and Yilmaz, 1993).
Figure 5 Decreasing voluntary costs
due to cost control.
The amount a company spends on prevention and appraisal costs helps determine the amount required for failure costs(Godfrey and Pasewark, 1988). Awareness of these voluntary costs allows management the opportunity to reduce costs. However, it is not always necessary to increase spending on prevention and appraisal to eliminate failure costs. If management accountants identify costs and relationships, management can reduce the voluntary quality cost categories of prevention and appraisal without increasing failure costs (Horngren et al., 1999) . Through effective design, selection, training, and inspection methods, prevention and appraisal costs can be reduced (Kaplan and Atkinson, 1989). In Figure 5, reduced voluntary costs (left cost line as opposed to the right cost line) shift the defect rate downward from point B to point C. Achieving zero defects may not be the strategy that immediately minimizes total quality costs; it make take several iterations of cost reductions before this is optimally profitable.
Three problematic elements of costing for management accounting have been identified and demonstrated above. By attending to these three issues—mis-measurement, exclusion of relevant costs, and lack of cost control—yesterday’s models evolve into today’s “philosophies”. First, in today=s computer-rich environment, accountants should be less concerned about meeting GAAP requirements and focus more on accurately measuring costs for internal decision purposes. Activity-Based Costing or other new costing methods are capable of performing these more accurate procedures.
Second, decision models must include all information including the best estimates of hard to quantify costs. Some of these hard to measure costs have been referred to as qualitative costs. Efforts must be made to quantify these costs and include them in the analyses. If the costs are too difficult to quantify for the analysis, some reasonable estimate of the impact of these hard to quantity costs must be used to intentionally bias the decision results. The direction and the magnitude of the bias must be estimated and included for more optimal decision results.
Third, accountants should explicitly identify all costs related to a decision process and assist management in developing means to control those costs. Much of the cost required to obtain this information should be incurred during the more elaborate costing processes. The value obtained from engaging in cost identification and control should far exceed the marginal costs of further information creation.
Attention to these three costing issues in current decision models can fill the gap until “new business philosophies” are available from business literature and/or research. Firms struggling to achieve JIT (zero inventories) or TQM (zero defects) may find benefits in using traditional decision models with more relevant cost information. Traditional decision models with better information may give reasonable estimates of where businesses should be, cost wise, at any point in time. The firm can then control the identified costs and move slowly and profitably towards the zero defect and/or zero inventory levels desired. Using traditional models with better information and cost controls may help in current decisions of re-engineering (downsizing) or out-sourcing. Businesses should make rational, controlled decisions based on accurate, complete information, moving towards the correct solution, while controlling those costs identified.
Management accountants should not be waiting for breakthroughs in the accounting profession to help bring back the relevance of management accounting; instead they should be working to make a difference now. Adhering to the three solutions suggested in this article is a good start for many organizations. Be assured that no implications are made that contemporary management accounting is adequate in its current form. However, many traditional decision models and evaluation techniques may be more beneficial, if only the management accounting information can be improved using the three suggestions.
Amenkhienan, F. E. and Green, F., “Regaining U.S. Manufacturing Competitiveness: The Role of Management Accounting,” International Journal of Management 7, 3 (Sept 1990) pp. 343-351.
Atkinson, A. A., R. D. Banker, R. S. Kaplan, and S. M. Young, Management Accounting, (Upper Saddle River, New Jersey: Prentice-Hall, Inc., 1999).
Dyckman, T. R., H. Bierman, Jr., and D. C. Morse, Cost Accounting: Concept and Managerial Application (Cincinniti, Ohio: South-Western, 1994), pp. 366-379.
Carr, Lawrence P., and Thomas Tyson, “Planning Quality Cost Expenditures,” Management Accounting, October 1992, pp. 52-56..
Chatterjee, Sangit and Mustafa Yilmaz, “Quality Confusion: Too Many Gurus, Not Enough Disciples,” Business Horizons, May-June 1993, pp. 15-18
Chalos, P. and A. Bader, “Focus on Industry,” Journal of Accountancy, March 1986, pp. 106-112.
Cooper, Robin and Robert S. Kaplan, The Design of Cost Management Systems: Text, Cases, and Readings 1991 (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1999).
DeLuzio, Mark C., “The Tools of Just-In-Time,” Journal of Cost Management for the Manufacturing Industry, Summer 1993, pp. 13-20.
Godfrey, James T., and William R. Pasewark, “Controlling Quality Costs,” Management Accounting, March 1988, pp. 48-51.
Horngren C. T., G. Foster, and S.M. Datar. Cost Accounting: A Managerial Emphasis, (Upper Saddle River, New Jersey: Prentice-Hall, Inc., 1999) pp. 140-153 and 682-685.
Johnson, H. T., “Activity-Based Information: A blueprint for World-Class Management Accounting,” Management Accounting, June 1988, pp. 23‑30.
Johnson, H. T., “It’s Time to Stop Overselling Activity-Based Concepts,” Management Accounting, Sept., 1992, pp. 26‑35.
Johnson, H. T., and R. S. Kaplan, “The Rise and Fall of Management Accounting,” Management Accounting, January 1988, pp. 5-12.
Jones, Daniel J., “JIT and the EOQ Model,” Management Accounting, February 1991, pp. 54-57.
Kaplan, R. S., “Accounting Lag: The Obsolescence of Cost Accounting Systems,” California Management Review, Winter 1986, pp. 174‑199
Kaplan, R. S., “In Defense of Activity-Based Cost Management,” Management Accounting, Nov., 1992, pp. 58‑63.
Kaplan, R. S. and A. A. Atkinson, Advanced Management Accounting, Second Ed. (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1989), p. 373.
Reider, B. and G. Saunders, “Management Accounting Education: A Defense of Criticisms,” Accounting Horizons, Dec., 1988, pp. 58‑62.
Troxel, Richard B., and Milan G. Weber, Jr., “The Evolution of Activity-Based Costing,” Journal of Cost Management for the Manufacturing Industry, Spring 1990, pp. 14-22.
Weisman, Denis L., “How Cost Allocation System can Lead Managers Astray,” Journal of Cost Management for the Manufacturing, Spring 1991, pp. 4-10