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March 20, 2012

Would you use a professional whose work was based on a mindset from the 1920’s?

Imagine you had to go into hospital and your surgeons suggested that they only use medical techniques that were known eighty years ago. Or your dentist proposed using a drill from the 1920’s. Do you think you’d go along with that? Let’s be honest, you’d run a mile!.

 

All professionals worthy of the name update their tools and techniques in the light of developments and new technology. Don’t they?

 

Would you use a professional whose work was based on a mindset from the 1920’s?. Take your time before answering that one. The truth is that many accountants are still wedding to accounting techniques that are eighty years old – and completely unsuited to the modern environment. Standard Cost Accounting was developed in the period between the world wars in line with mass production. It remains the most widely used tool of cost accountants the world over, even though the business and economic environments have completely changed.

 

Standard costing evolved alongside mass production (reference 1) and was ideally suited to the mass production environment. Indeed, standard costing can still work well where two conditions apply:

  • Demand exceeds supply, such that everything produced can be sold;
  • There is limited variation in the product produced.

 

The trouble is that these conditions are no longer valid in the modern manufacturing environment:

  • The power of the market means that we need to produce a wide variety of products to suit differing needs, including increasing levels of customisation for individual customers;
  • Wide product variety, and inflexibility in production processes, result in businesses holding large stocks as it is difficult to predict demand for individual products with any accuracy;
  • Global competition means that companies are rarely in the position that they can sell everything they produce.

 

The philosophy of standard cost accounting is that profitability is maximised when machine and labour utilisation is maximised. However, in the modern situation set out above the standard cost accounting philosophy drives costly and wasteful practices as the focus on full cost absorption encourages long production runs to maximise utilisation. This builds up inventory, which is expensive to hold and severely impedes cashflow. It also reduces the flexibility of the business to change as the market changes.

 

Thus, in the modern manufacturing environment, standard costing drives several suboptimal behaviours:

  • Where managers are judged on their ability to minimise production variances, they will push for higher production runs of standardised products. This builds up inventory, which is very costly and creates the danger of future write-offs. It is also the opposite of what the market wants – which is flexibility, choice, and attention to specific customer needs.
  • Long production runs greatly reduce the flexibility of the business to adapt to changing market needs. This, effectively, destroys the company’s ability to compete on speed of response to its customers (without tremendously high stocks);
  • A focus on purchase price variances encourages sub-optimal behaviour of buying on price alone. This encourages bulk buying; high raw material stocks; and poor supplier relations (always pushing on price). All of these behaviours further reduce the flexibility of the business to produce customised products to specific customer needs.

 

The fact is that Standard Cost Accounting has no relevance to any business seeking to compete in a global market with wide product variety and fast response to the market. A new approach to management accounting is needed – one which takes account of the need to be a flexible and responsive to stay competitive.

 

I wonder what members think that approach to management accounting is?

 

 

Reference 1)      “The Evolution of Cost Accounting to 1925”, S. P. Garner, University of Alabama Press 1954.