the Obsolescence of Cost Accounting Systems part 2
II. The Fall: Cost Accounting and Relevance Lost (Post-1925)
A. The Shift from Cost Management to Cost Accounting
Stagnation and Dominance of Financial Reporting
After 1925, the pace of innovation stopped, in part due to the dominance of the external financial accounting statements during the twentieth century [Johnson and Kaplan].
With increased public ownership and capital market crises, the demand for audited financial statements grew [Johnson and Kaplan].
Auditors insisted on product costs based on historical transactions recorded in the firm’s ledgers [Johnson and Kaplan].
This explanation details the historical shift that caused management accounting systems to lose their effectiveness for internal decision-making, drawing on information from Relevance Lost: The Rise and Fall of Management Accounting.
The End of Innovation: When Accountants Stopped Running the Factory
By 1925, American industrial firms had already developed virtually every management accounting procedure used today, including budgets, standard costs, and measures like Return on Investment (ROI). These tools had been developed over a hundred years by managers and engineers who needed information about the efficiency and profitability of their internal operations.
However, after 1925, the pace of innovation in management accounting seemed to stop. The systems managers relied on failed to keep pace with the increasing diversity of products and complexity of manufacturing, eventually leading to problems like distorted product costs and inadequate control information.
The reasons for this stagnation involve a fundamental takeover of internal management practices by the rules and demands of external financial reporting.
The Dominance of External Financial Accounting
After 1925, the pace of innovation stopped, in part due to the dominance of the external financial accounting statements during the twentieth century [Johnson and Kaplan, 25].
In the 19th and early 20th centuries, management systems were independent and unencumbered by external demands. They were designed to help managers run the shop efficiently. But as the 20th century progressed, the outside world demanded better financial transparency, and this external need began to control the internal reporting systems.
The demand for public transparency was driven by key economic shifts:
With increased public ownership and capital market crises, the demand for audited financial statements grew [Johnson and Kaplan, 25].
When more of the public started owning shares in companies (public ownership) and when there were periodic crashes or crises in financial markets, investors and creditors became increasingly nervous. They needed assurance that the financial statements released by the company—showing income and assets—were accurate and trustworthy. This assurance came in the form of audited financial statements.
An audit means an independent party (the auditor) checks the company’s books to ensure they follow specific rules. Because auditors now had great influence, they favored "conservative accounting practices" based on verifiable and objective data. This professional preference fundamentally changed what kind of cost data was considered legitimate for the entire organization.
The Auditor’s Mandate: Historical Cost
The crucial step that derailed management accounting was the rule set by the auditors regarding how product costs were to be calculated:
Auditors insisted on product costs based on historical transactions recorded in the firm’s ledgers [Johnson and Kaplan, 25].
This rule meant that every cost assigned to a product—especially those held in inventory—had to be traceable back to the original, historic transaction (the price the company actually paid weeks or months ago for materials or labor).
In the period before 1925, managers used costs that were often closer to replacement cost (what it would cost to make the item today) for pricing and control decisions. But auditors needed historical costs to be sure the company was not "anticipating income" or paying dividends out of capital. They did this by ensuring costs were objective and conservative.
To achieve this, auditors insisted on "integration" (later called "articulation"). This meant that the cost accounts used internally had to be mathematically tied to the main financial records (the general ledger). The amount reported as profit (income statement) and the amount reported as inventory (balance sheet) had to be based on the same recorded historical transactions and events.
The Unintended Consequences
Because auditors only cared that the total inventory value was correct for external reporting, they often accepted simple methods to assign indirect costs (overhead) to products, such as allocating those costs based on total labor hours.
This insistence on integration and historical cost created a system that was excellent for external reporting but useless for internal decision-making:
Distortion: Allocating massive fixed overhead costs based on a small input like labor systematically distorted the true cost of individual products. For example, profitable work was often lost because the inaccurate costing system made bids too high for work that used little overhead.
Managerial Confusion: Managers began relying on these integrated inventory cost figures for strategic decisions, such as pricing, even though the information was "misleading and irrelevant" for that purpose. Inventory costing became the "only form of 'cost accounting'" in manufacturing firms.
Loss of Focus: The internal system, which had once focused on timely, physical efficiency and replacement cost, was completely co-opted to satisfy external rules, leading to the stagnation of innovation after 1925.
The tragic outcome was that the system designed to produce auditable reports caused managers to "manage by the numbers," relying on data compiled for outside interests instead of information relevant to the operations of the business.
The Integration of Accounts
Auditors demanded "integration" or "articulation"—meaning all amounts reported in financial statements had to be traceable to the original historical costs of recorded transactions [Johnson and Kaplan].
This integration was the genesis of modern inventory costing [Johnson and Kaplan].
The primary purpose of cost accounting shifted entirely to valuing inventory for financial reports [Johnson and Kaplan].
The single most important change in modern accounting history: the moment when the system managers used to run their factories became the system used to satisfy external investors.
This shift, which took place primarily after 1900, is known as "Relevance Lost" because the systems became less relevant for managers’ daily jobs [Johnson and Kaplan].
The Birth of Modern Cost Accounting: The Demand for Traceable Costs
In the 19th century, large companies kept their management system (for measuring internal efficiency) completely separate from their financial system (for tracking cash and debt) [Johnson and Kaplan, 24, 131].
For example, if a textile mill had unsold cloth at the end of the year (inventory), they usually valued that cloth in their external reports by using the market price—the price a competitor would charge for it [Johnson and Kaplan, 131, 186, 219]. They did not need to calculate the precise internal costs of every unit [Johnson and Kaplan, 24].
However, as more people bought shares in companies and as financial crises occurred, public trust became critical [Johnson and Kaplan, 23]. Investors and banks increasingly demanded that companies prove their financial reports were truthful and reliable. This led to the rise of independent auditors.
1. The Demand for "Integration"
The auditors needed rules to ensure that the reported financial numbers were not based on guesswork or manipulation. They preferred financial practices based on objective, verifiable, and realized financial transactions [Johnson and Kaplan, 23]. This led to the first major requirement:
Auditors demanded "integration" or "articulation"—meaning all amounts reported in financial statements had to be traceable to the original historical costs of recorded transactions [Johnson and Kaplan, 131, 187].
In simple terms, "integration" meant that the total value of all assets, expenses, and income reported in the final financial statements had to be mathematically tied back to the specific historical costs recorded in the company’s original financial ledgers [Johnson and Kaplan, 23, 187]. You couldn't use the market price for inventory if that price hadn't been recorded in the company’s books as an actual transaction [Johnson and Kaplan, 187].
The external reports—the Income Statement (showing profit) and the Balance Sheet (showing assets)—had to be based on the same recorded transactions and events [Johnson and Kaplan, 23]. If a company reported inventory (an asset on the Balance Sheet), that inventory’s value had to be derived from the specific historical costs the company originally paid for the materials, labor, and overhead that went into it [Johnson and Kaplan, 23, 187].
2. The Genesis of Modern Inventory Costing
This demand for integration forced a technical change in how internal costs were tracked:
This integration was the genesis of modern inventory costing [Johnson and Kaplan, 131, 187].
Since auditors refused to accept inventory valuations based on market prices, accountants needed a new bookkeeping procedure to ensure that every cost flowed correctly [Johnson and Kaplan, 185, 187].
This new procedure was inventory costing. It works by "attaching" total manufacturing costs (materials, labor, and overhead) to every single unit of product produced [Johnson and Kaplan, 185, 196]. The idea is that the "value of any commodity... passes over into the object or product for which the original item was expended and attaches to the result, giving it its value" [Johnson and Kaplan, 196].
Costs that are attached to finished units are called Inventory (an asset) [Johnson and Kaplan, 185].
Costs that are attached to units that were sold are called Cost of Goods Sold (an expense) [Johnson and Kaplan, 185].
This allowed auditors to verify that the value of the remaining inventory was conservative and traceable to actual money the company had spent historically [Johnson and Kaplan, 188].
3. The Shift in Purpose
Because maintaining two parallel systems (one for management and one for auditors) was too expensive given the technology of the time, companies generally decided to let the external reporting rules determine the design of their single cost system [Johnson and Kaplan, 24]. This led to the final, and most damaging, outcome for internal management:
The primary purpose of cost accounting shifted entirely to valuing inventory for financial reports [Johnson and Kaplan, 130, 183].
Cost accounting stopped being a specialized tool for managers and engineers to measure the efficiency of internal processes and became a routine bookkeeping procedure designed to satisfy outside groups like stockholders, tax authorities, and regulators [Johnson and Kaplan, 131, 183, 195].
When managers used this inventory cost information—which was designed merely to allocate historical costs between inventory and expense—to make strategic decisions like pricing or deciding which products to focus on, the numbers were often misleading and irrelevant [Johnson and Kaplan, 11, 177]. The internal accounting system had lost its original focus on efficiency and was now driven by the needs of external financial reporting [Johnson and Kaplan, 10, 195].
Managerial Compromise
Managers, facing the high cost of maintaining separate, relevant systems for management and external reports, often yielded the design of their cost management systems to financial accountants and auditors [Johnson and Kaplan].
The belief that the financial system could also serve management led to the use of inventory cost information, prepared for external purposes, for strategic management decisions [Johnson and Kaplan].
The history of management accounting reveals a critical moment, starting in the early 20th century, where companies sacrificed the usefulness of their internal systems to satisfy external requirements. This shift fundamentally altered the quality of information managers received and used, leading to widespread dysfunction in decision-making.
The High Cost of Integrity—Why Managers Gave Up Control
For nearly a hundred years, successful companies used internal management accounting systems designed exclusively to measure efficiency and profitability in their unique processes [Johnson and Kaplan, 4, 20]. These systems focused on providing relevant, timely information to managers who ran the factory floor or transportation networks [Johnson and Kaplan, 11, 21].
However, the world of business changed. With more people owning shares (public ownership) and a growing need for corporate transparency, outside auditors and regulators demanded strict, standard financial reports [Johnson and Kaplan, 24]. These auditors required a system of "integration" or "articulation," meaning that all figures reported publicly (like profit and inventory value) had to be mathematically traced back to the original historical costs recorded in the company's books [Johnson and Kaplan, 131, 169].
This is the context for the first statement:
Managers, facing the high cost of maintaining separate, relevant systems for management and external reports, often yielded the design of their cost management systems to financial accountants and auditors [Johnson and Kaplan, 25].
The Choice: Relevance vs. Compliance
Managers faced a difficult choice:
Option A (Relevance): Keep their specialized internal system (which used timely, current costs for pricing and operational decisions) AND create a second, parallel financial system (to satisfy the auditors with historical costs) [Johnson and Kaplan, 25].
Option B (Compliance): Merge the systems into one, focusing solely on the rules set by external financial accountants.
In the early 20th century, running two comprehensive sets of books was simply too expensive and impractical[Johnson and Kaplan, 25, 128]. Information technology was limited; they didn't have modern, powerful computers [Johnson and Kaplan, 260]. Collecting and processing accurate data for two separate systems would have been too high a cost [Johnson and Kaplan, 25].
Therefore, managers often "yielded"—they essentially surrendered control over the design of their internal cost system [Johnson and Kaplan, 25]. They let the financial accountants and auditors dictate the rules, prioritizing compliance with external reporting requirements (GAAP) over providing useful, relevant information for day-to-day internal control [Johnson and Kaplan, 25, 195].
The Consequence—Managing by Misleading Numbers
Once the cost system was yielded to financial accountants, its primary function shifted entirely [Johnson and Kaplan, 130]. It was no longer a tool for efficiency; its job was to calculate inventory value [Johnson and Kaplan, 167, 176].
This system, which was designed purely to satisfy external rules, became the only source of cost data used inside the company, leading to the second point:
The belief that the financial system could also serve management led to the use of inventory cost information, prepared for external purposes, for strategic management decisions [Johnson and Kaplan, 159, 160].
The False Belief and the Distortion
The false belief that emerged was that this single, auditor-approved system could somehow perform both jobs: satisfying external compliance and guiding internal strategy [Johnson and Kaplan, 159, 160].
The problem is that a system designed to correctly value total inventory for the balance sheet is fundamentally unfit for measuring the cost of individual products needed for management decisions (such as pricing or product mix) [Johnson and Kaplan, 9].
The financial system relies heavily on arbitrary allocation methods to assign indirect costs (overhead, like rent and depreciation) to products [Johnson and Kaplan, 9, 24]. Auditors typically accepted simplistic, easily verifiable methods, such as allocating all factory overhead based on the hours of direct labor used [Johnson and Kaplan, 173].
Example of Distortion (Cross-Subsidy): Imagine a factory that makes two products:
Product X: Requires lots of labor time, but uses little administrative support (low overhead demand).
Product Y: Requires minimal labor time, but uses high-tech, expensive machines and complex engineering support (high overhead demand).
If the cost system uses the traditional rule of allocating overhead based on direct labor hours, Product X will be assigned a huge chunk of the total overhead costs, making it look incredibly expensive and potentially unprofitable[Johnson and Kaplan, 9]. Meanwhile, Product Y, which uses almost no labor but causes massive overhead costs, will appear to be cheap and highly profitable [Johnson and Kaplan, 9].
When managers used this misleading and irrelevant "inventory cost information" for strategic decisions—like pricing or dropping a product line—they made severe errors [Johnson and Kaplan, 160]. They might lose profitable contracts because their "high-cost" product was over-priced, or they might aggressively push production of their "profitable" product, only to lose money because that product's true resource demands were hidden [Johnson and Kaplan, 9, 173].
The consequence was that managers, relying on numbers designed for external reporting, became isolated from the true, value-creating operations of the organization [Johnson and Kaplan, 11, 28]. This practice is pejoratively called "managing by the numbers" [Johnson and Kaplan, 126, 159].
The Academic Contribution to the Lost Relevance
University accounting education, shaped by the demand to train public accountants, focused almost entirely on the theory and problems of financial reporting [Johnson and Kaplan].
Academic writers perpetuated the idea that the cost accountant's chief activity was the postulate that "cost dollars, as incurred, attach like barnacles to the physical flow of materials" (the "costs attach" idea) [Johnson and Kaplan].
This educational focus ensured that people trained in accounting used financial accounting data as a major source of information for managerial decision-making, despite its irrelevance [Johnson and Kaplan].
Academic management accountants, more than auditors or managers, may have contributed to accounting's lost relevance for cost management, especially since World War II [Johnson and Kaplan].
The Lost Education: How University Teaching Made Accounting Irrelevant
The system used to train future business leaders and accountants led them to mistakenly prioritize external compliance over internal usefulness. This focus, driven by academic institutions, perpetuated flawed practices that continue to harm companies today.
1. Education Focused on External Compliance
The first point explains how the priorities of the professional world reshaped university curricula:
University accounting education, shaped by the demand to train public accountants, focused almost entirely on the theory and problems of financial reporting [Johnson and Kaplan, 134].
Before 1900, accounting was rarely taught in colleges [Johnson and Kaplan, 134]. As corporations grew, and especially after financial market crises, the need for audited financial statements skyrocketed [Johnson and Kaplan, 27]. This created a huge demand for trained Public Accountants (CPAs) [Johnson and Kaplan, 134, 147, 157].
As a result, university accounting departments restructured their teaching to satisfy this demand [Johnson and Kaplan, 134, 157]. The curriculum shifted almost entirely to teaching the theory and problems of financial reporting [Johnson and Kaplan, 134].
What does this mean?
Instead of teaching managers how to design systems to run a factory efficiently (the original goal of internal cost management), universities taught students how to adhere to the strict rules of Generally Accepted Accounting Principles (GAAP) [Johnson and Kaplan, 27, 134, 157]. These rules are designed to satisfy external parties—investors, banks, and the government—by ensuring that reported numbers are objective, verifiable, and consistent[Johnson and Kaplan, 27, 131, 152].
Consequently, people trained in accounting, many of whom went on to become senior executives in finance and accounting, were fundamentally educated in financial reporting, not in management accounting [Johnson and Kaplan, 134, 157-158].
2. The Flawed Idea Taught in Textbooks
The second and third points describe the central, flawed idea that academics promoted, which cemented the focus on external reporting:
Academic writers perpetuated the idea that the cost accountant's chief activity was the postulate that "cost dollars, as incurred, attach like barnacles to the physical flow of materials" (the "costs attach" idea) [Johnson and Kaplan, 135].
This educational focus ensured that people trained in accounting used financial accounting data as a major source of information for managerial decision-making, despite its irrelevance [Johnson and Kaplan, 134, 140, 158].
This "costs attach" idea suggests that as a product moves through a factory, all expenses—material, labor, and indirect costs (overhead)—automatically stick to it, much like barnacles clinging to the hull of a ship [Johnson and Kaplan, 135]. According to academic writers in the 1920s and 1930s, this process of attaching costs was the core duty of a cost accountant [Johnson and Kaplan, 135, 159].
Why was this idea perpetuated?
This concept was necessary to fulfill the auditor's demand for "integration"—the rule that inventory value reported on the balance sheet had to be traceable to the original historical transaction costs in the ledgers [Johnson and Kaplan, 131, 137, 151]. By teaching students that the main goal of cost accounting was to ensure that "all the expenditures which were incurred for production have been properly attached to the finished products which were sold," academics reinforced the idea that cost accounting's purpose was to calculate cost of goods sold for financial reports [Johnson and Kaplan, 136, 160].
The disastrous outcome:
Since students were taught that the financial reporting system contained the official "product cost" (the cost with all barnacles attached), they naturally used this figure for internal managerial decision-making, such as pricing, even though the data was often misleading and irrelevant [Johnson and Kaplan, 134, 140, 158].
For instance, this integrated system often used arbitrary rules (like allocating fixed factory overhead based on labor hours) to attach costs [Johnson and Kaplan, 155]. This figure was acceptable for external auditors, but it was disastrously inaccurate for management. Managers using these numbers might incorrectly conclude that a high-volume product was unprofitable because it was unfairly allocated too much overhead, leading to "misguided decisions on product pricing, product sourcing, and product mix" [Johnson and Kaplan, 11, 12, 160].
3. The Academic Responsibility
The final point assigns significant blame for this enduring problem:
Academic management accountants, more than auditors or managers, may have contributed to accounting's lost relevance for cost management, especially since World War II [Johnson and Kaplan, 145].
While external auditors created the rule of integration, and managers yielded to the high cost of maintaining two systems, it was the academics who failed to correct the fundamental flaws in the system for decades [Johnson and Kaplan, 134, 137, 145].
How Academics Contributed to the Loss of Relevance:
Failure to Study Reality: Academic writers primarily focused on elegant, sophisticated cost analysis models based on simplified settings (like a single-product firm) borrowed from economic theory [Johnson and Kaplan, 15, 170, 177]. These simplified models completely ignored the complexity and diversity found in real companies and had little relationship to the actual problems managers faced [Johnson and Kaplan, 15, 170].
Reinforcing the Flaw: Even when academics did write about management accounting after World War II, they did not challenge the fundamental financial reporting view of cost accounting [Johnson and Kaplan, 139, 165]. They accepted that cost accounting's role was inventory valuation and instead tried to make the already flawed financial accounting information more useful for management decisions—instead of designing separate, relevant systems [Johnson and Kaplan, 139, 165].
The Perpetuation of History: Cost and managerial accounting textbooks published by academics as late as the 1980s continued to teach the false history that cost accounting was invented primarily to calculate inventory cost for financial reporting [Johnson and Kaplan, 140-141, 169-172].
By doing this, the academic community failed to sustain the "spirit and knowledge of management accounting systems design" that had existed before 1925, ensuring that new generations of managers and accountants continued to rely on irrelevant data [Johnson and Kaplan, 134, 145].
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