Activity-Based Costing and Its Later Developments - Essay Example

Running head: Activity Based Costing and Its Later Developments Activity Based Costing and Its Later Developments [The name of the writer appears here] [The name of institution appears here] Introduction Accounting has lost its relevance, its connection with reality. There is an urgent need to reconsider the basic (but unfortunately largely unsolved) problems of accounting in a new and critical light, using modern scientific theory and modern information technology. There is also an urgent need to draw up new, up-to-date management accounting systems for use in practice. This is the basic message of a book published in 1987 and written by H. Thomas Johnson and Robert S. Kaplan, two American professors of accounting (the latter at the prestigious Harvard Business School). Johnson and Kaplan's book is about the problems of modern accounting, thereby influencing the expectations of readers. It is called Relevance Lost. The Rise and Fall of Management Accounting. It is interesting that the authors have thought up this unusual and highly descriptive title, which uses two familiar descriptions of huge problems and processes to describe the world of accounting. Most people regard accounting as being necessary for modern society, but also as being unfortunately complicated, bound by tradition, with an authoritarian and dogmatic image, bone-dry, closed, lifeless, extremely boring and thus of absolutely no interest to anyone other than those who practice it. In an article published in 1984 entitled "The Evolution of Management Accounting," Robert S. Kaplan (1984) points out that the world of accounting is rigid, stagnant and barren, and he underlines this state of affairs in the following statement: "Virtually all of the practices employed by firms today and explicated in leading cost accounting textbooks had been developed by 1925." In 1925 almost all data processing was done manually. There were a few primitive mechanical calculators and typewriters, but these machines were relatively expensive, and few could afford them. Modern data processing techniques lay far in the future. Most people were forced to depend on the mathematical and writing skills of trusted individuals. Punch card machines had been invented in the United States before the turn of the century, but the development of these machines took a long time, using the primitive technology available at the time. So in 1925 punch card machines were only used by the very few, and the electronic data processing and data communication that would develop in the second half of the twentieth century were naturally quite unknown. Most readers will surely agree that it is preferable that accounting specialists (i.e., accounts managers or accountants) be good at counting and writing. After all, the very word "accounting" is derived from the verb "to count." But the theories of accounting--the foundations on which the subject is based--have remained largely unaffected by the revolutionary developments in information technology witnessed during the past 40 to 50 years. These developments, and the new opportunities they have brought to the world of accounting, could well mean that the old, traditional theories of accounting are now outdated. In many companies the financial accounting and production functions have very little contact, and the managerial accounting function is weak or nonexistent. The accounting department is concerned about gathering sufficient information to prepare financial statements. Operations may develop a series of its own performance measures to guide its actions. The two do not relate, and the functions ignore each other. About the only integrating factor in many organizations is the standard cost system. The standard cost system is interfunctional in that the inventory figures and the cost of goods sold data are outputs of the system that affect financial accounting. The variances of the system are used by operations to gauge performance, and management uses the system for control and responsibility accounting purposes. If the standard cost system is eliminated, the integrating factor is also eliminated. None of the proposed new systems cuts across functional lines as well as a standard cost system. In regard to activity-based costing, one consultant comments: At this stage of acceptance and development, many consider it an advanced analytical tool for management as opposed to an official set of records. It certainly may not yet be robust enough to replace our day-to-day systems. Each implementation of ABC at this point probably will be tailored to each user's objectives. (Raffish 1991: 39) Data on the explicit and implicit costs of installing new manufacturing cost systems are difficult to obtain. Most new systems proposed in the 1980s are in the early stages, and it is too soon to see if long-run benefits will outweigh the costs. The wealth of journal articles on new systems, particularly activity-based costing, tends to extol the virtues and ignore the problems. It will probably be some time before the romance factor wears off and a few souls are willing to admit there are difficulties. Nevertheless installing a new system is not a simple process, and disruption is to be expected. Systems have life cycles that may be divided into stages. Authorities on systems development differ in their terminology and grouping for such stages. However, a general outline would include: 1. Problem identification. At this stage the organization identifies that a problem or problems exist and tries to define them. 2. Analysis. The existing system is examined and analyzed. 3. Design. A new conceptual design is proposed and feasibility studies are done to determine whether it would be cost beneficial. 4. Development. Databases and programs are designed. Flow charts are made of work flows. Procedures are developed. 5. Implementation. Personnel are trained. The system is tested. Pilot operations may test the system in one segment, or parallel operations may be used by operating both the old and new systems until the bugs are worked out of the new system. Systems conversion occurs. 6. Maintenance. Systems maintenance requires correction of defects found subsequent to implementation, as well as updates as conditions change. 7. Post audit. An evaluation of effectiveness is made after the system has been in operation a year or more. Most managers who want to install a new accounting or management information system do not understand the complexity of the task. Therefore they underestimate both the cost and time involved. Likewise, they do not understand the disruption that will occur. The information given at seminars and in journal articles on new cost systems typically glosses over many steps in the process. There are two reasons why steps often are omitted. One is that advocates may be oversimplifying the actual process, and the other is that some new systems are only partial systems. These can lead to information deficiencies if the traditional standard cost system is abandoned prematurely. Another less drastic result is that redundancy may occur if the old system is not abandoned. The two new cost accounting systems that are most discussed in the new manufacturing environment are activity-based costing and backflush costing. Both are appropriate in certain circumstances but neither represents a complete managerial accounting system. Let us now turn our attention back to Kaplan and Johnson's book on the loss of relevance of accounting. The unusual, distinctive title gives the reader associations with the loss of something important that might be regained on new, modern terms (Relevance Lost), and also indicates that the reality known until now has had its day, and has now fallen so far that no one wishes it back (The Rise and Fall). The title may well indicate that a complete rethink is necessary. We need look no further than the preface of Kaplan and Johnson's book for an assessment of traditional accounting. The preface states that the accounting systems known today are completely inadequate. The requirements made on accounting these days are far too great for the systems used, and accounting systems can no longer meet these requirements: "In this time of rapid technological change, vigorous global and domestic competition, and enormously expanding information processing capabilities, management accounting systems are not providing useful, timely information for the process control, product costing, and performance evaluation activities of managers" (Kaplan Robert S. and Johnson H. Thomas, 1987) This sentence alone is a crushing condemnation of traditional accounting. It points out that managers need information that is useful and upto-date, and underlines the fact that accounting systems do not provide this useful and up-to-date information for managers, who are thus forced to act without it. This problem is not new, but it has grown increasingly visible and incontrovertible in recent years. Many different requirements have been made of accounting systems over the years, and it hardly seems strange that such practical requirements have also had a great impact on the development and prioritization of new theories. The fact that users of accounting systems have had different requirements over the years has forced accounting theorists to define a great number of different "accounting objectives," and to relate these objectives to each other. But the task has been far from easy, and misunderstandings have been unavoidable. Accounting systems for managerial decisions and control can be traced back to the origins of hierarchical enterprises in the nineteenth century. Unencumbered by any demands for external reporting, management accounting practices developed and flourished in the wide variety of nineteenth century corporations. Only in the past sixty to seventy years have external auditing and financial reporting systems come to perform the original function of management accounting systems. Naturally, Americans also use double entry bookkeeping, a system that has such formal strength that accounting experts quite simply regard it as a necessary, indeed indispensable, tool for all accounting, no matter whom the information is intended for. Another important question worth asking is whether double entry bookkeeping is logically sufficient as a measuring tool. We shall return to this question later on. Johnson and Kaplan summarize the inadequacies of traditional accounting in the following succinct, damning fashion: "Today's management accounting information driven by the procedures and cycle of the organization's financial reporting system, is too late, too aggregated, and too distorted to be relevant for managers' planning and control decisions" (Kaplan Robert S. and Johnson H. Thomas, 1987) This is the same as claiming that financial statements are out-of-date, unclear and incomprehensible, which is why traditional accounting in general is unreliable. This kind of judgment certainly says something significant about the impotence of traditional accounting. Three important consequences of this impotence are mentioned by Johnson and Kaplan. The first consequence is the paradox that traditional accounting uses the management, instead of the management using accounting, which must have been the intention of drawing up financial statements in the first place: "Management accounting reports are of little help to operating managers as they attempt to reduce costs and improve productivity. Frequently, the reports decrease productivity because they require operating managers to spend time attempting to understand and explain reported variances that have little to do with the economic and techno- logical reality of their operations. By not providing timely and detailed information on process efficiencies or by focusing on inputs such as direct labor that are relatively insignificant in today's production environment, the management accounting system not only fails to provide relevant information to managers, but it also distracts their attention from factors that are critical for production efficiencies” (Kaplan Robert S. and Johnson H. Thomas, 1987). Accounting reports are thus presented as being directly harmful because they distract the attention of managers. In general, managers are not interested in the so-called "management information" provided by traditional financial statements, which are difficult or even impossible to interpret. Managers are not, in general, accounting experts themselves, so they do not usually determine the design of accounting reports or the period covered. And if nonspecialist managers ask for certain figures from a financial statement, and suggest the figures they need, they are often met with polite refusal and an explanation that "The information you want is not what you need." Trained accountants are naturally regarded as experts in their field, and they even have the weight of tradition on their side. Financial statements observe the guidelines with regard to form and content that have been the only ones available since 1925 (Robert, 1987). But the information required by managers cannot be found in traditional financial statements. The second of the three consequences of the impotence of traditional accounting is described by Johnson and Kaplan as follows: "The management accounting system also fails to provide accurate product cost data. Costs are distributed to products by simplistic and arbitrary measures, usually direct-labor based, that do not represent the demands made by each product on the firm's resources. Although simplistic product costing methods are adequate for financial reporting requirements--the methods yield values for inventory and for cost of goods that satisfy external reporting and auditing requirements--the methods systematically bias and distort costs of individual products. The standard product cost system typical of most organizations usually leads to enormous cross subsidies across products. When such distorted information represents the only available data on "product costs," the danger exists for misguided decisions on product pricing, product sourcing, product mix and responses to rival products. Many firms seem to be falling victim to the danger" (Kaplan Robert S. and Johnson H. Thomas, 1987) This is a real condemnation of the familiar, so-called "standard cost accounting." The term "standard costs" Implies norms of time and material consumption that have already been studied, measured and commented upon. These norms are now regarded as "standard" elements of cost in financial statements, particularly those of industrial companies involved in series or mass production. By combining the "old" and "new" prices of materials and wages, it is now possible, after production has been completed, to present a completely itemized production cost report, making it possible to trace discrepancies between predicted and actual events. Such reports make it possible to locate such discrepancies and discover whether they were due to price deviations, waste, defective production or other factors. Kaplan and other authors have indicated that these ideas can be traced right back to the start of this century, when production processes, although standardized, were still largely manual or only partly mechanized. This meant that production processes were characterized by a lack of homogeneity and frequent defects or breakdowns. But in the 1990s and the future, production processes are not merely automatic, but actually controlled by computers that make virtually no errors at all once they have been properly installed and adjusted. Conclusion Johnson and Kaplan are not seeking merely to identify a few minor ailments in the theory or practice of accounting, or to present a new variation of (or new additions to) current accounting theory to enable it to fit a large, familiar frame of reference. No, the authors are actually preparing for an all-out assault on the accounting traditions of more than half a century. Revolution and innovation in the world of accounting are called for. These are no mere minor details. The entire framework and world picture of accounting have been fundamentally mistaken. It is high time that theoretical and practicing accountants realized that researchers in a subject whose very essence is the art of computing really should start working on the hypothesis that computers and electronic information technology in general must be incorporated into modern accounting. It is inadvisable to continue using a frame of reference whose entire world picture is anchored solidly in more than 60 years of authoritarian belief, tradition and dogma, and whose most advanced concept of tools is still the idea that the best way of performing two of the four known types of arithmetic (addition and subtraction) is by employing the services of a great number of people and large quantities of paper, pens and ink. Because these are all the tools needed to master the art of double entry bookkeeping. Johnson and Kaplan are not the only modern theorists who have recently started to speak out openly in order to bring about innovation in the world of accounting, even though the price of such innovation may be strife and confrontation with many supporters of traditional methods. Such confrontation and strife are probably unavoidable. After all, the traditions of accounting are extremely strong. Reference: Anthony Robert N. "We don't have the accounting concepts that we need." Harvard Business Review 1987.1. Kaplan Robert S. "The Evolution of Management Accounting." Accounting Review 1984. Kaplan Robert S. and Johnson H. Thomas, 1987. Relevance Lost. The Rise and Fall of Management Accounting. Harvard Business School Press, Boston, MA 1987. Read More