the Obsolescence of Cost Accounting Systems part 4
IV. Negative Consequences and Dysfunctional Behavior
A. Unintended Consequences of Traditional Measures
Cross-Subsidies and Misguided Decisions
Simplistic and arbitrary allocation methods (e.g., direct-labor based) systematically bias and distort costs of individual products, leading to enormous cross-subsidies [Johnson and Kaplan].
This results in misguided decisions on product pricing, product mix, and product sourcing [Johnson and Kaplan].
Companies frequently lose profitable work by over-pricing low-volume products that their system incorrectly allocates high overhead to [Johnson and Kaplan].
Conversely, products that appear highly profitable might actually have gross margins of -400% when their demand for support departments is accurately traced [Johnson and Kaplan].
They produce numbers that look precise but are fundamentally misleading, causing managers to make strategic errors that directly harm company profitability.
This flawed system arose historically because managers yielded the design of their internal management systems to financial accountants and auditors, prioritizing external reporting requirements (like valuing inventory for the balance sheet) over internal relevance [Johnson and Kaplan, 12, 112, 126, 198, 203].
The Illusion of Accuracy and the Problem of Cross-Subsidy
The first point explains the mechanical failure of the accounting process:
Simplistic and arbitrary allocation methods (e.g., direct-labor based) systematically bias and distort costs of individual products, leading to enormous cross-subsidies [Johnson and Kaplan, 4].
In modern manufacturing, total costs are dominated by overhead (indirect costs, such as utilities, engineering, depreciation, and maintenance), not direct labor or materials [Johnson and Kaplan, 206]. Because cost systems were designed 60 to 100 years ago when labor was the most expensive input, they rely on simplistic and arbitrary allocation methods to spread these large overhead costs across a company’s diverse products [Johnson and Kaplan, 4, 165, 227].
The Arbitrary Method
The most common arbitrary method is to distribute massive overhead costs based on the amount of direct labor or direct labor hours a product consumes [Johnson and Kaplan, 4, 121, 166, 204]. This method is convenient because labor hours are already being tracked, and it satisfies external reporting requirements and auditing rules for objectivity and verifiability [Johnson and Kaplan, 121, 204].
The problem is that direct labor is now a decreasing fraction of total product costs (often 10% or less) [Johnson and Kaplan, 206]. The largest cost category (overhead) is allocated based on the smallest cost category (direct labor), ignoring the fact that many overhead expenses are driven by activities other than direct labor, such as the number of machine setups, inspections, or engineering changes required [Johnson and Kaplan, 176, 224, 225].
The Systematic Bias and Cross-Subsidy
This misalignment creates a systematic bias and distortion in the cost figures reported for individual products [Johnson and Kaplan, 4, 176, 220].
This distortion is called cross-subsidy [Johnson and Kaplan, 4, 176, 220]. It means that the true costs of making one set of products are unfairly shifted onto the reported costs of another set of products.
Under-costed Products (The Hidden Drain): Complex products that require specialized engineering, frequent machine setups, or extensive quality control inspections—all high-overhead activities—but use minimal direct labor are assigned a low overhead burden. They appear cheap and highly profitable [Johnson and Kaplan, 176].
Over-costed Products (The False Target): Simple, mature, high-volume products that require lots of direct labortime but demand little specialized overhead support (few setups, simple design) are assigned a huge share of the plant’s fixed costs. They appear expensive and less profitable [Johnson and Kaplan, 177, 232].
The final reported product costs, often presented with five or six significant digits, suggest great accuracy, but the arbitrary overhead allocation makes it likely that even the first digit is wrong [Johnson and Kaplan, 170, 228, 240].
The Consequence—Misguided Decisions
When managers rely on these distorted figures, they inevitably make poor strategic choices because they are managing based on irrelevant, biased data [Johnson and Kaplan, 4, 140, 158].
This results in misguided decisions on product pricing, product mix, and product sourcing [Johnson and Kaplan, 4].
Misguided Decisions and Examples
1. Losing Profitable Work (Product Pricing and Sourcing):
Companies frequently lose profitable work by over-pricing low-volume products that their system incorrectly allocates high overhead to [Johnson and Kaplan, 121].
Historically, companies using this arbitrary system often failed to win bids for work that was confined to shops where the actual expense percentage was low, because they were forced to use a much higher average overhead rate, making their bids too high [Johnson and Kaplan, 121].
The distortion forces companies to misprice products:
Over-pricing: The high-volume, standard products, which should be aggressively priced to win market share, are made to look expensive by the system [Johnson and Kaplan, 177, 232]. If a company raises the price on these products due to their artificially high reported cost, they will lose profitable volume to focused competitors who know their true, low cost [Johnson and Kaplan, 178]. This can lead to the misguided decision to drop these "unprofitable" high-volume products [Johnson and Kaplan, 178].
Subcontracting Mistakes (Sourcing): Managers frequently find it easy to locate an outside supplier who can produce a labor-intensive component cheaper than the internal cost center can fabricate it [Johnson and Kaplan, 175]. This leads to the misguided decision to subcontract (buy rather than make). However, because much of the factory overhead is not driven by direct labor, outsourcing saves only a relatively small fraction of the component’s true cost, leaving the company stuck with a large portion of the fixed overhead costs it thought it was avoiding [Johnson and Kaplan, 175].
2. Pushing Unprofitable Work (Product Mix):
Conversely, products that appear highly profitable might actually have gross margins of -400% when their demand for support departments is accurately traced [Johnson and Kaplan, 231].
In a study of a plant with a diverse product line, the traditional direct-labor-based system showed high profit margins (45% to 50%) for low-volume customized products [Johnson and Kaplan, 231]. When a more accurate method (Activity-Based Costing or strategic cost analysis) was used to trace overhead costs based on actual transactions and resource consumption, the results were astonishing:
The products that appeared most profitable, such as the low-volume customized jobs, were found to have negative margins, sometimes as low as -400% [Johnson and Kaplan, 231].
These products were "bleeding the division to death" through the heavy demands they made on the plant’s support departments [Johnson and Kaplan, 231].
When a company believes these distorted figures, it aggressively pushes a "profitable" product line (product mix) that is actually incurring significant hidden costs, expanding its capacity for loss while starving its truly profitable core products of resources [Johnson and Kaplan, 177, 232].
In short, the flawed cost system conceals the high profits earned by high-volume products and shifts those profits onto complex, low-volume products, resulting in a vicious cycle where the firm is led to the exact decisions that compromise its overall profitability [Johnson and Kaplan, 177, 232].
Inventory Manipulation and the Cash Flow Disconnect
Absorption cost accounting creates incentives to build up inventories, which results in the costs (fixed overhead) being capitalized as an asset until the product is sold [Noreen, Smith, and Mackey (1995)].
This practice enables the manipulation of reported earnings, as management can signal increased profits even when the long-term economic health of the firm has been compromised [Johnson and Kaplan].
Building excess inventory, an action driven by the accounting system, is not the goal; throughput is [Smith (1999)]. The truth of the company’s health is always reflected in the cash flow, which is distorted by inventory buildup decisions [Smith (1999)].
The Inventory Trap—Why Building Products Can Look Like Earning Money
How the widely used accounting method called absorption costing can encourage managers to take actions that make their company look financially successful in the short term, even if those actions harm the business over time.
How Absorption Costing Creates the Incentive
The heart of the problem lies in how fixed expenses are treated when products are manufactured but not yet sold:
Absorption cost accounting creates incentives to build up inventories, which results in the costs (fixed overhead) being capitalized as an asset until the product is sold [Noreen, Smith, and Mackey (1995), xxiv, 512].
Fixed Overhead: Fixed overhead refers to manufacturing costs that do not change based on production volume in the short run (such as the cost of the factory building, depreciation on machinery, and fixed salaries for supervisors and maintenance staff) [Smith (1999), 403].
Capitalized as an Asset: Under the rules of financial accounting, specifically the Matching Principle, these fixed overhead costs must be attached to the products being made [Smith (1999), 402]. When a product is finished, all costs—material, labor, and a portion of the fixed overhead—are "fully absorbed" by that product [Smith (1999), 416]. Since these products haven't been sold yet, they are recorded on the balance sheet as inventory, which is a type of asset [Noreen, Smith, and Mackey (1995), xxiv, 497]. The fixed costs are thus capitalized (turned into an asset) rather than immediately recorded as an expense against current revenue [Noreen, Smith, and Mackey (1995), xxiv, 512].
The Incentive: Because a portion of fixed expenses is removed from the income statement and tucked away in the inventory asset account on the balance sheet, the total recorded expenses for the current period go down. When expenses go down, reported profit goes up, even if the company hasn't sold a single extra unit [Noreen, Smith, and Mackey (1995), xxiv, 512; Smith (1999), 417]. This creates a strong financial incentive for managers to overproduce inventory.
The Problem of Earnings Manipulation
This leads directly to the second point about the deceptive nature of the resulting financial figures:
This practice enables the manipulation of reported earnings, as management can signal increased profits even when the long-term economic health of the firm has been compromised [Johnson and Kaplan, 7].
Managers, especially those under pressure to meet short-term targets for monthly or quarterly earnings, can achieve these goals by arbitrarily manipulating production schedules to inflate inventory levels [Smith (1999), 398, 401]. This practice can signal increased profits to external parties, even when the company's long-term competitive position and economic health have been compromised [Johnson and Kaplan, 7, 201].
Example of Manipulation: Imagine a factory is having a slow sales month and is falling short of its profit goal. The factory’s fixed overhead (rent, depreciation, salaries) is £100,000 per month. If the manager instructs the plant to produce extra inventory that is not currently needed, a large portion of that £100,000 is transferred out of the current income statement and into the inventory asset account. The resulting net profit figure on the income statement will look good because the expenses were deferred [Smith (1999), 417].
However, this temporary boost to reported earnings comes at the expense of long-term health [Johnson and Kaplan, 7]. The firm is spending cash to buy and store products that are not being sold, creating potential problems with obsolete stock, storage costs, and reduced cash flow [Smith (1999), 407, 415].
Throughput, Cash Flow, and the Economic Reality
The final two points explain why building inventory is a flawed goal and how to correctly measure a company's success.
The Real Goal: Throughput, Not Inventory
The action of building excess inventory, though rewarded by the accounting system, is not the true objective of a business:
Building excess inventory, an action driven by the accounting system, is not the goal; throughput is [Smith (1999), 400].
Throughput is defined as sales revenue minus truly variable costs (which often means raw materials and outside manufacturing costs) [Noreen, Smith, and Mackey (1995), 514; Smith (1999), 400, 439]. Products are not considered throughput until they are sold and shipped [Smith (1999), 400]. Pushing excess inventory into the supply chain that the market doesn't demand does not maximize profit; it only depletes cash [Smith (1999), 400, 408].
If a plant focuses on running at maximum efficiency to produce the least-cost unit, it will overproduce and create excess inventory, which increases cycle time and inventory costs without generating sales [Smith (1999), 382].
If a plant focuses on throughput, it runs at the pace of the constraint (the limiting resource), avoiding the costs, cash drain, and obsolescence risk associated with unnecessary inventory buildup [Smith (1999), 382].
For instance, companies implementing Just-in-Time (JIT) systems understand that work-in-process (WIP) inventories are a major operational liability and create operating problems that outweigh holding costs [Noreen, Smith, and Mackey (1995), 511, 517]. Therefore, a decision to build inventory for the sake of reported profit runs contrary to sound operational objectives [Noreen, Smith, and Mackey (1995), xxiv].
The True Reflection of Health: Cash Flow
The last statement provides the most reliable yardstick for measuring the company’s real health:
The truth of the company’s health is always reflected in the cash flow, which is distorted by inventory buildup decisions [Smith (1999), 400, 407].
Cash flow tracks the actual movement of money into and out of the business [Smith (1999), 400]. When management uses absorption costing to build up inventory, cash flows out of the business to pay for materials, labor, and overhead in the current period. However, the fixed expenses associated with that inventory are not recognized in the income statement until the product is finally sold (which may be months or years later) [Smith (1999), 416].
Because of this mechanism, expense reporting and the actual timing of cash outflows have little relationship to each other in financial accounting [Smith (1999), 416]. Reported income (or net profit) can look strong due to capitalized fixed costs, but the cash position may be deteriorating rapidly due to money tied up in inventory [Smith (1999), 407]. The use of throughput accounting (also known as direct costing) is preferred because it is closer to a cash flow concept of income and does not create the incentive to build unnecessary inventories [Noreen, Smith, and Mackey (1995), xxiv, 499].
The Overhead "Death Spiral"
When companies use full-absorption costing for pricing, losing a competitive bid leads to a loss of volume over which to spread fixed costs, resulting in an increase in the overhead rate for the remaining products [Smith (1999)].
This higher overhead rate makes the next bid even less competitive, forcing the elimination of more products, thus depleting the value of the division [Smith (1999)].
The Vicious Cycle: How Cost Accounting Can Destroy a Business
A perilous situation, often called the "death spiral," where a company's outdated accounting methods force it into a cycle of bad pricing, lost business, and shrinking profitability. This cycle is a direct consequence of using full-absorption costing for decisions like pricing and bidding [Johnson and Kaplan, 4, 121, 126; Smith (1999), 398].
The Loss of Volume and the Rising Overhead Rate
The problem begins when a company uses full-absorption costing—a method that requires fixed costs to be assigned to every unit produced—to set its prices in a competitive market [Smith (1999), 399].
When companies use full-absorption costing for pricing, losing a competitive bid leads to a loss of volume over which to spread fixed costs, resulting in an increase in the overhead rate for the remaining products [Smith (1999), 339, 417].
1. Full-Absorption Costing and Pricing
When a company calculates its selling price, a manager using traditional cost accounting will typically calculate the fully absorbed cost of the product (raw materials, labor, plus an assigned share of fixed overhead) and add a desired profit margin [Johnson and Kaplan, 4, 121, 234].
Fixed Costs (Overhead): These include large, unavoidable expenses like rent, plant depreciation, and salaries for supervisors, which remain constant regardless of whether the company produces 100 units or 1,000 units [Smith (1999), 403, 421].
The Overhead Rate: To assign these fixed costs to products, the total fixed costs are divided by an assumed production volume (often called the standard volume) to get a rate (e.g., £5 of overhead per unit) [Johnson and Kaplan, 106, 234].
2. Losing the Bid
In a competitive market, prices are often dictated by efficient producers [Johnson and Kaplan, 220]. If a company uses a high, fully absorbed cost to bid on a job, it often prices itself above the market and loses the bid [Johnson and Kaplan, 121; Smith (1999), 340]. The competitor, especially a smaller job shop, might be able to calculate its costs more accurately and submit a lower bid [Johnson and Kaplan, 121].
3. The Loss of Volume
When the bid is lost, the company loses the volume of product that would have been produced under that contract [Smith (1999), 340]. Crucially, the company does not get rid of the underlying fixed expenses, such as the rent or the salaries of the maintenance staff—these costs are sunk costs that cannot be changed by the day-to-day decision to lose the bid [Smith (1999), 422].
4. The Increase in the Overhead Rate
Since the overall fixed costs remain the same, but the expected total production volume has shrunk, the accounting system must recalculate the overhead allocation. Now, the large fixed costs must be spread over a smaller base of remaining products [Smith (1999), 340].
Example: A factory has £1,000,000 in fixed overhead. It expects to make 100,000 units. The overhead rate is £10 per unit. If it loses a contract for 10,000 units, the remaining 90,000 units must now absorb the £1,000,000 cost. The new overhead rate for all remaining products jumps to £11.11 per unit.
This increase in the overhead rate makes the remaining products appear more expensive [Smith (1999), 340].
The Death Spiral of Pricing and Elimination
The spiral gains speed because the initial distortion in the accounting system makes the company less competitive with every subsequent bidding decision, which is described in the second statement:
This higher overhead rate makes the next bid even less competitive, forcing the elimination of more products, thus depleting the value of the division [Smith (1999), 340].
1. Less Competitive Bids
Because the accounting system now reports a higher unit cost for all products (due to the increased overhead rate), managers will consequently set a higher minimum price for the next round of bids [Smith (1999), 340].
Example: A product previously cost £15 to make (including £10 overhead). After the first loss, the cost is now reported as £16.11 (including £11.11 overhead). The manager, forced to use this figure for pricing, submits a non-competitive bid, and the company loses another contract [Smith (1999), 340].
2. Forced Elimination of Products
As the company consistently loses bids, it sheds volume, which further inflates the overhead rate for the increasingly small base of remaining products [Smith (1999), 340]. Eventually, the reported costs of the company’s entire product line become so high that managers—who are often judged on local unit cost minimization—are forced to eliminate products that are incorrectly identified as "unprofitable" [Smith (1999), 436; Johnson and Kaplan, 178].
In the case of an aerospace division, new program costs and existing program costs increased dramatically when fixed costs were spread over a dwindling volume base [Smith (1999), 339]. The division routinely lost out on bids to smaller job shops not trapped in this death spiral of allocating higher and higher overhead rates [Smith (1999), 340].
3. Depleting the Value of the Division
This systematic process of losing volume and eliminating product lines, which is driven by an accounting flaw, ultimately depletes the value of the division [Smith (1999), 340]. The company finds itself managing smaller and smaller operations while still carrying a large portion of its original fixed costs, which it thought it was avoiding [Johnson and Kaplan, 175]. The company is caught in a predictable negative result where, in order to get new business, it must meet a competitive price, but to maintain margins, it must bid at a price that covers the constantly increasing overhead rate [Smith (1999), 340].
The ultimate irony is that the original, lower-volume products were only made to look unprofitable by the arbitrary cost assignment in the first place [Johnson and Kaplan, 177, 242]. The company, chasing accurate financial reports, makes decisions that compromise its economic health [Johnson and Kaplan, 7].
Analogy: The death spiral of full-absorption pricing is like a group of neighbors sharing the cost of a large security fence around their subdivision. The annual cost of the fence is fixed (the fixed overhead). The cost is spread evenly among the 100 residents. If 10 residents leave because the annual cost is too high, the remaining 90 residents must now each pay more to cover the same fixed cost. This higher price makes a few more neighbors leave, increasing the rate again for the remaining residents, until only a few people are left paying an enormous fee for a security fence they can no longer afford, depleting the value of the neighborhood for everyone.
Conflict and Subordination Failure
Maximizing local efficiencies (e.g., maximizing machine utilization of a non-constrained resource) drives dysfunctional behavior, resulting in long work-in-process inventories, increased costs, and increased cycle times [Smith (1999)].
The Purchasing Conflict: Rewarding purchasing managers for favorable purchase price variances (PPVs) encourages large volume buys and accepting substandard quality, which creates unfavorable usage variances, increased scrap rates, and lost throughput later in the plant (e.g., operations working overtime to cut out imperfections caused by cheap materials) [Smith (1999)].
The "Alligator's Teeth": The consequence of failing to provide relevant cost information is that managers who rely on the inadequate system unwittingly court trouble [Johnson and Kaplan].
The Trap of Local Efficiency and the Vicious Cycle of Overproduction
The first concept explains how traditional cost systems, by trying to make every single department look efficient, actually harm the overall company performance [Noreen, Smith, and Mackey (1995), 462]. This issue focuses on local optimization, meaning managers are attempting to maximize the performance of their small part of the organization in isolation, rather than looking at the big picture (the global goal) [Smith (1999), 251, 462].
Maximizing local efficiencies (e.g., maximizing machine utilization of a non-constrained resource) drives dysfunctional behavior, resulting in long work-in-process inventories, increased costs, and increased cycle times.
The Conflict of Goals
For a manager to be considered "good" under a traditional system, they are judged on two conflicting criteria: shipping products on time (a global goal) and minimizing unit product cost (a local goal) [Smith (1999), 311].
Shipping On Time (Global): Requires the entire factory to run at the pace of the slowest machine or process (the constraining resource). This necessary pacing action will result in low labor efficiencies at machines that are faster than the constraint, as those workers must slow down or wait for the constraint to catch up [Smith (1999), 312].
Minimizing Unit Cost (Local): Requires every machine and every worker to run at maximum efficiency and output [Smith (1999), 312; Noreen, Smith, and Mackey (1995), 507]. This pressure comes from reports that measure "units per man-hour" or utilization rates for every resource [Smith (1999), 284, 328, 360].
These two necessary criteria require opposite actions from managers [Smith (1999), 312].
The Dysfunctional Result: Inventory Buildup
Since managers are rewarded for high local output and utilization, they are driven to maximize production at their workstations. If a machine is not the constrained resource (meaning it is faster than the bottleneck), producing at maximum efficiency only results in problems for the rest of the factory [Smith (1999), 314, 366]:
Long Work-in-Process (WIP) Inventories: Any operation that out-paces the system's slowest resource (the constraint) simply adds to excess inventory without contributing anything to the total sales (throughput) of the company [Smith (1999), 314, 366]. This creates mountains of excess WIP that cannot be turned into salable output [Noreen, Smith, and Mackey (1995), 465, 507].
Increased Cycle Times and Costs: Excessive WIP clutters the shop floor, increases labor, storage, and handling expenses, lengthens the time it takes for a product to travel through the plant (cycle time), and decreases cash flow[Smith (1999), 312, 314, 362].
In short, maximizing output at non-constrained resources to generate favorable efficiency reports is dysfunctionalbecause it creates large WIP buffers and increases total operational costs, even if the individual department looks efficient [Smith (1999), 310, 314; Noreen, Smith, and Mackey (1995), 465]. Effort spent trying to improve the efficiency of a non-constrained resource is often wasted because it does not increase shippable product and provides no return on investment [Smith (1999), 247, 359].
The Purchasing Conflict and the Risk of Relying on Bad Data
The problems caused by flawed accounting measures extend beyond the manufacturing floor into strategic functions like procurement, leading to conflicts between departments.
The Purchasing Conflict
The purchasing department is typically measured on its ability to produce favorable raw materials purchase price variances (PPVs) [Smith (1999), 356, 318]. A favorable PPV means the purchasing manager acquired the material for less than the standard cost assigned to it [Smith (1999), 318].
The Purchasing Conflict: Rewarding purchasing managers for favorable purchase price variances (PPVs) encourages large volume buys and accepting substandard quality, which creates unfavorable usage variances, increased scrap rates, and lost throughput later in the plant (e.g., operations working overtime to cut out imperfections caused by cheap materials).
To maximize favorable PPVs, purchasing managers are encouraged to pursue two actions [Smith (1999), 357]:
Large Volume Buys: Buying in large lots to obtain quantity discounts [Smith (1999), 357].
Sacrificing Quality: Shopping for the lowest-cost vendor, which may result in accepting substandard quality or sacrificing supplier reliability [Smith (1999), 356, 357].
Example of Dysfunction: A purchasing manager might make a large-lot purchase of wood for a milling division at a very low price to generate a favorable PPV that is immediately recorded, boosting financial statements in the current month [Smith (1999), 318, 319]. However, the wood might be substandard, having twice the normal amount of knotholes [Smith (1999), 319].
For the next four months, the plant performance suffers [Smith (1999), 319]:
Operations incur unfavorable direct labor variances as workers spend time cutting out imperfections (often requiring expensive overtime) [Smith (1999), 319].
The raw material usage variance is unfavorable, and scrap rates are high [Smith (1999), 319].
The production bottleneck is starved, shipments are late, and throughput is lost [Smith (1999), 319].
In this scenario, the purchasing department succeeded on its local measure (PPV), while the plant failed on multiple measures, including scrap and on-time delivery. This conflict can even result in the purchasing manager being promoted while the plant manager is penalized or fired [Smith (1999), 319].
The Danger of Ignoring the Flaws
This consistent failure to provide relevant, global cost information leads to the final consequence:
The "Alligator's Teeth": The consequence of failing to provide relevant cost information is that managers who rely on the inadequate system unwittingly court trouble.
When management accounting systems are ineffective, they provide a "misleading target" for managers' attention and fail to provide measures that accurately reflect the competitive environment or the technology used by the organization [Johnson and Kaplan, 6].
Managers are put in a precarious position: they unwittingly court trouble if they fail to recognize that the system is inadequate and rely on it erroneously for managerial control information and product decisions [Johnson and Kaplan, 7]. The only positive outcome when a poor system prevails is when managers realize its irrelevance and bypass it entirely by developing their own personalized, often informal, information systems [Johnson and Kaplan, 7, 146].
The problem is that traditional cost accounting has been designed to meet the requirements of external financial reports, not to serve the operational and strategic needs of internal managers [Johnson and Kaplan, 3, 14]. Thus, managers are left navigating their complex organizations using data that encourages the pursuit of local, conflicting goals rather than overall financial health [Smith (1999), 240, 360].
發表文章
