the Obsolescence of Cost Accounting Systems part 8
VIII: The Measurement Nightmare and Behavioral Dysfunction
This topic addresses the CPA’s professional role as a manager of information systems and internal controls. It argues that the system the CPA manages actively causes conflict and encourages bad behavior that harms cash flow.
Conflict Creation: Cost accounting measures create deep, chronic conflict because people are rewarded for local optimization (e.g., maximizing machine utilization or labor efficiency) which is detrimental to the global goal (throughput and ROI) [Smith (1999), 210, 221, 263, 293, 328]. This forces intelligent, hardworking people into illogical actions and compromises [Smith (1999), 240, 274, 294].
The Vicious Trap of Local Cost Measures
The core issue is that management accounting systems often fail to align with a company’s overall success, creating profound friction inside the business [Smith (1999), 221, 263].
Cost accounting measures create deep, chronic conflict because people are rewarded for local optimization (e.g., maximizing machine utilization or labor efficiency) which is detrimental to the global goal (throughput and ROI).
Local Optimization vs. The Global Goal
This conflict arises because traditional internal cost systems focus too narrowly on measuring the performance of individual departments or machines in isolation, which is known as local optimization [Smith (1999), 221, 243, 367].
In any organization, people want to do a good job and will naturally try to maximize their performance based on the specific measure given to them [Smith (1999), 244, 251, 367]. If a manager’s pay or evaluation is tied to maximizing output per man-hour (labor efficiency) or making sure a machine is running 100% of the time (machine utilization), they are driven to maximize that local measure [Smith (1999), 285, 367].
The problem is that maximizing every local area does not automatically lead to maximum results for the company as a whole. The company’s global goal is to maximize Throughput (the rate at which money is generated through sales) and Return on Investment (ROI) [Smith (1999), 263, 328, 371; Noreen, Smith, and Mackey (1995), 470, 454].
When local measures conflict with what is necessary to optimize global performance, the employee is faced with an immediate conflict [Smith (1999), 251]. This misalignment creates deep, chronic conflict across the organization [Smith (1999), 210, 221, 263, 369].
The Chronic Conflict in Production
A production manager, for example, is typically evaluated on two conflicting goals [Smith (1999), 311]:
Shipping On Time (The Global Goal): This requires the entire plant to run at the pace of the slowest machine (the constraint). If a machine is faster than the constraint, its workers must slow down, resulting in low labor efficiencies in that local department [Smith (1999), 311, 312].
Minimizing Unit Cost (The Local Goal): This requires all resources to operate at maximum output and maximum efficiency to produce the least-cost unit [Smith (1999), 311, 312].
These two necessary criteria require opposite actions [Smith (1999), 312]. Managers are forced to constantly battle symptoms with very little results because they are caught in chronic conflicts they cannot accurately define or solve [Smith (1999), 318, 328]. This situation leads to total chaos on the manufacturing floor [Smith (1999), 318].
Illogical Actions and Costly Compromises
When companies reward managers based on these conflicting local measures, even intelligent and hardworking employees are forced into actions that defy common sense and harm overall profitability [Smith (1999), 240, 271, 294, 318].
This forces intelligent, hardworking people into illogical actions and compromises.
Example 1: The Inventory Trap (WIP Buildup)
If a production area that is not the plant's constraint runs at maximum efficiency to achieve a favorable utilization report, the result is detrimental to the whole company [Smith (1999), 314, 367]:
Illogical Action: The manager produces huge volumes of product [Smith (1999), 312].
Detrimental Result: Any operation that out-paces the system's true limiting resource (the constraint) only adds to excess work-in-process (WIP) inventory on the floor [Smith (1999), 312, 314]. This excess WIP increases cycle time, adds unnecessary storage and handling expenses, and decreases cash flow [Smith (1999), 312, 314, 370]. Building inventory is not the goal; throughput (sales) is [Smith (1999), 345].
The manager succeeds on their local measure (efficiency), but harms the global measure (ROI, cycle time, and throughput) [Smith (1999), 297, 314, 370].
Example 2: Sabotaging the Bottleneck
One of the most illogical outcomes occurs when management tries to apply local efficiency measures directly to the scarce resource (the constraint):
Illogical Action: A division vice president mandates increasing "units per man-hour" by cutting direct labor at the looms, which are known to be the constraint [Smith (1999), 285, 286].
Detrimental Result: This action decreases total output (throughput) of the looms and the entire plant [Smith (1999), 287]. It causes machine downtime to increase substantially, shipments to drop, and on-time delivery to deteriorate [Smith (1999), 287]. Despite the measure "units per man-hour" showing improved local performance, the plant experiences dramatically deteriorating net profit and faces possible closure [Smith (1999), 287, 288]. The company chose a measure to exploit labor input rather than exploiting the high-cost machine investment [Smith (1999), 289].
In this scenario, managers believed the negative effects they saw were tied to the staffing decision but were unable to communicate the logical connections clearly to corporate leaders [Smith (1999), 288]. This systemic failure forces highly capable people into unsatisfactory compromises as they try to manage competing, multiple objectives [Smith (1999), 240, 300, 316, 318].
The overall conflict means that intelligent employees intuitively understand that maximizing the output of their local area conflicts with what makes sense to move product through the plant [Smith (1999), 337]. This confusion and lack of logical connection is one easy way to block throughput and make less money [Smith (1999), 318].
Analogy: The situation is like a team playing basketball where each player is rewarded only for holding the ball for the longest possible time (local efficiency). Every player tries to hoard the ball, maximizing their individual metric, but the team will never score a point (zero throughput) because they cannot pass the ball to the final player (the constraint) fast enough, leading to constant conflict over possession and guaranteed failure of the team's global goal (winning the game).
Negative Feedback Loops: Illustrate the devastating effect-cause-effect relationships that managers cannot easily trace [Smith (1999), 279]:
A purchasing manager creating a favorable variance (local profit) by buying cheap, substandard material results in unfavorable usage variances, increased scrap, overtime, and lost throughput downstream, ultimately firing the wrong manager [Smith (1999), 277, 278].
Using short-term ROI measures compels managers to reduce discretionary investments in R&D, maintenance, and training to meet profit goals, thereby compromising the long-term economic health of the firm [Johnson and Kaplan, 8, 9, 150, 160].
The Devastating Untraceable Chain of Conflict
The sources illustrate how common financial measurements encourage managers to make decisions that look good locally but create a cascading series of negative, costly effects throughout the rest of the company, which often go unnoticed or are blamed on the wrong people [Smith (1999), 277, 279, 363].
The Purchasing Manager’s Favorable Variance
This example demonstrates how optimizing one small part of the system—the purchasing department—can lead to disaster for the overall organization:
A purchasing manager creating a favorable variance (local profit) by buying cheap, substandard material results in unfavorable usage variances, increased scrap, overtime, and lost throughput downstream, ultimately firing the wrong manager [Smith (1999), 277, 278, 363].
The Action (Local Optimization): Purchasing managers are typically measured on their ability to generate favorable purchase price variances [Smith (1999), 330, 362, 396]. A favorable variance means buying materials for less than the standard cost assigned [Smith (1999), 362, 395]. To achieve this, the manager may buy in large lots or shop for the low-cost vendor, sometimes resulting in sacrifices in supplier reliability or quality of material [Smith (1999), 396, 397].
In one example, a purchasing manager bought a large lot of wood for a milling division that had a very large favorable variance. In accordance with GAAP, this entire favourable variance was recorded in the financial statements in the month of purchase, making the purchasing department look financially successful [Smith (1999), 362, 363].
The Effect-Cause-Effect Cascade (Global Dysfunction): The wood purchased, however, was substandard (it had twice the "normal" amount of knotholes) [Smith (1999), 363]. The negative effects then spread downstream through the production chain:
Usage and Labor Variances: Operations had to spend extra time cutting out the knotholes, leading to unfavorable direct labor usage and rate variances due to increased overtime [Smith (1999), 363].
Scrap and Delay: The raw material usage variance became unfavorable, and scrap rates were high [Smith (1999), 363]. Slowdowns and delays were passed to every station in the plant [Smith (1999), 363].
Lost Throughput: The bottleneck was starved, and subsequent operations worked overtime just to catch up [Smith (1999), 363]. Shipments were late, and on-time delivery performance deteriorated, leading to lost throughput and potential market loss [Smith (1999), 363].
The Illogical Conclusion: The negative variances (overtime, increased scrap, etc.) were ultimately passed on to the operations managers’ measures [Smith (1999), 363]. The purchasing manager, who generated the initial "local profit," may be rewarded or promoted, while the plant manager, who was dealing with the catastrophic consequences of the poor material, is blamed or fired [Smith (1999), 278, 363].
The irony is that costs that were intended to be controlled by generating a favourable variance were simply increased through waste and decreased ROI [Smith (1999), 397, 402]. Without a methodology like the Theory of Constraints (TOC), the organization cannot easily make the effect-cause-effect link between the purchasing decision and the ultimate downstream chaos [Smith (1999), 279, 364].
Compromising Long-Term Health for Short-Term Profit
The second critical problem arises from the intense pressure on managers to achieve immediate, short-term financial targets, often measured using Return on Investment (ROI). This focus sacrifices the long-term health of the business [Johnson and Kaplan, 6, 7].
Using short-term ROI measures compels managers to reduce discretionary investments in R&D, maintenance, and training to meet profit goals, thereby compromising the long-term economic health of the firm [Johnson and Kaplan, 8, 9, 150, 160].
The Short-Term Horizon Problem
Driven by the monthly cycle of the profit and loss statement, managers' perspectives tend to contract to the short term [Johnson and Kaplan, 6]. When management accounting systems focus narrowly on producing monthly earnings reports, they provide a misleading target for managerial attention [Johnson and Kaplan, 7].
The financial accounting system often treats many cash outlays as expenses of the period in which they are made, even if those outlays will benefit future periods [Johnson and Kaplan, 6, 207]. These discretionary investments—spending on future growth—include [Johnson and Kaplan, 6, 207]:
Research and Development (R&D) for new products and processes.
Preventive maintenance for machinery.
Employee training and skill development (human capital).
Long-term marketing positioning and promotion.
The Action (Meeting the Target): Managers who are under pressure to meet aggressive short-term profit and ROI goals can compromise the long-term health of the firm by reducing their spending on these discretionary investments [Johnson and Kaplan, 6, 201, 207, 204]. When sluggish sales or escalating costs make near-term profit targets hard to achieve, managers often cut these expenditures to prop up short-term earnings [Johnson and Kaplan, 201].
The Illogical Outcome (The Long-Term Damage): The financial statements, using practices mandated for external reporting, can signal increased profits even as the long-term economic health of the firm is compromised [Johnson and Kaplan, 7].
This phenomenon is possible due to a fundamental flaw in the financial accounting model [Johnson and Kaplan, 202]:
Expensing Investments: Cash outlays for R&D, process improvements, and training are often completely expensed in the current period [Johnson and Kaplan, 198, 207].
Ignoring Intangible Assets: A company’s economic value includes intangible assets (e.g., innovative products, flexible processes, employee talent, and customer loyalty) [Johnson and Kaplan, 202]. Since accounting lacks objective methods to value these intangible assets, the reduction in spending on them does not show up as a loss in asset value [Johnson and Kaplan, 202].
Therefore, reducing these vital, long-term investments immediately boosts reported profitability because the associated expenses vanish from the current period, even though the company is sacrificing its future competitive position [Johnson and Kaplan, 201, 202]. The ROI measure, designed to help top management allocate capital effectively in the early 20th century, has been misused as a short-term financial target, leading to dysfunctional behavior [Johnson and Kaplan, 7, 78, 179].
In Summary: The examples show that when management relies on accounting measurements (like favorable purchase variances or monthly ROI) that prioritize local efficiency or short-term earnings, the outcome is a series of predictable negative consequences that compromise the organization’s overall goal of maximizing long-term profit. It is like constantly trimming the roots of a tree (R&D, training, maintenance) to make the leaves (quarterly profits) look thicker, guaranteeing that the tree will be unable to survive the next drought.
The TP Solution to Conflict: Introduce the Thinking Process (TP) tools (like the Evaporating Cloud) as a logical, objective, and repeatable methodology developed by TOC to systematically diagnose and resolve these policy constraints and measurement conflicts that trap organizations [Smith (1999), 217, 218, 252, 263, 359, 504]. This appeals to the CPA’s need for rigor and control, offering a tool to manage conflict proactively rather than perpetually fighting symptoms.
The Logical System to Unmask Organizational Conflict
Organizations are often trapped in deep, ongoing conflicts because people are forced to maximize local performance measures that clash with the company’s overall goal [Smith (1999), 263, 274]. These conflicts are not random errors; they are predictable effects caused by flawed underlying management policies or beliefs [Smith (1999), 216].
The Theory of Constraints (TOC) addresses this dilemma by introducing a logical, objective, and repeatable system called the Thinking Process (TP) [Smith (1999), 210; Noreen, Smith, and Mackey (1995), 437].
The Theory of Constraints is no longer inappropriately confined to the shop floor. The generic Thinking Process approach involves building logical “trees,” which basically are cause-and-effect diagrams [Noreen, Smith, and Mackey (1995), 436].
Identifying the Policy Constraint
The biggest barrier to improvement is often not a physical machine but an unwritten rule, belief, or policy—a policy constraint [Smith (1999), 130; Noreen, Smith, and Mackey (1995), 480].
Most constraints are not physical limitations but are restrictions created by our assumptions about how resources should be managed [Smith (1999), 130]. These policies exist because they were originally responses to problems that occurred long ago, and they are often followed without thinking [Noreen, Smith, and Mackey (1995), 481].
Example of a Policy Constraint: A company may have a policy that the purchasing manager must maximize their local favorable purchase price variance [Smith (1999), 362]. This policy (a measure) encourages the manager to buy cheap, substandard material (the local action), which then causes chaos downstream (increased scrap, lost time at the constraint, and late shipments) [Smith (1999), 277, 363]. The policy, intended to save money, is actually the constraint that costs the company profit.
TOC's TP provides the framework to systematically diagnose and resolve these policy constraints and measurement conflicts that trap organizations [Smith (1999), 217, 218, 252, 263, 359, 504].
Appealing to Rigor and Control
This structured approach is highly valuable to professionals like accountants and managers who require rigor and control in their operations:
Logical and Objective: The TP is a powerful and flexible system for logical problem solving [Noreen, Smith, and Mackey (1995), 439]. It uses effect-cause-effect logic to diagram the current environment and pinpoint a core underlying problem that connects the symptoms [Smith (1999), 129].
Focus and Leverage: The TP provides the criteria for relevant information by focusing analytical skills precisely on the most critical limited resource [Smith (1999), 216]. This ensures actions are aligned with the company’s global goal: maximizing Throughput and Return on Investment (ROI) [Smith (1999), 263].
Proactive Management: Instead of managers battling symptoms (firefights) every day, the TP provides a simple, repeatable process to solve chronic problems by identifying and breaking the core conflict causing those symptoms [Smith (1999), 210, 271, 330].
The Evaporating Cloud—Resolving Chronic Conflicts
The central TP tool for diagnosing and solving conflicts that hold organizations back is the Evaporating Cloud (or simply the "Cloud") [Smith (1999), 210, 192; Noreen, Smith, and Mackey (1995), 492].
How the Cloud Works
A chronic conflict exists because a manager feels pressure to take two actions that appear necessary but are mutually exclusive (you cannot do both) [Smith (1999), 183, 197]. The Cloud logically diagrams this conflict to expose the root cause: a flawed assumption [Smith (1999), 175, 290].
The Cloud uses necessity-based logic to map out the conflict (D vs. Not D) by tracing it back to a shared, overarching objective (A) [Smith (1999), 195].
Box
Element
Purpose
A
Common Objective
The ultimate goal both sides are trying to protect.
B & C
Necessary Conditions
The critical issues required to reach the objective.
D & Not D
Conflicting Actions
The two opposite actions required to satisfy B and C, respectively.
Example of Conflicting Actions:
In manufacturing, local managers are often caught in a conflict between running the plant smoothly and responding to customer demands [Smith (1999), 312, 318]. The actions might be diagrammed as follows:
Action D: The manager must leave the daily schedule intact to minimize confusion on the shop floor (Necessary Condition C).
Action Not D: The manager must break into the schedule to accommodate their best customer's expedites (Necessary Condition B) [Smith (1999), 358].
A manager cannot simultaneously break into the schedule and leave it intact [Smith (1999), 197]. The compromise typically chosen leads to delays and chaos [Smith (1999), 199].
Achieving a Breakthrough Solution
The Cloud reveals that the true conflict is not between the necessary conditions (B and C) but in the flawed assumptions(the logic) that link the necessary conditions to the conflicting actions (D and Not D) [Smith (1999), 356, 361].
The goal is to evaporate the cloud—to find a solution, called an injection, that invalidates at least one of the flawed assumptions [Smith (1999), 292; Noreen, Smith, and Mackey (1995), 492, 494]. By creating an injection, the organization finds a way to satisfy both necessary conditions (B and C) without being forced to take the contradictory actions (D and Not D) [Smith (1999), 292].
Example of the Breakthrough (Injection): In the customer expedite example, a flawed assumption might be that the current production schedule is too rigid to handle any last-minute changes. The injection could be a new policy that creates a protective buffer of time (Buffer Management) only around the crucial limited resource (the constraint) and uses that buffer visibility to prioritize expedites [Smith (1999), 272, 274]. This injection allows the company to accommodate expedites (satisfying B) while simultaneously minimizing confusion (satisfying C) because all employees now clearly understand their priority based on the constraint's needs [Smith (1999), 275, 280].
By using the Cloud, the analytical process shifts from justifying conflicting local actions to designing a win-win solutionthat ensures every action reinforces the behavior a company is seeking—maximizing Throughput generated by the constraint [Smith (1999), 290, 292, 328]. This rigorous, logical methodology allows management to actively solve policy constraints that previously trapped the organization in perpetual conflict [Smith (1999), 228].
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