Book Reviews

Relevance Lost: The Rise and Fall of Management Accounting

by H. Thomas Johnson and Robert S. Kaplan
Copyright 1987, Harvard Business School Press

Reviewed by Sandy Friedman, CFPIM, CIRM

This book introduces the idea that currently accepted management and cost accounting methods as used today in Corporate America are "...inadequate for today's environment. In this time of rapid technological change, vigorous global and domestic competition, and enormously expanding information processing capabilities, management accounting systems are not providing useful, timely information for the process control, product costing, and performance evaluation activities of managers." Modern cost management systems have lost their relevance to management in that they do not provide accurate and timely data to the various levels of management to assess return on investment, profitability, and overall performance. Most management accounting systems described herein by Johnson and Kaplan provide only information necessary for tightly controlled external reporting requirements and other financial accounting needs, i.e., annual reports, government reporting, etc., and do not provide necessary visibility to front-line and cost account managers.

As the need developed to raise large amounts of capital from increasingly widespread and detached suppliers (e.g., sale of stock, bonds), so did the need for periodic audited financial statements. Management accounting, accordingly, evolved mainly to support these external reporting requirements. Auditors became less interested in the relevance of product cost information for management decisions than for its impact on reported profits. Financial reports were "...too late, too aggregated, and too distorted to be relevant for managers' planning and control decisions." As a result, these reports offered little value to operations managers towards reducing costs and improving productivity, failed to provide accurate product costs [i.e., are direct-labor based], and short-term cycle of monthly profit/loss statements required that cash outlays in a given period be expensed in that period [even though their benefits may be long-term]. Short-term profit pressures therefore lead to a decrease in long-term investment.

This book also explores the history of financial and managerial accounting systems, and tries to delineate the pressures that caused the divergence of the two practices. Although "bookkeeping" accounting has been in existence for at least 500 years, modern-day management accounting had its roots in the nineteenth century with the Industrial Revolution, in which economies of scale were achieved in textiles, railroads, and steel. Costing standards came into existence at the turn of the century with the advent of Scientific Management techniques, developed by engineers, rather than accountants. Finally, an intricate Return On Investment (ROI) model was developed by the Du Pont brothers in 1903 to support the management of large, diversified organizations. In this model, which is still taught in business schools today, ROI is equal to the return on sales (operating ratio) multiplied by the sales to assets ratio, or stock turn. This ROI model was successfully applied at General Motors in 1920 (when Pierre Du Pont became CEO), to support its decentralized, multidivisional environment. By 1925, almost all management accounting practices used today had been developed.

Distorted product costs, delayed and overly aggregated process control information, and short-term performance measures as observed today, should have imposed new demands on the organization's management accounting systems. When cost systems became automated beginning in the 1960's, system designers basically automated the existing manual systems found in the factory. Left unquestioned was whether these systems were still sensible given the great expansion in information technology and migration to highly technical operations. "As product life cycles shortened, and as more cost must be incurred before production begins [e.g., R&D], ... traditional financial measures such as periodic earnings and accounting ROI become less useful measures of corporate performance."

Optimal cost management systems should: allocate costs for periodic financial statements; facilitate process control; compute product costs; and support special studies (e.g., discount cash flow evaluations for new asset acquisitions). "That many of the most significant product costs are called fixed or sunk signifies the poverty of current cost accounting thinking... The goal of a good product cost system should be to make more obvious, more transparent, how costs currently considered to be fixed or sunk actually do vary with decisions made about product output, product mix, and product diversity." Such systems are supportive of JIT/TQM and CIM environments, which minimize inventory and WIP costs, and hence, overall product costs. "The accounting system is most valuable to management not when it answers questions, but when it raises them." Failure to recognize these problems and make required modifications will inhibit the ability of firms to be effective and efficient global competitors.