the Obsolescence of Cost Accounting Systems
I. The Historical Foundation: Cost Management (Pre-1925)
A. Original Purpose and Development of Accounting Systems
Management Accounting is Not New
The use of accounting information for internal management planning and control is not a new phenomenon [Johnson and Kaplan].
Accounting systems for managerial decisions and control can be traced back to the origins of hierarchical enterprises in the early nineteenth century [Johnson and Kaplan].
Management accounting practices developed and flourished in the 19th and early 20th centuries, unencumbered by demands for external reporting [Johnson and Kaplan].
The Ancient Roots of Business Control: Why Management Accounting Isn't New
When people talk about modern business management—things like budgeting, calculating product costs, and evaluating managers—it is often assumed that these are new inventions, perhaps developed only after World War II [Johnson and Kaplan, 4].
In fact, the way managers plan and control their operations using internal information is a very old practice.
What is a Hierarchical Enterprise?
A hierarchical enterprise is simply a business big enough to have different levels of management, where owners or senior leaders employ managers and workers [Johnson and Kaplan, 19].
Before the 1800s, most businesses were small, and they bought or sold almost everything they needed in the open market[Johnson and Kaplan, 18]. If a merchant needed yarn and cloth, they paid an outside artisan a piece rate (a market price) to produce it [Johnson and Kaplan, 50].
However, starting in the early 19th century, especially with the rise of factories, large companies began doing multiple activities—like spinning, weaving, and dyeing—inside their own buildings, rather than buying these services on the market [Johnson and Kaplan, 19, 41, 42].
This change created a new and urgent problem for managers: How do we know if our internal operations are efficient?[Johnson and Kaplan, 19].
Because these internal activities were no longer priced by the market, managers had to invent their own measures to see if resources (like cotton, labor, and fuel) were being converted effectively into finished products [Johnson and Kaplan, 19, 51]. This need to monitor internal processes gave birth to management accounting [Johnson and Kaplan, 19, 43].
Early Examples of Management Control
One of the first places these systems appeared was in New England textile mills [Johnson and Kaplan, 46]. These companies integrated spinning and weaving into a single plant [Johnson and Kaplan, 52]. The accounting systems they created tracked conversion costs—the expenses related to changing raw material into a final product [Johnson and Kaplan, 24, 74]. These accounts tracked the outlay on internally controlled resources per unit of output, such as labor and overhead costs per pound of yarn [Johnson and Kaplan, 46, 48]. This information helped managers make short-run decisions, like setting prices for special orders [Johnson and Kaplan, 58].
Another prime example is the railroad industry [Johnson and Kaplan, 21, 64]. To oversee vast operations stretching across wide geographical areas, railroads had to develop detailed internal accounting systems [Johnson and Kaplan, 21, 65]. They invented measures like cost per ton-mile (how much it costs to move one ton of freight one mile) and the operating ratio (revenues divided by operating costs) to measure the efficiency and profitability of different segments (like passenger services versus freight) [Johnson and Kaplan, 22, 36, 68].
The Freedom of Focusing on Internal Needs
The third point explains why these early systems were so effective before they became standardized and distorted:
To be "unencumbered by demands for external reporting" means that early managers did not have to worry about rules set by government regulators, the tax authorities, or outside auditors [Johnson and Kaplan, 5, 30]. They did not have to worry about pleasing stockholders with periodic reports [Johnson and Kaplan, 24].
Instead, they kept two separate systems [Johnson and Kaplan, 24]:
Financial Accounting: Simple books (usually double-entry) to record cash received and paid, mainly to track assets and debts for owners and creditors [Johnson and Kaplan, 24, 43].
Management Accounting: A completely independent system designed purely to measure internal efficiencyand help managers make daily and strategic decisions [Johnson and Kaplan, 24, 74].
Because they were only focused on internal utility, the records were incredibly practical. For instance, the conversion cost measures used by managers like Andrew Carnegie in his steel works only focused on continuously gathering data on all direct costs in every process [Johnson and Kaplan, 61]. The system gave managers good information about operating costs to make decisions but ignored things like asset depreciation, which is a major concern for today's external financial reports [Johnson and Kaplan, 63].
In short, in the 19th century, management accounting was a tool for control and profit-seeking—a straightforward way to figure out where to reduce costs and increase productivity [Johnson and Kaplan, 19, 74]. It only became complicated and misleading decades later, when the financial system demanded that internal accounting rules be bent to meet the needs of external auditors and regulators, causing the system to lose its focus on internal relevance [Johnson and Kaplan, 5, 32].
The Necessity of Internal Measurement
Management accounting emerged when conversion processes (like manufacturing or transportation) that were formerly priced through market exchanges began occurring within organizations [Johnson and Kaplan].
Lacking market prices for these internal conversion processes, owners devised measures to determine the "price" of output from internal operations and monitor efficiency [Johnson and Kaplan].
Management accounting focused people's attention on the potential gains from internal coordination, thus facilitating the growth of large-scale firms [Johnson and Kaplan].
The Invisible Handshake: Why Factories Needed Accountants
For a very long time in history, if you owned a business, you knew exactly how much things cost because you bought and sold everything on the open market.
If you made shoes, you paid a shoemaker a piece rate (a market price) for every pair of soles he stitched [Johnson and Kaplan, 48]. If you needed leather, you bought it from a supplier at a market price [Johnson and Kaplan, 41]. Your business was simply recording cash going in and cash going out [Johnson and Kaplan, 18].
But, starting in the 1800s, everything changed, which explains the first statement
The Move Indoors
This means that owners started bringing many separate steps of production inside their own business [Johnson and Kaplan, 40]. Instead of paying an independent worker a market price for weaving yarn, the owner built a factory and hired that worker for a fixed wage [Johnson and Kaplan, 49]. The process of converting raw materials (like cotton) into finished goods (like cloth) was now happening "within the organization," under one roof [Johnson and Kaplan, 40].
This was a vertical change—instead of relying on the market to price every step, the owner took over two or more of those processes [Johnson and Kaplan, 40, 42].
Imagine a railroad company [Johnson and Kaplan, 21]. Previously, moving freight across a tiny region might have involved negotiating with several independent local carting services (the market). Once the railroad built a massive system spanning hundreds of miles, they were doing the job themselves [Johnson and Kaplan, 35]. The activity of moving goods (transportation) was now performed within their gigantic organization [Johnson and Kaplan, 19].
This led immediately to the problem described in the second statement:
Lacking market prices for these internal conversion processes, owners devised measures to determine the "price" of output from internal operations and monitor efficiency [Johnson and Kaplan, 19].
Inventing the Internal Yardstick
When you hire a worker for a daily wage instead of paying a piece rate, you lose the automatic market signal of how efficient that worker is [Johnson and Kaplan, 49]. If the market used to charge £5 per bolt of cloth, and now your internal factory takes too much labor time and too much wasted material to produce it, how do you know? No one is selling you that internal step anymore [Johnson and Kaplan, 19, 49].
Owners needed a new kind of accounting, which became management accounting, to figure out the "price" of those internal activities [Johnson and Kaplan, 19].
They started creating measures to monitor efficiency [Johnson and Kaplan, 19]:
In Textile Mills: They calculated conversion costs—how much they spent on labor and factory overhead (things like fuel and maintenance) to convert raw cotton into finished yarn or fabric [Johnson and Kaplan, 24, 74]. These calculated costs provided a rational basis to evaluate internal costs and compare them to the prices the market used to charge [Johnson and Kaplan, 50].
In Railroads: They couldn't use "cost per bolt" of cloth, so they invented entirely new measurements like cost per ton-mile (how much it costs to move one ton of freight one mile) [Johnson and Kaplan, 36].
These measures served two crucial purposes: first, to calculate if the internal process was truly profitable [Johnson and Kaplan, 50], and second, to motivate and evaluate the managers who oversaw these internal processes [Johnson and Kaplan, 19]. If the internal manager could keep the conversion costs low, they were doing a good job.
The Growth Engine
The ability to create these accurate internal measurements had a huge outcome, as noted in the final statement:
Management accounting focused people's attention on the potential gains from internal coordination, thus facilitating the growth of large-scale firms [Johnson and Kaplan, 43].
Before this type of accounting existed, a company could only grow so large before the owner lost control. Imagine trying to manage a nationwide railroad or a complex steel mill without knowing the cost per unit in each region or department [Johnson and Kaplan, 21, 59]. The system would collapse into chaos.
Management accounting provided the necessary information and control needed to coordinate highly complex operations [Johnson and Kaplan, 21]. By creating numbers that showed managers where value could be gained by coordinating activities inside the firm—rather than using the market—it provided the justification and the tools for companies to increase their size and complexity [Johnson and Kaplan, 43]. This is why management accounting may have facilitated the growth of large-scale firms in the first place [Johnson and Kaplan, 42]. It gave owners the confidence that they could expand without losing track of their profits.
Key Managerial Focus: Conversion Costs
In nineteenth-century single-activity firms (like textile mills and railroads), management accounting practices had one common purpose: to evaluate a company's internalized processes [Johnson and Kaplan].
Textile Mills (Early 19th Century): Cost accounts were created to ascertain the direct labor and overhead costs of converting raw material, focusing primarily on the outlay on internally controlled resources per unit of intermediate output [Johnson and Kaplan].
Railroads: Systems were created to control operations across large geographic scales, using measures like cost per ton-mile [Johnson and Kaplan].
Steel Works (Andrew Carnegie): The system focused primarily on continuously gathering data on all direct costs in every process, using cost sheets to evaluate department managers and check raw material mix [Johnson and Kaplan].
The First Job of the Manager: Measuring the Internal Engine
For businesses in the 1800s, success depended on how well they converted raw materials into finished goods or services. The sources explain that management accounting was created for this precise task.
The first key idea is the central, shared mission of early internal accounting:
In nineteenth-century single-activity firms (like textile mills and railroads), management accounting practices had one common purpose: to evaluate a company's internalized processes [Johnson and Kaplan, 37, 74].
In the early 1800s, businesses began growing very large by bringing many steps of production or service delivery "inside" their organization, rather than paying outside merchants or contractors for every small task [Johnson and Kaplan, 19, 35]. These companies were called "single-activity firms" because they focused on mastering just one overall job, like manufacturing or transportation [Johnson and Kaplan, 35, 74].
Since managers were no longer using market prices to judge how well their internal steps were running, they had to invent a single purpose for their internal accounting: to evaluate and control the efficiency of these self-managed processes [Johnson and Kaplan, 15, 74]. If the internal process was efficient, the owners were confident the entire business would be profitable in the long run [Johnson and Kaplan, 74].
The following examples show how this common purpose led to different, specialized internal measurement tools for each industry:
Example 1: The Textile Mills (Measuring Conversion Cost)
The early textile factories in New England, which combined spinning and weaving into one integrated plant, needed to measure the cost of changing raw material (cotton) into finished goods (cloth) [Johnson and Kaplan, 24, 46].
Textile Mills (Early 19th Century): Cost accounts were created to ascertain the direct labor and overhead costs of converting raw material, focusing primarily on the outlay on internally controlled resources per unit of intermediate output [Johnson and Kaplan, 24, 48].
This means they focused on Conversion Costs [Johnson and Kaplan, 24]. They meticulously tracked:
Direct Labor Costs: How much they spent on workers’ wages in each step (like picking, spinning, or weaving) [Johnson and Kaplan, 25, 29].
Overhead Costs: Expenses beyond raw material and labor, such as fuel, starch, repairs, and factory supplies [Johnson and Kaplan, 28, 50].
By tracking these costs, managers could determine the "outlay on internally controlled resources per unit" [Johnson and Kaplan, 42]. For example, they could calculate the labor cost per pound of yarn produced [Johnson and Kaplan, 29, 51]. This information was used to make quick decisions, such as setting prices for special orders, because it measured the one thing the manager could influence: the rate at which workers converted raw cotton into fabric [Johnson and Kaplan, 54].
Crucially, these early textile accounts were not designed to satisfy external financial reports; they were strictly an internal tool to control costs and provide incentives for workers to achieve productivity goals [Johnson and Kaplan, 55].
Example 2: The Railroads (Measuring Scale and Distance)
Railroad companies were some of the largest, most geographically spread-out businesses of the 19th century [Johnson and Kaplan, 35]. Their activity was transportation, not manufacturing.
Railroads: Systems were created to control operations across large geographic scales, using measures like cost per ton-mile [Johnson and Kaplan, 36].
Since a railroad’s output isn't a factory-made unit, they had to invent measures specific to their vast operations [Johnson and Kaplan, 36]. The most famous measure was Cost Per Ton-Mile [Johnson and Kaplan, 36]: the cost of moving one ton of freight over one mile [Johnson and Kaplan, 37].
This measurement allowed managers to:
Control Operating Costs: They could see how much operating expenses (like fuel and maintenance) were costing per unit of work (the ton-mile) [Johnson and Kaplan, 36, 64].
Evaluate Subordinate Managers: Because railroads were so complex, they were the first businesses to have managers reporting to other salaried managers. The cost per ton-mile became a critical tool for assessing the performance of those subordinate managers across different geographical segments [Johnson and Kaplan, 37, 65].
Measure Profitability: They also developed the "operating ratio" (revenues divided by operating costs) to measure the profitability of segments like passenger versus freight services [Johnson and Kaplan, 37, 66].
Example 3: The Steel Works (Measuring Cost Obsession)
The giant steel companies of the late 1800s were highly complex and capital-intensive, but like the textile mills, their activity was still converting raw materials into a finished product [Johnson and Kaplan, 32, 56].
Steel Works (Andrew Carnegie): The system focused primarily on continuously gathering data on all direct costs in every process, using cost sheets to evaluate department managers and check raw material mix [Johnson and Kaplan, 33, 57].
Andrew Carnegie, a famous steel entrepreneur, was obsessed with continuously gathering data on all direct costs in every process from the blast furnace to the rolling mill [Johnson and Kaplan, 33, 57].
He used cost sheets as his main control tool [Johnson and Kaplan, 59]. These reports gathered daily or monthly data on every input—ore, coal, labor, repairs, fuel—for each ton of steel produced [Johnson and Kaplan, 58]. These precise cost sheets were used to:
Evaluate Managers: They were Carnegie’s primary instrument of control, used to question department heads about any changes in unit costs [Johnson and Kaplan, 59].
Check Quality: They helped check the quality and mix of raw materials [Johnson and Kaplan, 60].
Pricing: They were invaluable for estimating costs and quoting prices for non-standard items like bridges [Johnson and Kaplan, 60].
Carnegie's famous rule was: "Watch the costs and the profits will take care of themselves" [Johnson and Kaplan, 59]. His success demonstrated that managers could achieve high returns simply by having excellent information about their direct operating costs [Johnson and Kaplan, 61].
Original Assumptions of Early Cost Management
External Independence: The management and financial systems operated independently of each other [Johnson and Kaplan].
Focus on Efficiency: The goal was to promote efficiency in the key operating activity [Johnson and Kaplan].
No Inventory Valuation: These early systems did not typically compile data to attach costs to product inventory for financial reporting. Inventories were often valued at market prices in reports to stockholders [Johnson and Kaplan].
The Early Days of Business: Two Separate Books of Truth
In the early years of large companies (the 1800s and early 1900s), the way businesses kept track of their money was very different from today. They kept two entirely separate sets of books, each serving a clear and distinct purpose. This explains the three concepts you asked about, particularly why managers were free to focus solely on running the factory efficiently.
1. External Independence: Two Systems, Two Jobs
The first concept addresses the separation between the internal view and the external view of the company:
External Independence: The management and financial systems operated independently of each other [Johnson and Kaplan, 5, 21].
Think of a successful business today. It needs to know two things:
External Truth (Financial System): Did we make enough money to please our investors, satisfy the government’s tax rules, and keep our bank happy? This system tracks cash coming in and cash going out, recording transactions with the outside world [Johnson and Kaplan, 17, 36].
Internal Truth (Management System): Is the factory running smoothly? Are our workers being productive? Which internal departments need help?
In the 19th century, these two "truths" were kept completely apart [Johnson and Kaplan, 21]. The managers did not have to worry about the rules of the financial system when designing the internal one [Johnson and Kaplan, 5].
For example, a railroad company had a financial system to track ticket sales and expenses for the owners and creditors (people who loaned money) [Johnson and Kaplan, 36]. Separately, they had a unique internal system to calculate things like "cost per ton-mile" to see if their trains were moving freight efficiently [Johnson and Kaplan, 36]. The internal system was designed purely for management’s use and control; it did not need to be shown to the public or external regulators [Johnson and Kaplan, 5].
2. Focus on Efficiency: Mastering the One Job
Because management was free from external reporting demands, their internal system could concentrate entirely on what they could control inside the factory or warehouse:
Focus on Efficiency: The goal was to promote efficiency in the key operating activity [Johnson and Kaplan, 21].
In those days, companies typically focused on mastering just one core task—a "single economic activity" [Johnson and Kaplan, 35, 59]. For instance, a textile mill’s single activity was converting raw cotton into finished cloth [Johnson and Kaplan, 59]. A railroad’s single activity was transportation [Johnson and Kaplan, 34].
The management accounting system was set up solely to measure and promote efficiency in that main, "key operating activity" [Johnson and Kaplan, 21].
Example (Andrew Carnegie's Steel Works): The key activity was converting raw materials (iron, coal) into steel [Johnson and Kaplan, 59]. Carnegie’s managers didn't focus on abstract financial ratios; they focused relentlessly on direct costs in every process and kept detailed records (cost sheets) to check the efficiency of conversion for every ton of steel produced [Johnson and Kaplan, 33, 59]. Carnegie believed if they watched the costs and kept efficiency high, the profits would naturally follow [Johnson and Kaplan, 59].
3. No Inventory Valuation: Using Market Prices
The third idea explains a crucial difference in how they valued their products compared to modern companies:
No Inventory Valuation: These early systems did not typically compile data to attach costs to product inventory for financial reporting. Inventories were often valued at market prices in reports to stockholders [Johnson and Kaplan, 24, 131].
"Inventory valuation" means figuring out the specific monetary cost of all the goods the company hasn't sold yet (the inventory). Today, accountants use complex rules to "attach" every expense—labor, overhead, and materials—to each unit of product still sitting in the warehouse [Johnson and Kaplan, 131, 136].
In the early days, they skipped this complicated process entirely [Johnson and Kaplan, 131]. When preparing financial statements for outside investors, if a textile mill still had unsold cloth, they didn't try to calculate exactly how much every worker and every machine contributed to that cloth's cost. Instead, they often simply used the current market price of similar cloth to value their inventory [Johnson and Kaplan, 131].
Why this matters:
Speed and Simplicity: They didn't have to spend time and effort accumulating all those internal costs into a unit cost figure for external reports [Johnson and Kaplan, 24]. They just looked at what the market was charging for the same item.
Focus on Action: This freed the internal management system to focus purely on cost control and efficiency[Johnson and Kaplan, 47, 48]. The internal reports only measured controllable elements like conversion cost per unit of output [Johnson and Kaplan, 24, 48]. Managers used this direct cost information to decide on special order prices or equipment modifications, ignoring complex overhead figures that are mandatory today [Johnson and Kaplan, 47].
In essence, these three principles meant that early management accounting was a practical, streamlined tool for making things and saving money, unburdened by the external rules now known as Generally Accepted Accounting Principles (GAAP) [Johnson and Kaplan, 5, 27]. It was only later in the 20th century that the external financial rules took over and forced the internal management systems to become "too late, too aggregated, and too distorted" for managers to use effectively [Johnson and Kaplan, 9].
The Scientific Management Movement (1880-1910)
Engineers like Frederick W. Taylor developed information about standards to gauge the potential efficiency of tasks and minimize waste of material and time [Johnson and Kaplan].
This led to the calculation of finished product unit cost to aid managerial decisions, such as pricing, and these costs were closer to replacement cost than to historic cost [Johnson and Kaplan].
By 1925, virtually every management accounting procedure used today had been developed [Johnson and Kaplan].
The Golden Age of Management: Inventing the Tools of Business Control
The history of management accounting, particularly in the period between 1880 and 1925, shows a time of intense creation. This was when business managers and engineers invented almost every internal financial tool we still use today. These innovations were driven by the need to control complex factories and ensure every resource was used as efficiently as possible.
1. Frederick W. Taylor and the Invention of "Standards"
The first idea focuses on efficiency and minimizing waste:
Engineers like Frederick W. Taylor developed information about standards to gauge the potential efficiency of tasks and minimize waste of material and time [Johnson and Kaplan, 75, 76].
This development happened mainly in metal-working firms (companies making complex machine parts, locks, typewriters, etc.) in the late 19th century [Johnson and Kaplan, 47, 48, 71]. These factories were complicated, and managers found it hard to know if workers were performing tasks as efficiently as possible [Johnson and Kaplan, 73].
Frederick W. Taylor led the movement known as "Scientific Management" [Johnson and Kaplan, 50, 75]. His goal was to find the "one best way" to perform every job, minimizing waste of both labor and material [Johnson and Kaplan, 76].
What are Standards?
Taylor's approach meant moving beyond simple historical records and actually determining what output should be [Johnson and Kaplan, 75].
Standards are Planned Measures: Instead of just recording that a job took four hours (historic cost), Taylor's engineers would study the task (using things like time-and-motion studies) and develop physical standards [Johnson and Kaplan, 18, 76]. They would determine that the job should take, say, only three hours and use exactly 10 pounds of steel, thus minimizing wasted time and materials [Johnson and Kaplan, 75, 76].
Focus on Physical Efficiency: This information was designed to monitor the physical efficiency of labor and materials [Johnson and Kaplan, 76]. It was a tool for planning the flow of work and making sure waste was kept to an absolute minimum [Johnson and Kaplan, 76].
This process allowed managers to stop relying on luck or custom and start relying on measured, engineered rules for efficiency [Johnson and Kaplan, 48, 50, 75].
2. Unit Costs for Real-Time Pricing Decisions
Once engineers had accurate physical standards (how much labor and material should be consumed), they converted these into financial terms, leading to the second point:
This led to the calculation of finished product unit cost to aid managerial decisions, such as pricing, and these costs were closer to replacement cost than to historic cost [Johnson and Kaplan, 18, 78].
The engineers calculated the finished product unit cost by translating the standard time and standard material usage into standard labor cost and standard material cost [Johnson and Kaplan, 18, 78].
A Key Tool for Pricing
This finished product unit cost was used to help managers make critical decisions, especially pricing [Johnson and Kaplan, 78]. Managers used this unit cost to set the minimum price they needed to charge a customer [Johnson and Kaplan, 78].
The Difference Between Replacement and Historic Cost
The most important feature of these costs was that they were designed to be current and actionable, meaning they were not tied to old, outdated records [Johnson and Kaplan, 18].
Historic Cost: This is the traditional accounting cost—what the product actually cost to make using the labor wages and material prices paid weeks or months ago [Johnson and Kaplan, 78].
Replacement Cost: These standard costs were frequently updated to reflect the most current prices for labor and materials [Johnson and Kaplan, 18]. They told managers what it would cost to replace or reproduce the item today [Johnson and Kaplan, 18].
By using costs closer to replacement cost, managers had a reliable figure for current pricing decisions [Johnson and Kaplan, 78]. This calculation was solely meant to aid management decisions and was kept separate from the official, historical records used for external financial reporting [Johnson and Kaplan, 18, 78].
3. The Culmination of Management Innovation
The efforts of engineers like Taylor, combined with the earlier work in railroads and textile mills, reached a peak in the early 20th century:
By 1925, virtually every management accounting procedure used today had been developed [Johnson and Kaplan, 21, 173].
This statement confirms that the entire foundation of modern business planning and control was laid in this 100-year window (roughly 1825 to 1925) [Johnson and Kaplan, 173]. By 1925, businesses had invented and fully developed nearly every internal procedure needed to run a complex, large-scale enterprise [Johnson and Kaplan, 21]:
Cost Accounts: Systems to track the cost of labor, materials, and overhead [Johnson and Kaplan, 21].
Budgeting: Tools for planning cash flow, income, and large capital investments [Johnson and Kaplan, 21].
Control Systems: Standard costs and variance analysis (tracking deviations from standard costs), and flexible budgets (adjusting costs based on volume changes) [Johnson and Kaplan, 21, 173].
Performance Measures: Methods like Return on Investment (ROI) and divisional performance measures [Johnson and Kaplan, 21, 64].
This means that the management accounting systems we use today are fundamentally based on practices developed decades ago to meet the needs of those historical organizations [Johnson and Kaplan, 173]. After 1925, the pace of innovation stopped [Johnson and Kaplan, 21].
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