The history of management accounting

History Of Management Accounting

Management accounting has been defined as "the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of financial information that is used by management to plan, evaluate, and control within an organization. It is the accounting used for the planning, control, and decision-making activities of an organization" (Siegel and Shim,1995, p. 508). Based on an essay by Robert N. Anthony that identified several significant changes in management accounting in recent years, this study provides an overview of management accounting and how it is used today. The study provides a review of the relevant and scholarly literature to identify changes in methods of product costing, investment analyses and organizational performance evaluation; a summary of the research is provided in the conclusion. One of the most important recommendations to emerge from this study was the need to transcend existing approaches and integrate the best from organization theory, behavioral sciences, information theory, and others, in a multidisciplinary approach that will facilitate the production of information for top management decision-making purposes.

The History of Management Accounting

More and more people -- inside the business world and out -- realize the significant changes which have been taking place for years in accounting and the role of the accountant in business. No longer is he simply a recorder of business history. He now plays a dynamic role in making business decisions, in future planning and in almost every aspect of business operations. This new accountant is called a Management Accountant and he sits with top management because his responsibility is developing, producing and analyzing information to help management make sound decisions. -- The National Association of Accountants, 1992

Introduction

The epigraph above is indicative of the growing importance being assigned to management accounting today. Indeed, corporate transparency has assumed new importance in the wake of the accounting frauds perpetrated by Enron and their ilk in recent years, and management accounting is playing an increasingly crucial role in this broad initiative. For example, in his essay, "Management accounting: A personal history," Robert N. Anthony (2003) reports that the field of management accounting has experienced some fundamental changes over the years that have had a profound effect on how corporate managers and the general public alike view the field itself, but more importantly, there has also been a shift in the emphasis from its record-keeping function to the actual people who participate in the process. To identify what important changes have taken place in the field of management accounting in recent years that have created the accounting disasters of years past and what steps are being taken to improve the techniques involved, this paper reviews the relevant literature to determine changes in methods of product costing, investment analyses and organizational performance evaluation. A summary of the research will be provided in the conclusion.

Review and Discussion

Background and overview.

Accounting has been defined as "an attempt to wrest coherence and meaning out of more reality than we ordinarily deal with" (Weick, 1979). While this definition may appear extreme, it serves to provide a sense of the complexity of the challenges that are confronted by much accounting measures. According to Neely (2002), financial statements are supposed to provide, within the just a few pages of numerical reports, an account of the complete financial outcomes of a complex set of interrelated activities that have been undertaken over a period of time.

When used for management control purposes," Neely advises, "the task becomes even more complex, for these accounting measures are intended to help ensure that operating managers will be continually motivated and challenged to exercise their managerial skills in the interests of the overall organization. In such a way, the accounting numbers provide a 'window' into the organization which gives an (albeitly imperfect) image of the activities being undertaken and their consequences. (p. 20).

Clearly, managers today need timely information upon which to base informed decisions, and management accounting represents a solid framework in which this information can be gathered, analyzed, interpreted and communicated to those who are in a position to need to know. Not surprisingly, then, management accounting has become a hot topic in recent years, due in large part by the demands from governmental regulatory agencies such as the Securities and Exchange Commission and Internal Revenue Service, that require specific financial measures to be reported. In addition, in 2002, the U.S. Congress passed legislation that established the Public Company Accounting Oversight Board; this is a private, quasi-regulatory body that was established by the Sarbanes-Oxley Act, which was signed into law on June 30, 2002 (Gips, 2003). The oversight board has been tasked with the responsibility of replacing the longstanding practice of self-regulation by accountants. "The board, overseen by the Securities and Exchange Commission (SEC), is charged with registering accountants that prepare audits for public companies; establishing auditing, ethics, and other standards for the industry; investigating accounting firms that work on public companies; and enforcing compliance with the oversight board's own rules" (Gips, 2003, p. 12). In response, accounting experts have worked to refine these measurements through decades of work with governmental agencies (Denton, 2003).

According to Siegel and Shim (1995), management accounting is "the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of financial information that is used by management to plan, evaluate, and control within an organization. It is the accounting used for the planning, control, and decision-making activities of an organization" (p. 508).

Changes in methods of product costing.

In this regard, while the relationship between cost accounting and management accounting has not been specifically described, it is generally held that it is one point of emphasis. For example, Riahi-Belkaoui (1992) reports that, "Cost accounting deals mainly with cost accumulation, inventory valuation, and product costing. It emphasizes the cost side. The objective function is implicitly perceived to be cost minimization. Similarly, management accounting deals with the efficient allocation of resources. The objective function may be perceived to be profit maximization" (p. 3). It is also widely accepted that the cost accountant and the management accountant perform different activities; for example, cost control falls within the purview of the cost accountant, while cost reduction is the responsibility of the management accountant (Riahi-Belkaoui, 1992). Generally speaking, accounting textbooks that are labeled cost accounting emphasize cost control while those labeled management accounting or managerial accounting tend to focus on the planning function; this in turn has most likely reinforced the concept that there is a fundamental difference between both of these areas (Riahi-Belkaoui, 1992).

In this regard, though, Riahi-Belkaoui recommends that a more appropriate approach that emphasizing the differences in these approaches is to conceive of management accounting as an effort to integrate the techniques from other disciplines into the area of cost accounting. In fact, in recent years, the scope of cost accounting has been expanded in a number of areas, including the following:

1. It emphasizes not only the explanatory but also the predictive ability of accounting data;

2. It develops normative models to be applied in the accounting context with an emphasis on mathematical, statistical, and operations research techniques.

3. It stresses the behavioral impact of accounting information on the users;

4. It uses nonaccounting information -- economic, environmental, and qualitative -- to improve the relevance of management accounting data;

5. It merges economic and social goals and consequently draws the accountant into program budgets and "performance" auditing in not-for-profit organizations; and, 6. It relies on more frequent and heavier use of computers, leading to a centralization of information and the expected candidature of the management accountant for the job of the "information manager" having overall responsibility of this resource (Riahi-Belkaoui, 1992).

This expansion of the scope of cost accounting into management accounting has caused the role of managerial accounting to consider the entire formalized information function of an organization (Riahi-Belkaoui, 1992). In this regard, Mitchell, Reid, and Terry (1997) suggest that "overall management accounting systems tended to bear the characteristics of the Universalist theory... i.e. that practical management accounting procedures remain similar despite differing contexts in terms of contingent variables" (p. 46).

The systems of product costing that became widely used in the United States and the United Kingdom were introduced in contract engineering firms where unique "one-off" products were constructed to order. In those situations, engineers were required to be able to quickly calculate prices for their work in the same manner contractors do today (Garner & Tsuji, 1995). For those purposes, some rule of thumb was needed such as "keystoning," or doubling the price or to 'provide for overhead by multiplying direct labor by 150%; these have always been useful techniques for quickly calculating the costs associated with any project, but they are only useful in some specific applications.

For example:

motor mechanic, plumber, electrician, or engineer has to be able to prepare the customers' accounts quickly and authoritatively without trying to recalculate an appropriate share of the overhead which each job should bear. It even makes sense to trace the overhead component of each job subsequently to see how much was recovered and what relationship that recovery bore to the overheads incurred. The mistake occurred when enthusiasts tried to use those data for other purposes such as 'strategic product decisions.' The average cost of production never could, and never will, be relevant for those classes of decisions where only the change in total costs and revenues are relevant. That is, the rough, average post calculations provided a guide for pricing unique one-off products or services, but were of no use for the other purposes (emphasis added) (Garner & Tsuji, 1995, p. 52).

The strategic product decision function of management accounting described above is based on the strategic management accounting method; this approach serves to cause change in the management framework through various accounting devices designed to adapt effectively to the constantly changing external business environment (Garner & Tsuji, 1995). Strategic management accounting, though, should be managed by production people (including sales and engineering), rather than by accounting staff (Garner & Tsuji, 1995).

Under activity-based costing (ABC), Cooper and Kaplan (1990) suggest that "virtually all" of a business's activities are in place to support the production and delivery of today's goods and services and therefore should be considered product costs: "Nearly all factory and corporate support costs can be split apart and traced to individual products or product families. These costs include logistics, production, marketing and sales, distribution, service, technology, financial administration, information resources, general administration" (p. 38). "ABC systems are designed by first identifying the activities performed by each support and operating department and then computing the unit cost of performing these activities.... Once the unit costs of all activities have been determined, we can accurately assign support and indirect product costs based on the number of activities performed for each individual product" (Kaplan, 1991, pp. 209, 210).

Today, Denton (2003) suggests that what is needed by managers for product costing purposes is the ability to acquire real-time measurement of variables such as production rates, yield quantities, cycle time, reject rates, stockouts, and subjective issues and then a way to integrate or cross-reference these issues to achieve a more complete perspective of what is actually going on. "Concepts like activity-based costing (ABC)," he advises, "provided an initial effort to fix the inadequacies of our current system, but it, too, has limited usefulness" (p. 101). Furthermore, the activity-based costing literature has consistent references to instances in which there have been grossly different cost estimates that were provided by traditional and ABC-based cost accounting systems; these disparities may have led to inappropriate product pricing decisions being made (Neely, 2002).

There have been some other notable changes in product costing in recent years. For example, just 15 years ago, one industry analyst predicted that: "Attempting to meet these diverse -- even contradictory demands [of operational control and product costing] with a single system design seems well beyond the capabilities of any existing system. [A]t this time and with our present state of knowledge of what is possible and beneficial from newly designed operational control and activity-based costing systems I am skeptical that we can develop the detailed specifications for (a single fully integrated) system" (Kaplan, 1990, p. 25). Moore's law has held true over the years, though, and computer programs specifically designed for operational control and product costing applications are readily available. For instance, even by the 1970s, it became clear that technology was beginning to affect accounting practices; at first, these innovations provided increasing amounts and variety of data more frequently and placed stress on long-standing accounting practices (Cortada, 2004). By the turn of the 21st century, there were literally hundreds of computer applications on the market to help management accountants produce more frequent management reports with more information of higher quality than in years past (Cortado, 2004).

Changes in investment analyses.

According to Anthony, "Management accounting differs from the cost accounting that was used prior to that time in two important respects. Cost accounting, as the name suggested, dealt with the measurement of the cost of products, whereas management accounting deals with the activities of managers" (p. 249). As a result, the transition to management accounting has changed the focus of management accounting from a record keeping function to the actual people who are involved in the process itself. In this regard, Anthony reports that: "Its central theme was 'responsibility centers' -- that is, organization units headed by a responsible manager -- rather than products. Some responsibility centers were profit centers; they focused on revenues, expenses, and the difference between them. Other responsibility centers were called investment centers, which focused on profit as a percentage of investment" (p. 250). The following definitions of responsibility center, cost center, and profit center are provided by Lewis (1993):

Cost center. A cost center is a responsibility center that has control over costs only. A cost center may have costs allocated to it over which it has no control. It has no jurisdiction over revenues or investment funds. All budgetary units from the smallest to the overall company are cost centers.

Profit centers. A profit center is a responsibility center that has control over both costs and revenues. An example of a profit center is a product line division of a multiproduct company. The product line division generates revenue and incurs costs most of which are controllable, however, the division does not issue capital stock separate from corporate headquarters. Investment decisions such as new plants, major changes in product lines, and stock issues are made at the corporate level, not at the division level.

Investment center. An investment center is the corporate headquarters or any segment of the corporation that has control over costs, revenues and investment funds. Operating divisions that are given autonomy in making investment decisions, such as expansion of physical plant and changes in product lines, are investment centers. Operating divisions that are given autonomy in making operating decisions, but not in the use of investment funds are profit centers. The authority over investment funds remains with the corporate headquarters (Lewis, 1993, p. 219).

According to Neely (2002), the basic accounting approach to motivation and control is to divide an organization into "responsibility centers"; these responsibility center are organizational units that are as autonomous as possible, and which are responsible for specific aspects of organizational performance. "At the highest level," Neely says, "these are defined as investment centers, where managers have responsibility both for investing in business assets and in using the assets entrusted to them effectively. A typical performance measure for an investment center manager would be return on capital employed, as this involves both profit and asset value components" (Neely, 2002, p. 13).

At the lower organizational levels, profit centers are defined; at this stage, managers are responsible for generating sales revenue and for managing the costs involved in production or service delivery (Neely, 2002). As a result, profit represents an appropriate performance measure. Further, the lowest level of responsibility is the cost center; at this level, the results of the units of activity are unable to be assessed in terms of revenue earned, and managers are held responsible (in accounting terms) only for the associated costs. "Clearly," Neely says, "in performance management terms, cost centers require other (non-accounting) measures to be associated with them to capture the outputs that result from expenditure on inputs" (Neely, 2002, p. 14).

In order to operate control based primarily on accounting measures has meant that profit or investment centers had to be created. This author points out that there has been a trend toward the creation of so-called "pseudo-profit centers" recently wherein revenues are somewhat artificially attributed to responsibility centers in order to achieve the advantages that is typically associated with control of profit centers. According to Neely:

These advantages are primarily those of having only to consider accounting measures of performance, expressed as an overall profit measure and its components. In particular, if a profit center is indeed generating profits, it can potentially be left alone to continue the good work, with control exercised in a relatively decentralized manner. However, to construct profit statements for an organizational unit requires revenues as well as costs to be attributed to it. This is not an issue where products are sold to an external customer and sales revenues generated, but it is more problematic where intermediate products are transferred internally within a larger organization, or in the public sector where services may be provided at no cost to the immediate user (Neely, 2002, p. 14).

At this point, a value must be attributed to the transferred goods and services, the so-called "transfer price"; like other aspects of management accounting, this aspect of the discipline has been the focus of much attention in recent years in the accounting literature as to the establishment of appropriate transfer prices that will motivate managers to act in the interest of the overall organization while maximizing their own reported profit measure. Neely suggests that this optimum arrangement can be achieved under the right circumstances; however, it is more common for transfer prices to create more "heat than light":

If they are mis-set, there is considerable potential for managers to appear to be performing well in local terms, but to be acting dysfunctionally from a more global perspective. An extreme example was the case of the motor car manufacturer which set transfer prices on a full cost plus basis. That is, each component plant, and the assembly plant had transfer prices set on the basis of their full costs plus a percentage addition for profit margin. Not surprisingly, all the units reported healthy profits; the only black spot was the marketing division which reported heavy losses, as it was unable to sell the vehicles at anything like the costs which had been transferred to it. (p. 14).