the Obsolescence of Cost Accounting Systems part 5
V. Why Traditional Fixes Fail (Critique of ABC/Traditional Methods)
A. The Limits of Rearranging Costs
Activity-Based Costing (ABC) is Insufficient
Concepts like Activity-Based Costing (ABC) and others evolved to answer the deficiencies of absorption unit costing [Smith (1999)].
However, ABC has failed to integrate or prove compatible with major improvement mechanisms like Just-in-Time, Total Quality Management, or the Theory of Constraints at a global level [Smith (1999)].
ABC promotes local optimization and results in conflicting actions between departments [Smith (1999)].
The major flaw is that ABC and similar costing models, as routinely implemented, ignore the impact of the scarce resource (the constraint) [Smith (1999)].
The Evolution and Failure of Activity-Based Costing (ABC)
The first point, a, explains why modern management thinkers needed to move beyond the traditional system of absorption unit costing (also known as full-absorption costing) [Smith (1999), 226].
Concepts like Activity-Based Costing (ABC) and others evolved to answer the deficiencies of absorption unit costing [Smith (1999)].
Traditional absorption costing systems were often considered misleading and irrelevant for making strategic product decisions [Johnson and Kaplan, 71, 77]. They spread large, indirect costs (overhead) using simple, arbitrary measures like direct labor, which systematically biased and distorted the reported costs of individual products [Johnson and Kaplan, 6, 227].
ABC was developed alongside other concepts, such as Activity-Based Management (ABM) and economic value management, specifically to overcome these failings and provide better information for management decision-making [Smith (1999), 226]. ABC attempted to trace costs more accurately by identifying the specific activities that consumed resources (e.g., machine setups, inspections, or engineering changes) rather than relying solely on volume-based measures like direct labor hours [Johnson and Kaplan, 75, 176].
The Failure to Integrate
Despite being designed to improve cost accuracy, ABC has not been able to successfully align with major modern operational philosophies at a global level:
However, ABC has failed to integrate or prove compatible with major improvement mechanisms like Just-in-Time, Total Quality Management, or the Theory of Constraints at a global level [Smith (1999), 226].
ABC aims to give managers accurate cost data, but it does not effectively support breakthrough improvement programs like Total Quality Management (TQM), Statistical Process Control (SPC), Just-in-Time (JIT), or the Theory of Constraints (TOC) [Smith (1999), 226].
This failure stems from the next major flaw: ABC focuses too narrowly on optimizing small parts of the business instead of maximizing the success of the entire system.
Promoting Local Focus and Conflict
ABC inherits a core problem from the outdated systems it sought to replace—it encourages managers to optimize their local areas, even if that hurts the company as a whole:
ABC promotes local optimization and results in conflicting actions between departments [Smith (1999), 226].
As commonly implemented, ABC creates local optimization, meaning managers focus on making their department or cost centre look as good as possible, regardless of the overall impact [Smith (1999), 226]. This is similar to the dysfunctional behaviour driven by traditional standard cost systems, where the focus is on local resource efficiency [Smith (1999), 222].
This system creates conflict by setting cost centres in competition for resources and resulting in conflicting actions between departments [Smith (1999), 226]. The focus remains on cost minimization, which conflicts with the goal of maximizing throughput (sales revenue minus truly variable costs) for the entire company [Noreen, Smith, and Mackey (1995), 457; Smith (1999), 233].
The Core Flaw of Ignoring Scarcity
The most significant technical flaw of ABC, which prevents its compatibility with TOC and other global management systems, is its neglect of the most important operational reality: scarcity.
The major flaw is that ABC and similar costing models, as routinely implemented, ignore the impact of the scarce resource (the constraint) [Smith (1999), 226].
The Theory of Constraints (TOC) asserts that every business system is limited by at least one constraint (a scarce resource) [Smith (1999), 306]. This constraint determines the total output and the rate of profit the entire company can achieve [Smith (1999), 306].
ABC fails to incorporate this reality into its calculations and decision models [Smith (1999), 226, 421]. This means that even with detailed activity data, the costing model cannot help managers prioritize decisions based on where they will leverage the highest return for the overall company [Noreen, Smith, and Mackey (1995), 476; Smith (1999), 225].
ABC’s Flawed Cost Assumption
The difference in strategy between ABC and TOC is rooted in a difference in fundamental assumptions about how costs behave [Noreen, Smith, and Mackey (1995), 563]:
ABC Assumption: In the usual ABC implementation, it is assumed that all costs are variable in the sense that they are strictly proportional to activity (e.g., strictly proportional to the number of batches, parts, or activities used as an allocation basis) [Noreen, Smith, and Mackey (1995), 564].
TOC Assumption: TOC assumes that almost all costs other than materials are fixed—meaning they will not ordinarily increase solely due to a short-term increase in the volume of output [Noreen, Smith, and Mackey (1995), 564].
If ABC views all costs as variable and proportional to activity, it encourages managers to minimize the activity cost per unit, even if that activity occurs at a non-constrained resource.
Consequences: Misguided Strategy and Product Mix
By ignoring the constraint and promoting activity-based unit cost minimization, ABC can lead to strategic decisions that are detrimental to the firm's profitability, especially regarding product mix:
Example: Low-Volume Products The complexity of ABC can cause it to shift overhead costs to low-volume productsbased on the transactions they generate (e.g., lots of engineering support or setups) [Noreen, Smith, and Mackey (1995), 562]. These low-volume products then appear less profitable, sometimes prompting managers to drop them [Noreen, Smith, and Mackey (1995), 562].
However, if those low-volume products use non-constrained resources (machines with excess capacity), they contribute profit without hindering the system's output. Dropping them based on their high reported ABC unit cost leads to the loss of incremental cash flow, leaving the company with the same fixed costs it thought it was avoiding [Noreen, Smith, and Mackey (1995), 473].
TOC, in contrast, uses the contribution margin per unit of the constrained resource to prioritize products, encouraging product diversity if the new products have positive throughput and do not consume time on the constraint [Noreen, Smith, and Mackey (1995), 471, 473]. Thus, ABC and TOC can have opposite effects on the variety of products a company offers [Noreen, Smith, and Mackey (1995), 563].
In summary, ABC is a tool designed to count and measure cost activities more accurately, but because it fails to incorporate the reality of the constraint, it provides information that is irrelevant and often contradictory to the actual goal of maximizing profitability [Smith (1999), 235]. It is like meticulously measuring every calorie consumed in a meal (accurate cost tracing) but ignoring whether the person eating the meal is starving or overfed (ignoring the constraint) before offering health advice.
Failure to Target the Root Cause
The problems are more behavioral and systemic than technical [Smith (1999)]. The goal is not merely "rearranging the costs" but aligning measures, work practices, and reporting to reinforce the behavior a company is seeking [Smith (1999)].
The use of sophisticated electronic technology and software to devise new systems only removes the technical barriers; it does not address the underlying conceptual flaws [Johnson and Kaplan].
Managers do not have any methodology to control costs other than the existing standard cost data, and they lack the training or methodology to tackle redesigning their system to emphasize management information [Smith (1999)].
This explanation addresses why reforming a company’s internal accounting system is not merely a technical task for IT professionals or accountants, but a deep challenge involving the psychology and structure of the entire organization.
The Conceptual Flaw—Why Technology Cannot Fix the Problem
The problems inherent in modern corporate accounting systems are fundamentally rooted in human behavior and organizational structure, rather than mechanical errors in calculation [Smith (1999), 289].
The Technical vs. Conceptual Conflict
Decades ago, when computers first entered the factory and accounting departments, designers simply automated the manual or mechanical cost systems they found there, with few changes to the underlying logic [Johnson and Kaplan, 172, 183].
The critical error was failing to recognize the difference between technical difficulty and conceptual relevance:
The use of sophisticated electronic technology and software to devise new systems only removes the technical barriers; it does not address the underlying conceptual flaws [Johnson and Kaplan, 10, 204].
In the past, detailed cost tracing procedures, such as those advocated by early 20th-century engineers, were often deemed too costly or infeasible to maintain alongside the ledgers needed for financial reporting [Johnson and Kaplan, 17, 104]. Today, the "enormous expansion in computing capabilities" and the constant reduction in information processing costs mean that all technical barriers to the design and implementation of effective management accounting systems have been removed [Johnson and Kaplan, 9, 10].
However, the core issue remains the conceptual flaw of designing internal measurement systems to satisfy external financial reporting requirements, such as valuing inventory (absorption costing), rather than providing relevant information for internal managers [Johnson and Kaplan, 16, 102, 186]. Even though modern software can calculate inventory values to five or six significant digits, it is still based on arbitrary rules that make the numbers useless or misleading for management [Johnson and Kaplan, 175, 176].
The True Goal: Aligning Measures and Behavior
Because the technical tools are now available, the focus must shift entirely from "rearranging the costs" to fixing the human system:
The goal is not merely "rearranging the costs" but aligning measures, work practices, and reporting to reinforce the behavior a company is seeking [Smith (1999), 289].
The behavioral implications of management accounting are extremely important, "and in all significant respects, more important than rearranging the costs" [Smith (1999), 289].
The goal is to design a system that encourages local actions that are consistent with the company's ultimate goal: maximizing throughput and profitability [Smith (1999), 276]. When measures and goals are not aligned, it creates chronic conflicts and dysfunction across the organization [Smith (1999), 276].
Example of Misalignment: If a manager's bonus is based on maximizing their local machine utilization (a local measure), they will run the machine at full speed, even if the plant's true bottleneck (the constraint) is slower [Smith (1999), 286, 379]. This action builds up long queues of unnecessary Work-In-Process (WIP) inventory, increasing costs and cycle times. The manager is acting to maximize their individual measure, but this behavior is dysfunctional because it compromises the global goal of maximizing total company throughput and cash flow [Smith (1999), 286, 362]. If management does not define the appropriate metrics, individuals will create their own, based on their local perception of good performance [Smith (1999), 281, 379].
The Practical Barrier—The Lack of Methodology and Training
If the problems are systemic and the technology exists to fix them, why do managers continue to rely on obsolete, dysfunctional systems? The final concepts explain the training and methodology gap that sustains the problem.
Relying on Flawed Standard Cost Data
Managers are trapped by the inertia of the current system because they lack practical alternatives:
Managers do not have any methodology to control costs other than the existing standard cost data, and they lack the training or methodology to tackle redesigning their system to emphasize management information [Smith (1999), 292, 374].
There is a powerful and ingrained belief, often erroneous, that the information generated by the existing standard cost system is necessary to control costs [Smith (1999), 292]. Consequently, when managers need to make major decisions (such as product pricing, capital investment, or product emphasis), they commonly resort to the standard cost information, rather than focusing on incremental cash flow or the system's constraint [Smith (1999), 344].
This reliance persists because managers have been taught to interpret and use these numbers: business and engineering education often teaches students to make management decisions using financial statement information [Smith (1999), 291].
The Knowledge and Training Gap
The problem is further complicated by a lack of communication and specific expertise among different company functions:
Accountants Lack Operational Knowledge: Accounting is a technical field [Smith (1999), 291]. The accountants who provide the cost information often do not understand the consequences to global operations of focusing on the local optimization measures they calculate [Smith (1999), 291].
Operations Managers Lack Technical Methodology: Operations managers cannot effectively verbalize the negative consequences of their actions using the cost information provided to them [Smith (1999), 291]. They understand the conflict intuitively but cannot break it down into logical, communicable connections [Smith (1999), 362].
As a result, many accountants lack the training or methodology to tackle redesigning their accounting system to emphasize management information rather than simply generating financial statements [Smith (1999), 292].
The Theory of Constraints (TOC) addresses this gap by providing a repeatable, logical system (the Thinking Process) that identifies the root cause of conflicts and defines the criteria for relevant information based on the organization’s constraint (or scarce resource) [Smith (1999), 283, 294, 351]. Without such a framework, managers are left with no practical alternative to the inadequate standard cost data they already possess [Smith (1999), 292, 381].
Analogy: The situation is like upgrading a car’s dashboard with a modern digital display (removing the technical barrier), but the gauges are still showing readings that punish the driver for following the map (the misaligned incentives). Because the driver was never trained to read a different map or understand how the engine truly works (lacking methodology/training), they continue to follow the faulty old gauges, even though it consistently sends them in the wrong direction. The fix isn't the screen; it's redesigning the information and retraining the driver to use it for the actual goal of reaching the destination.
The Unfixable Disconnect
The fundamental issue is the continued assumption that the accounting system must provide fully absorbed cost for inventory valuation and real-time decision-making [Smith (1999)].
This results in cost information that is too slow and too aggregated for operational control, while simultaneously being inaccurate for product costing due to arbitrary allocations [Johnson and Kaplan].
The simple truth remains: The existence of a limiting factor changes what is considered relevant information [Smith (1999)]. Traditional methods fail because they do not change this premise.
The Core Flaw—Demanding One System to Do Two Conflicting Jobs
The fundamental issue in modern management accounting is that companies rely on a single, integrated accounting system to fulfill two completely different and often contradictory purposes: satisfying external reporting rules and guiding internal management decisions [Smith (1999), 360; Johnson and Kaplan, 19, 137, 145].
The fundamental issue is the continued assumption that the accounting system must provide fully absorbed cost for inventory valuation and real-time decision-making [Smith (1999), 360, 404].
The Origin of the Conflict: Inventory Valuation
The initial purpose of cost accounting (which produces data on product costs) was to help managers control the conversion of raw materials into finished goods [Johnson and Kaplan, 27, 39, 131, 137]. However, after the early 1900s, this internal focus shifted [Johnson and Kaplan, 126, 135]. As corporations began issuing public securities, auditors and regulators required that internal accounting procedures be consistent with external financial reporting rules (Generally Accepted Accounting Principles or GAAP) [Johnson and Kaplan, 130, 131, 198].
GAAP requires that manufacturing costs be "fully absorbed" (allocated) to products for the purpose of inventory valuation on the balance sheet and for calculating the cost of goods sold on the income statement [Smith (1999), 404, 407; Johnson and Kaplan, 130, 159, 193]. This means that the system must calculate a single, official unit cost that includes all manufacturing costs (materials, labor, and fixed overhead) [Smith (1999), 416].
For financial purposes, this practice ensures that the cost figures are objective and auditable [Johnson and Kaplan, 13, 132, 134]. It does not matter to external auditors if the final cost figure is distorted for individual products, so long as the total value recorded in the inventory accounts is correctly integrated with the firm’s historical ledgers [Johnson and Kaplan, 130].
The Unreliable Result for Managers
When this integrated system is used for internal decisions, it becomes useless because the numbers are flawed in two ways:
This results in cost information that is too slow and too aggregated for operational control, while simultaneously being inaccurate for product costing due to arbitrary allocations [Johnson and Kaplan, 13, 17, 194, 218].
1. Too Slow and Aggregated for Operational Control: The financial reporting cycle generally operates monthly or quarterly [Johnson and Kaplan, 13, 175, 194]. When managers need information for short-term control of processes (like monitoring labor efficiency, quality, or machine utilization), they need data hourly or daily [Johnson and Kaplan, 194, 230].
The aggregated cost reports arrive too late and at too high a level (e.g., division or plant level) to help a manager pinpoint the immediate source of an adverse production problem on the factory floor [Johnson and Kaplan, 175, 176]. The operational actions for control occur daily, but the cost information arrives weekly or monthly [Johnson and Kaplan, 194].
2. Inaccurate for Product Costing (Arbitrary Allocation): The core inaccuracy comes from the arbitrary allocation of overhead [Johnson and Kaplan, 176, 188]. Large, fixed overhead costs (like rent or depreciation) are distributed to products using simple and arbitrary bases, usually direct labor hours [Johnson and Kaplan, 132, 188, 192]. This method systematically biases the costs of individual products, making them inaccurate for pricing or product mix decisions [Johnson and Kaplan, 13, 176, 204].
For example, a product that is simple to make (low overhead consumption) but uses lots of labor might appear artificially expensive because it is arbitrarily assigned a huge portion of the fixed overhead based on those labor hours (cross-subsidy) [Johnson and Kaplan, 177, 232]. This inaccurate data leads to misguided decisions on pricing and product mix [Johnson and Kaplan, 13, 234].
The Constraining Resource and Relevant Information
The continued failure of traditional cost accounting lies in its inability to adjust its core premise when faced with the operational reality of scarcity.
The simple truth remains: The existence of a limiting factor changes what is considered relevant information [Smith (1999), 254, 316, 317]. Traditional methods fail because they do not change this premise [Smith (1999), 239, 314].
The Role of the Limiting Factor
A limiting factor or constraining resource is the machine, person, or market capacity that determines the rate at which the entire company can generate profit [Smith (1999), 254, 314, 381]. Every dependent system, whether internal or external, has such a limiting factor [Smith (1999), 417].
The concept of relevant information in management accounting is defined as the predicted future costs and revenues that will actually differ among alternative actions [Smith (1999), 254, 316]. When a limiting factor exists, the existence of that factor fundamentally changes the assumptions behind relevant costing [Smith (1999), 254, 316].
Example: Suppose a company has an internal machine that is a bottleneck (the limiting factor) and is fully booked for the next month. A manager is deciding which of two products to emphasize:
Traditional Method: Looks at the overall gross margin of Product A (£10) versus Product B (£8) and would push Product A [Smith (1999), 314, 415].
Constrained Resource View (Relevant Information): Recognizes that the bottleneck time is the scarce resource and asks: which product generates the most contribution margin per minute of bottleneck time [Smith (1999), 314, 381]?
If Product A takes 2 minutes on the bottleneck (£5 per minute), and Product B takes 1 minute on the bottleneck (£8 per minute), Product B is the only logical choice to maximize total profit [Smith (1999), 381].
The Failure to Change the Premise
Traditional methods fail because they do not change their premise when a constraint is present [Smith (1999), 239, 314]. The fully absorbed unit cost generated for financial reporting is irrelevant because it includes sunk costs that cannot be changed by today's decisions and it ignores the constraints that determine the highest return on investment [Smith (1999), 317].
The simple truth is that management accounting should guide managers toward maximizing profit by exploiting the scarce resource [Smith (1999), 253, 314, 380]. Because traditional methods prioritize fully absorbed cost for inventory valuation, they inherently fail to recognize that the core issue in management is maximizing the contribution margin per unit of the scarce resource [Smith (1999), 317, 381; Noreen, Smith, and Mackey (1995), xxv, 483].
In Conclusion: Asking the traditional cost accounting system to simultaneously provide fully absorbed costs for external reporting and relevant decision data for internal management is like trying to use a financial history book to guide a space shuttle launch. The book may be perfectly accurate about past expenditures, but it is too slow, aggregated, and focused on irrelevant historical costs (arbitrary allocations) to help the pilot make a critical, real-time decision about where to steer or which part of the system is limiting maximum performance.
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