Magazine article Training & Development Journal

Strategic Accounting

Magazine article Training & Development Journal

Strategic Accounting

Article excerpt

Strategic Accounting

Human resources are an increasingly important factor in the economy. Investments in human capital are already key to improvements in productivity, wages, and national income. And the role of human capital will continue to expand as the economy becomes dominated by service-oriented jobs requiring extensive knowledge and training. At the same time, jobs in manufacturing will be highly skilled and vital for maintaining the operating efficiency of manufacturing technology.

HRD's heightened importance must be viewed in light of the labor pool preparing to enter the workforce: millions of potential employees are unequipped with basic workplace skills. For these people to be constructively assimilated in the economy, employers will have to intervene and provide training. What's more, the current workforce will require continual skills upgrading to keep pace with technological advances. But, partly because of traditional tax incentives and managerial accounting systems, organizational expenditures for human capital lag behind investments in physical and equipment capital.

a strategic element that today's managerial accounting statements lack, but that decision makers need, is financial information about human resources. Conventional accounting systems don't provide adequate data for decision making and planning about human resource use. And they don't provide feedback to permit evaluation of organizational effectiveness in using human resources. Yet accounting information is what's reported to upper management about an organization's overall performance.

An organization's management accounting system acts as a two-way communications device for upper and middle management because it lists important organizational and departmental goals. Economic indicators measured by the accounting system also serve as the basis for promotion of middle managers. So information that appears on management accounting reports has a strong influence on management behavior.

When accounting systems don't feature performance reports on effectiveness in managing people, it's only to be expected that managers will concentrate on the aspects of their jobs for which they are held accountable. This encourages managers to reduce or eliminate training expenditures and sacrifice long-term profit gains in favor short-term cost cutting. Under current management accounting standards, the economic impact of such mismanagement is not assessed.

An economy based largely on the knowledge and skills of human capital has important implications for the role of HRD professionals in organizations. They have come under pressure to become full business partners who make money for their organizations. This new role requires HRD professionals to think, speak, and operate more in economic and financial terms.

At present, training activities typically are evaluated in other terms--such as participants' reactions to training or supervisors' observation of participants' post-training, on-the-job behavior. But it has become necessary to account for and evaluate training activities in terms that assess the value of investment in employees.

Most American organizations have published statements that extol the importance of human resources. But where managerial accounting systems fail to look at the tradeoffs of training costs and benefits, HRD is likely to be treated as a secondary activity.

Antiquation of management accounting


Corporate management accounting systems are antiquated for the modern work environment. Despite the evolution of product and process technologies, management accounting systems have remained essentially unchanged for more than 50 years.

In part, this stagnation results from the integration of organizational balance sheets and income statements. A balance sheet represents the organization's total assets, debts, and net worth. Nobel prize-winning economist Paul Samuelson has likened a balance sheet to a snapshot of water at the end of a tub; it shows how much is there at the moment, but not whether or how much is flowing in or out. An income statement represents the result of operations (profit/loss) for a specific accounting period.

Integrating these two reports requires their foundation on the same financial transactions. If they were not integrated with income statements, balance sheets wouldn't emphasize short-term profit goals as much. As matters stand, investments in product development or human capital are discouraged because, as a rule, their benefits flow into the organization over longer periods than monthly, quarterly, or annual accounting reports consider.

Wall Street's emphasis on short-term earning targets and other corporate pressures have lead management cost accounting systems to focus narrowly on monthly earning reports. These reports--based largely on the distribution of manufacturing costs between goods sold and inventory in stock--don't represent the actual increase or decrease in an organization's economic value during the accounting period.

For example, modern just-in-time inventory systems significantly reduce inventory. Organizations that implement just-in-time manufacturing without upgrading their accounting systems leave managers without timely information for measuring product costs and promoting operating efficiency. Besides, even if the time lag in reporting operating costs were overcome, most reports now have too many important cost components hidden in summary figures to be of much benefit to production supervisors.

Because cash outlays for training are long-term investments, they distort an organization's profit measurements over short-term periods. So short-term reports obscure a manager's view of true value-creating activities, such as investment in human capital. Managers may be reassured by an incomplete picture and not realize that accounting systems aren't providing appropriate measures of operational growth or decline.

As B. Charles Ames, chairman and CEO of Uniroyal Goodrich Tire Company, and James D. Hlavacek, training consultant and professor of management at Wake Forest University, have noted, managers may "tighten the belt in the wrong way in the wrong places" if they simply inform their decisions with data "from accounting systems designed primarily to meet outside financial reporting requirements." In depicting a "cycle of competitive decay," Ames and Hlavacek show training as a competitive factor that may suffer inadequate investment because of inadequate accounting systems.

In many organizations, recent strategies--such as automation, quality improvements, reduced inventory, more efficient production processes--for replacing people with machines and minimizing waste have done almost all they can to reduce costs. The conventional savings strategy of reducing direct labor costs (wages, salaries, mandated employer contributions to Social Security, and so forth) by cutting back on employees no longer works as well.

consider a manufacturing unit that once consisted of four employees who were replaced by a programmable controller and a robotic "eye" and arm.

The unit now has no direct labor costs, but people are still needed--to decide when to change what the unit makes, design its products, program and reprogram the controller, maintain the controller and robots, market the products, review legal documents such as service agreements for the unit's machinery, keep records of product sales, and train and retrain maintenance technicians and others--in support of the unit's operation. But now the costs associated with human resources are categorized as indirect costs (also known as overhead; see page S-10 for definitions).

The actual processing of services and products is increasingly a function of such overhead human resource activities, as the Manufacturing Studies Board of the National Research Council noted in a 1986 study.

Office automation has the same effect. One administrative assistant using a personal computer may do work that used to be done by four people: an office manager, secretary, clerk typist, and bookkeeper. But the administrative assistant needs the support of training on how to use software, repair computers, and so on.

Traditional managerial accounting systems' emphasis on direct labor costs is outdated. At the height of the manufacturing economy, direct labor costs far exceeded indirect costs. Overhead costs were distributed (allocated) throughout organizations by requiring managers to multiply their department or division's direct labor costs by a percentage. Accounting systems' use of direct labor costs as the means of distributing overhead costs to products, services, and departments reflected direct labor costs' predominance then.

But workplace automation has escalated overhead costs while greatly diminishing direct labor as a percentage of total costs. A june 1988 Business Week article stated that, in automated factories, direct labor typically represents 8 to 12 percent of production costs. In the electronics industry, the percentages are halved. Accounting systems haven't adapted to this major change.

Considerable management time is still devoted to recording and reducing direct labor costs, although these are a small fraction of overhead costs. According to H.T. Johnson of Pacific Lutheran University and R.S. Kaplan of Harvard Business School and Carnegie-Mellon University, overhead burden rates on direct labor ranged from 400 to 1,000 percent in the late 1980s. Obviously, any activity involving large amounts of direct labor costs appears expensive--and saving on direct labor costs has significant impact on cost records, if not actual costs.

Allocation of overhead costs to departments and products by direct labor also distorts product costs. Products made with low labor content have their overhead costs placed on products with high direct labor hours. Customized, infrequently produced products incur few direct labor hours, but create significant overhead costs for specialized design, engineering, and marketing. So these products appear less costly in comparison with high-volume mature, stable products. In short, in a direct labor cost-allocation system, mature products subsidize customized products.

A direct labor cost-allocation system also promotes decisions to "buy" rather than "make" labor. Managers can reduce direct labor costs by finding suppliers of cheaper labor. So corporate accounting systems favor subcontracting work to people outside the organization ("buy decisions") over assigning work to people inhouse ("make decisions"). Buy decisions may defeat the purpose of reducing organizational costs, though, because overhead costs tend to rise as subcontracting does. For example, subcontracting places demands on the departments (such as purchasing, scheduling, and training) that specify product or service requirements for the subcontractor. Yet these overhead costs aren't traced to the practice of subcontracting because it has zero direct labor content.

A focus on direct labor costs prevents organizations from getting a good financial management grasp on human resource costs. Overhead costs are the most rapidly increasing human resource costs in organizations. Because the impact of overhead costs is often underrated, few managements understand the economic impact of human resource elements on the profitability of their products or organization.

Management accounting systems must be altered to reflect the growing importance of overhead and equipment costs, and the diminished importance of direct labor costs.

Potentially most productive now are structural organizational changes such as more efficient communication systems and better worker management. Intangible benefits that stem from structural change, advanced technology, and training--such as design and process flexibility and more knowledgeable and skilled employees to speed turnaround time--have become crucial to organizational competitiveness. But current cost accounting systems don't deal with intangible benefits, so they are rarely measured or estimated and factored into cost management. Managerial accounting systems must begin to consider such factors.

The National Association of Accountants, Harvard and Stanford business school representatives, several of the nation's largest accounting firms, and dozens of corporate sponsors have joined in a cost-management task force to recommend changes to help accounting "catch up" with computer-aided manufacturing.

The task force's first report concluded that, for sound investment decisions, qualitative factors (such as quality, flexibility, and timeliness) are more important than quantitative factors, although those should be measured. Having hammered out a new philosophy of accounting, the task force moves into the 1990s with plans to release new accounting software in keeping with the thinking behind the first report.

These days, as Business Week has noted, time is the "most precious commodity." This has many implications and effects. For instance, one Cleveland manufacturer no longer measures an employee's "pieces per hour." Now "throughput" (time to turn material into product) is the emphasis, so the company calculates how long each subprocess (including those in the overhead category) takes and how much each adds to product cost.

Ability to assess, with reasonable accuracy, the overhead human resource costs of a product or service would bring a new order of management of human resource investments. Return on investments in human capital could be improved through training and other personnel interventions. The human resource component of operational finances is poorly managed now because it isn't counted or measured well enough to allow for its true control.

Global competition

and accounting systems

The obsolescence of management accounting systems is particularly damaging to American organizations competing in the global arena. In some cases, a foreign manufacturer may produce products--at significantly lower prices--for direct competition with an American organization's high-volume mature products.

Meanwhile, the American organization's cost accounting system leads its decision makers to conclude that their organization can't make money if it matches the foreign competitor's lower prices. This conclusion has driven many American companies to abandon product lines or move production of mature, stable products to low wage countries.

The December 25/January 1, 1990, issue of U.S. News & World Report reported that the United States, after a decade of restructuring, "now has an average cost advantage of about 20 percent." But Martin Starr of Columbia University, in a study that compared American-owned companies with foreign-owned U.S. operations, found that "Japanese and European managers spend three to five times as much on worker training."

Computer-integrated manufacturing has led the revolution of improvements in quality, inventory reduction, reduced set-up time, and product customization. The new technologies of computer-integrated manufacturing allow factories to change rapidly from one product to another, driving down economies of scale for production processes. That is, it may cost the same (or almost the same) to produce a few widgest as it does to make thousands.

Product life cycles are also shrinking rapidly, especially in high-tech markets, where a generation of technology may become outmoded in three years. Traditional management accounting systems also lose relevance as more costs--for research and development, physical investment, and training--must be incurred before production begins.

In response to the fast-paced competitive environment, many organizations have hastened to increase the number of products and services they offer, making it harder to attach inputs of resources (costs) to outputs (products and services).

Changes required in management

accounting systems

New manufacturing and office technologies call for new cost accounting procedures to deal with such matters as measurement and justification of investments in employees. Data about such managerial considerations shouldn't necessarily be used for external financial reports, but it's critical that they be accounted for in internal management reports.

Organizations must understand the full costs of acquiring and developing resources: technologies, equipment, materials, and people. Organizations must also be aware of the long-term costs of translating those resources into final products or services. Management accounting systems that fail to provide measures of and warning signals about the efficiency and profitability of products and services undermine managers' ability to guide their organizations.

For operational control in the contemporary work environment, managers need accounting systems that provide information on important resources during an accounting period. And, to assess progress toward long-term profitability goals, greater use of nonfinancial indicators (such as more complimentary or fewer complaint letters from customers) is required.

Traditional accounting methods treat people only as expenses, so funds used to train people are computed as expenses when an organization's net income is figured. Accordingly, managers tend to regard human resources as expenses to be minimized instead of assets to be optimized.

Human resource management accounting is the next step for organizations progressively adopting a human resource management perspective. Human resource accounting would enable organizations to quantify the worth of people as organizational assets. Human resource accounting systems would strengthen the human resource professional's role as advisor to senior management on the human resource implications of business strategies. By measuring the expected worth of proposed investments in human capilal, human resource accounting also would facilitate management decisions about training.

Costing human resources

HRD has expense and asset components. For a human resource expenditure to be treated as an asset, it must return benefits to the organization in future accounting periods. If the benefits of training or development all take place during the current accounting period, the expenditure is treated as an expense.

There are no generally accepted accounting procedures for valuation of human assets--employees. Valuation of employees differs from valuation of things because people are not owned. But, like other assets, people have future usefulness that adds value to an organization.

The first attempt at implementing employee valuation came from the R.G. Barry Corporation. The aim was to improve planning, management, and investments in human resources. Training and development costs were accumulated in individual subsidiary accounts. Costs were amortized (written off gradually) over a person's expected term of employment or over the time a training program's effects were expected to have worth. If an employee left the organization before the end of the expected working-life estimate, unamortized costs were written off during the quarterly earnings period of the employee's departure. Quarterly accounting reports monitored managers' investments in employees and motivated managers to view human resources as valuable assets.

The Barry system employed historical costs (that is, original expenses incurred) for employee valuation. This method follows an asset model of accounting that measures the costs organizations sacrifice to develop people. This historical cost accounting approach has the advantage of helping managers understand that investments in human resources are parallel to investments in other organizational resources such as equipment.

One difficulty with using this approach for human resource accounting is that writing off unamortized costs based on turnover involves a great deal of subjectivity. It's also difficult to pinpoint to wha extent organizational investments in an employee should be attributed to and written off for recruitment costs versus orientation costs or training and development costs. And, this approach only accounts for costs, not for an employee's worth to the organization.

An alternative to the historical costs method is to measure the cost of replacing employees. Replacement costs refer to the expenditure of organizational resources that would go to replacing current employees. Replacement costs include recruitment and training costs for new employees, and income not gained because new-comers are in training rather than producing on the job.

The major drawback of both the historical and replacement cost models of human resource accounting is their limited focus. They highlight investments in human resources, but ignore human resource effectiveness. They fail to gather and assess information about the economic effects of employees' behavior.

A better approach is to tie dollar estimates to positive changes in employee behavior that were produced by training interventions. This expense model measures the economic consequence of training programs in dollar-expense terms. The idea behind this way of "costing" human resource behavior is to measure the contribution of employees to overall organizational efficiency--while recognizing that an employee's contribution isn't dependent on the size of organizational investments in him or her, but relates to how effective and efficient the employee's on-the-job performance is.

This cost accounting strategy is different because it quantifies the benefits that training and development programs bring to employee performance. As in all frameworks for financial analysis, anticipated cost-benefit ratios are determined and applied. Calculating training programs' costs and benefits requires an understanding of how accountants categorize them.

Direct costs are expenses associated with costs that can be traced directly to specific projects or activities. Out-of-pocket direct costs are expenses for which money is paid on a specific project. In terms of training, these include travel fees and daily expense allowances (per diems), costs for purchased learning materials, contracted consultants, training room rental, and food service.

Out-of-pocket direct costs are the most obvious and easily tracked costs associated with training. But, according to Lyle M. Spencer, Jr., of McBer and Company, these expenses rarely equal more than 10 percent of a training program's total costs. The major costs of training activities relate to people's time--to salary costs for people conducting or participating in a specific training program.

Indirect costs are expenses that can't be directly associated with a specific project or activity but which are necessary for the organization to function. Sometimes the term overhead is used to describe all the indirect costs of doing business.

Examples include costs for interest on organizational debt, general building maintenance and repair, lights, heat, office equipment, and administrative salaries and expenses (for example, for a main receptionist or a legal staff). Some organizations subdivided such costs into over-head and general and administrative expenses (G&A) categories, and some calculate overhead on bases other than direct labor.

Fringe benefits are overhead costs related to time for which employees are paid but don't work (vacations, sick leave, and holidays) plus employer payments for health insurance, pensions, and other indirect compensation. Spencer states that, in American industry in the late 1980s, fringe benefits averaged 35 percent of direct salary costs. And in professional service firms, overhead averaged around 115 percent of direct salary plus fringe expenses.

Full costs are the total of direct costs plus indirect costs. Full costs are the best measure of how much it actually costs an organization to deliver a training service. In particular, recognition of the full cost of people's time is the basis for understanding the total costs of training programs.

It's useful to track training's full costs according to eight phases: administration, research and development, analysis, design, development, delivery, evaluation, and marketing.

Costs for each training phase can be subdivided into:

* Personnel costs--for people involved in a training project including in-house subject-matter experts and outside personnel's fees and expenses

* Outside purchase of goods and services--for materials and supplies bought from an outside provider for a specific training program.

* Facilities costs--for the use of rental facilities such as classrooms, research and development laboratories, or production shops

* Incidental expenses--for travel and daily expense allowances during a training program

* General and administrative costs--for costs that, although associated with maintaining the training department, can't be directly traced to a particular training program. Such costs include general supplies and materials, equipment, facilities, and administrative and staff support salaries, wages, and fringe benefits.

Benefits of training programs:

* Increased revenue. By affecting quantity of output or sales per unit of time, training-based improvements can increase revenue. Increased output or sales can be documented and training's share in the increase claimed.

* Decreased or avoided expenses. A frequent benefit of training programs is the reduction (saving) or avoidance of costs. By ensuring employees' skills, training can help improve the quality of a product or service. Measurement of the related organizational benefit relate to reduction of scrap, absenteeism, inaccuracy, grievances, accidents, and wasted time or materials.

* Intangible benefits. Intangible benefits are activities, qualities, or conditions that have value but are extremely difficult or impossible to quantify. For instance, employee flexibility benefits an organization, but its worth is difficult to quantify. To keep investment in these benefits in perspective, decision makers should consider the potential risk of not investing in them and should estimate how substantial intangible benefits might possibly be. And, a brief narrative about anticipated intangible benefits (and indicators of them) may add meaning to the "hard numbers" of internal financial reports.

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