Management Accounting-Performance Evaluation: Ian Herbert Considers the Effects of Increased Investments in Capital Equipment and Lower Direct Labour Content on Standard Costing
Herbert, Ian, Financial Management (UK)
May 2006's P1 exam had the question: "Briefly discuss three reasons why standard costing may not be appropriate in a modern business environment." But what is meant by "modern" and what should we be comparing it with? And what are the implications for management accounting? To answer these questions, first it helps to look back in history.
Manufacturing was a modest affair before the 18th century, with activity centred on cottage industries. (Of course, you'd be justified in saying: "Hang on: what about the great cathedrals?" Such projects employed vast numbers of labourers and artisans on one site for years, which shows that in real life things are complex and progress isn't always linear-often we can talk only of general trends.) Then the British industrial revolution heralded key technological advances--for example, the harnessing of water by Richard Arkwright to power machines in cotton mills. The nature of the technology necessitated the concentration of activity on single sites and a specialisation of skills. Arkwright's mills were a complete departure from the traditional, craft approach and would have been described as "modern" in his day. Now we might think of a factory full of robots as "modern" and a typical eighties car factory would be seen as traditional--even old-fashioned. So "modern" is a relative term.
In time, factory work processes became more formal and intensive. The most striking example was Ford's production lines at Baton Rouge in the early 20th century. The emphasis was on producing standardised, affordable consumer goods. Product specialisation and the division of labour meant that factories became more dehumanised and there was antagonism between workers and managers, although Ford paid quite good wages. This discontent manifested itself in strikes and poor-quality goods. The School of Scientific Management reinforced the scrutiny of activity at a micro level, resulting in further standardisation and measurement. This facilitated the widespread use of standard costing, which also required a stable environment with long batch runs and relatively few model changes. Setting standards for the future, typically up to a year ahead, was now possible and, even in large factories, costs could be controlled on a "management by exception" basis.
While these developments were radical, management accounting evolved slowly. Initially it was restricted to product costing for the purposes of controlling costs and valuing stock for profit-reporting purposes rather than setting selling prices. When CIMA was formed in 1919 it was called the Institute of Cost and Works Accountants; supporting management decision-making is a more recent role.
From 1945 to about 1980, consumer demand often outstripped capacity, so manufacturers prospered with a level of inefficiency that would be unthinkable today. Then Japanese factories started making high-quality goods at incredibly low cost. At first, western firms assumed Japan's labour costs were far lower. When it became clear that Japan's edge came from new approaches to production, it was too late for many to adapt. Academics Thomas Johnson and Robert Kaplan argued that "remote control" management and the supporting accounting techniques had contributed to western firms' inefficiency-eg, an overreliance on simplistic plant-wide overhead absorption rates, especially when these were based on direct labour. Their 1987 book Relevance Lost (Harvard Business School Press) outlines the evolution of management accounting within the wider context of industrial development. It provides a valuable background against which to appreciate later advances in accounting.
Before we fast-forward to the present, let's review what we now refer to as traditional manufacturing. In the eighties most industries were mechanised, although the equipment required constant maintenance. Machines broke down, forcing firms to hold large stocks of work in progress at each stage of manufacture to keep production flowing. …