Episode #66 - The Death of Standard Cost Accounting

Andrew Carnegie’s favorite saying might have been, “Watch the costs and the profits will take care of themselves,” but in an intellectual capital company, it should be,  “Watch your value and price, and the profits will take care of themselves. Management accounting is a thoroughly inward-looking discipline, from cost accounting to the DuPont return on investment (ROI) formula. One of the century’s most influential accounting academics was William Paton, who in a 1922 treatise described what he believed to be the cost accountant’s chief activity:

The essential basis for the work of the cost accountant—without it, there could be no costing—is the postulate that the value of any commodity, service, or condition, utilized in production, passes over into the object or product for which the original item was expended and attaches to the result, giving it its value.

Fortunately, Paton later repudiated this notion that costs attached to a product as it moves through the factory in a speech he gave at a conference in 1970:

The basic difficulty with the idea that cost dollars, as incurred, attach like barnacles to the physical flow of materials and stream of operating activity is that it is at odds with the actual process of valuation in a free competitive market. The customer does not buy a handful of classified and traced cost dollars; he buys a product, at prevailing market price. And the market price may be either above or below any calculated cost figure.

In their outstanding book, The Strategy and Tactics of Pricing (third edition), Thomas T. Nagle and Reed K. Holden offer the following indictment of cost-plus pricing:

The problem with cost-driven pricing is fundamental: In most industries it is impossible to determine a product’s unit cost before determining its price. Why? Because unit costs change with volume. This cost change occurs because a significant portion of costs are “fixed” and must somehow be “allocated” to determine the full unit cost. Unfortunately, since these allocations depend on volume, which changes with changes in price, unit cost is a moving target.

Price is how the firm captures the results of its value proposition, and since a company is what it charges for, focusing on maximizing value is a better metric than maximizing profit, which is nothing but a lagging indicator, derived from value creation.

This debate between cost accounting and profitability is not over. Much work is being done in this area. In 1987, as mentioned before, H. Thomas Johnson and Robert S. Kaplan published Relevance Lost: The Rise and Fall of Management Accounting, which was named in 1997 one of the 14 most influential management books to appear in the first 75 years of Harvard Business Review’s history. The book is credited with launching the activity- based costing (ABC) revolution.

ABC always asks, “Does this process have to be done?” If so, what is the most effective way of doing it? This costing method has provided manufacturers with the information they need to cut costs substantially, but the real promise of ABC may rest with service industries. Peter Drucker makes this observation in his book Managing in a Time of Great Change:

Activity-based costing shows us why traditional cost accounting has not worked for service companies. It is not because the techniques are wrong.

It is because traditional cost accounting makes the wrong assumptions. Service companies cannot start with the cost of individual operations, as manufacturing companies have done with traditional cost accounting. They must start with the assumption that there is only one cost: that of the total system. And it is a fixed cost over any given time period. The famous distinction between fixed and variable costs, on which traditional cost accounting is based, does not make much sense in services.

But that all costs are fixed over a given time period and that resources cannot be substituted for one another, so that the total operation has to be costed—those are precisely the assumptions with which activity-based costing starts. By applying them to services, we are beginning for the first time to get cost information and yield control.

Toyota—No Cost Accounting?

Johnson’s later book, Profit Beyond Measure, is a seminal work, although not yet fully developed. Johnson profiles Toyota and Scania as two manufacturers that do not have a standard cost accounting system.

As Glenn Uminger, a financial controller at Toyota Motor Manufacturing-Kentucky (TMM-K) since 1988, says, “TMM-K has never had a standard cost system to track operating costs, and we probably never will.”

 So how do they do it? How can a manufacturing company run without a standard cost accounting system? Toyota understands price justifies costs, not the other way around. Here is how Johnson explains it in his book, Profit Beyond Measure:

None of these comments is meant to imply that Toyota does not have accounting and production planning information systems. Of course it does. Toyota has a comprehensive array of information systems, accounting and otherwise, with which to plan, in advance of operations, and to report results of operations after the fact. But information from such systems is not allowed to influence operational decisions.

Toyota management discharges its responsibility for costs not by taking arbitrary steps to manipulate operations, but largely in the vehicle planning stage. During the design stage, long before the first penny has been committed to making a vehicle, Toyota has always placed enormous importance on setting and achieving cost targets.

To do so, over the years Toyota has developed a famous technique for target costing. Simply stated, target cost is the maximum cost the company can afford to incur to produce and sell a vehicle and still earn a required profit at the price customers are expected to pay.

He notes Dr. Edward Deming’s observation that over 97 percent of the events that affect a company’s results are not measurable, while less than 3 percent of what influences final results can be measured:

Managers who adopt the new thinking offered here will accept as second nature the idea that what decides an organization’s long-term profitability is the way it organizes its work, not how well its members achieve financial targets.

Management accounting simply takes accounting revenue, cost, and profitability information, which is appropriate for measuring the overall financial results of a business, and inappropriately attempts to trace it to the particular activities and products of the business that gave rise to those results. Assigning such quantitative measures to parts of a mechanistic system makes sense. However, the parts of a natural living system cannot be so treated. Accounting measures are unable to penetrate the organic, multifaceted union between customer and company that ultimately is the source of a company’s financial results.

Because cost and profit are not objects, but are properties that emerge from relationships, quantitative measures can only describe them, they cannot explain them.

Wisdom Is Timeless

Henry Ford’s understanding of this topic is truly prescient, as demonstrated in his autobiography, My Life and Work, published in 1922. It is worth quoting at length for the historical lessons it teaches. The notion that price justifies costs was not foreign to Ford:

If the prices of goods are above the incomes of the people, then get the prices down to the incomes. Ordinarily, business is conceived as starting with a manufacturing process and ending with a consumer. If that consumer does not want to buy what the manufacturer has to sell him and has not the money to buy it, then the manufacturer blames the consumer and says that business is bad, and thus, hitching the cart before the horse, he goes on his way lamenting. Isn’t that nonsense? But what business ever started with the manufacturer and ended with the consumer? Where does the money to make the wheels go round come from? From the consumer, of course. And success in manufacturer is based solely upon an ability to serve that consumer to his liking.

Keep in mind that Ford’s primary objective was the mass consumption of the automobile, so he focused more on driving the price down in order to increase volume. In a growing industry this is a viable strategy. In mature markets, it is probably better to increase value, thus allowing higher prices. Nevertheless, with Ford’s objective in mind, consider his views on the importance of cost accounting and prices, which are profound:

Our policy is to reduce the price, extend the operations, and improve the article. You will notice that the reduction of price comes first. We have never considered any costs as fixed. Therefore we first reduce the price to the point where we believe more sales will result. Then we go ahead and try to make the prices. We do not bother about the costs. The new price forces the costs down. The more usual way is to take the costs and then determine the price; and although that method may be scientific in the narrow sense, it is not scientific in the broad sense, because what earthly use is it to know the cost if it tells you that you cannot manufacture at a price at which the article can be sold?

Notice Ford “never considered any costs as fixed.” He understood, in the long run, that all costs are avoidable, and by subjecting every cost to the test, does it add value to the customer?, he was able to increase the efficiencies in the factory:

But more to the point is the fact that, although one may calculate what a cost is, and of course all of our costs are carefully calculated, no one knows what a cost ought to be. One of the ways of discovering what a cost ought to be is to name a price so low as to force everybody in the place to the highest point of efficiency. The low price makes everybody dig for profits. We make more discoveries concerning manufacturing and selling under this forced method than by any method of leisurely investigation.

Disney’s Brilliant Price Hike

Our VeraSage colleague Kirk Bowman, The Visionary of Value, does his own podcast, The Art of Value. He interviewed Joni Newkirk, who used to lead pricing for Walt Disney World.

We highly recommend you listen to this show, then read her whitepaper on the price hike story.

It’s a perfect illustration how pricers have to optimize profits overall, not for each silo or department.

Yet cost accounting tends to atomize a business, under the false believe that maximizing each part results in a more optimal whole. This runs counter to systems thinking, where sometimes certain departments need to be less efficient (or profitable) in order for the whole to be more effective.

The Price-led Costing Revolution

By its very nature, cost accounting is a historical function, but what is important for pricing are planned costs, not past costs. Furthermore, cost accountants usually pay far too much attention to sunk costs, which should have no influence over pricing or value considerations.

As Henry Ford pointed out, no one knows what a cost should be. Yet, cost accounting has held hegemony for far too long over the pricing strategies of businesses everywhere, embedding the conventional wisdom that costs determine price. Merely because a practice is widely adopted and utilized does not make it optimal, not to mention true. Check out the debate on Ron’s LinkedIn post on this topic in the comments.

One of Peter’s Principles is bureaucracy defends the status quo long past the time when the quo has lost its status. Cost accounting, and its more modern cousin activity-based costing, does not deserve to be the apotheosis of pricing, let alone running a business.

No doubt, it has its role in any organization, but that role is very specific and historical, not one that should have a major influence in production and pricing decisions.

Innovation requires builders not bean-counters, and the last person who should be running something is the man who controls the costs. Sure, you need that man in there somewhere to keep a rein on things, but he shouldn’t be at the top.

—James Dyson, Against the Odds: An Autobiography



 

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Ed Kless

Ed Kless joined Sage in July of 2003 and is currently the senior director of partner development and strategy. He develops and delivers curriculum for Sage business partners on the art and practice of small business consulting. Courses include: Sage Consulting Academy, Business Strategy and Customer Experience Workshops. Ed is the author of The Soul of Enterprise: Dialogues on Business in the Knowledge Economy, a compendium of a few of the episodes of his VoiceAmerica talk-show The Soul of Enterprise: Business in the Knowledge Economy with Ron Baker, founder of the VeraSage Institute where Ed is also a senior fellow.