Financial Issues For Manufacturing

1 INDT 562 Financial Issues for Manufacturing December 14, 2001 Book Review: Relevance Lost: The Rise and Fall of Management Accounting The Basics of Finance: Financial Tools for Non-Financial Mangers By Anthony Cappucci

Relevance Lost: The Rise and Fall of Management Accounting H.Thomas Johnson Robert S.Kaplan Relevance Lost describes the evolution of management accounting in American business, from the early textile mills of New England to present-day computer-automated manufacturers. But after World War I, the management accounting system became subservient to financial reporting procedures and requirements. Soon, internal accounting systems were no longer providing relevant information to allow manufacturing managers to make timely and cost efficient decisions. The book begins by tracing the development of simple textile mills in the early 1800’s. They were the first American business organizations to development management accounting systems. They used cost accounts to determine the direct labor and overhead costs of converting raw material into finished yarn and fabric. The double-entry cost accounts, among the earliest discovered anywhere, differed from any accounting methods used before. Before the industrial revolution, accounting was mainly a record of the external relations of one business unit with another, a record of relations determined in the market. But with the emergence of large scale manufacturing operations, necessity arose for more emphasis upon the accounting for interests with the competitive unit, and the use of accounting records as a means of administrative control over the enterprise. By the middle of the nineteenth century, great advances in transportation and communication provided further opportunities for gain to large, hierarchical organizations such as the railroads, steel mills, and distribution firms. Accounting systems began to link a company’s business when organizations combine two or more separable activities in a single managed enterprise. Known as vertically integrated firms, these businesses appeared in the United States around 1900. In the late 1800’s, a demand rose for new management information that was not provided by conversion cost systems. The demand originated in firms that mass produced complex machine

2 made metal goods. The complex manufacturing processes made it difficult for managers to gather precise and accurate information about the efficiency of workers engaged in specialized tasks. The search for this information inspired a systematic analysis of factory productivity that came to be known as “scientific management.” These “scientific managers” focused their attention on predetermining standard rates at which material and labor should be consumed in manufacturing tasks. The methods they devised to determine standards for material and labor inputs included engineering design of bills of materials and timeand-motion study. Engineers and accountants used information about standards for three very different purposes. Scientific management engineers developed information about standards in order to gauge the efficiency of tasks or processes. Detailed systems were later developed by accountants for analyzing variances between standard and actual cost performance to control their operations. Accountants, not engineers, developed a third purpose for standard cost information. Some financial accountants recognized that standard costs greatly simplified the task of inventory evaluation. The multidivisional structure and management accounting procedures devised in the early 1920’s, enabled giant industrial firms to overcome the inefficiency and bureaucratic disabilities that were endemic to large-scale orginazations. In large, diversified enterprises, the multidivisional organization sharply reduces the volume of communication between divisional managers, thus enabling managers to employ resources more efficiently and more effectively than if they used centralized organizations. Internal accounting procedures enabled top managers to transmit to managers in sharp, unambiguous terms the goals for company-wide profits and growth. Little evidence exists to believe that auditors after 1900 persuaded managers to substitute inventory cost accounting figures for strategic product cost information. That managers were inclined to compile accurate product costs data in the decades after 1900 likely reflects their judgment on costs and benefits of such information, not a lost sense of what information is relevant to management decision. Yet having the accounts used to value inventories for financial reporting purposes be the only source of product cost information undoubtedly has affected how accountants and managers thought about cost management during the past sixty years. Many accountants and managers have come to believe that inventory cost figures give an accurate guide to product cost, when they do not. Contemporary academic literature on applying analytic techniques to management accounting problems further led to lost management accounting relevance. It was devoid of references to “systems actually in use” or to “systems installed in well-known organizations”. Instead, the references were to writings of other university researchers’ knowledge of managerial issues derived not

3 from studying decisions and procedures of actual firms, but from the stylized models of managerial and firm behavior articulated by “theorists” in other academic disciplines. Thus, the models were not developed for or tested on actual enterprises. The obsolescence of contemporary management accounting systems has likely created significant problems for the managers of large, diversified organizations. Contemporary cost accounting and management control systems are no longer providing accurate signals about the efficiency and profitability of internally managed transactions. Consequently, managers are not getting information to help them compare the desirability of internal versus external transactions. Without the receipt of appropriate cost and profitability information, the ability of the “visible hand” to effectively manage the myriad transactions that occur in a complex hierarchy has been severely compromised. The loss of relevance in most companies’ cost accounting systems is particularly unfortunate for the global competition of the 1980’s. The consequences of inaccurate product costs and poor accounting systems for process control and performance measurement were not severe during the 1970’s since a combination of high inflation and a weak dollar sheltered most U.S. companies from foreign competition. High levels of worldwide demand for U.S. products during that decade placed a premium on production throughput. Higher costs and, and occasionally, goods of substandard quality could generally be passed on to customers. The competitive environment for U.S. manufacturers completely changed in the 1980’s. First, disinflation reversed the previous inflationary psychology, and manufacturers could no longer recover cost increases through higher prices. At the same time, a sharp increase in the value of the U.S. dollar made foreign produced goods less expensive to the U.S. consumer. Also manufacturers in Japan started to place an emphasis on adapting improved quality standards. Current cost accounting systems attempt to satisfy three goals: to allocate certain period costs to products so that financial statements can be prepared monthly, quarterly, and annually; to provide product cost estimates to product and business managers; and to provide process control information to cost center managers. It would be desirable to have a single systems satisfy all three cost accounting objectives. But given the low cost and high power of information processing technology, this should not be a necessary design criterion. Of more importance is to perform each function well. The obsolescence of management accounting systems has not occurred overnight. The systems, whose intellectual roots can be traced to events sixty to one hundred years ago, worked well for the times in which they were designed. It has been speculated that the dominance of financial accounting procedures, both in education and in

4 practice, has inhibited the dynamic adjustment of management accounting systems to the realities of the contemporary environment. These realities, including remarkable expansions of information technology, a more virulent global competition, a shortened life cycle of products, and innovations in the organization and technology of operations, have all contributed to the new demands and new opportunities for corporate management accounting systems.

The Basics of Finance: Financial Tools for NonFinancial Managers Bryan E.Milling This book explains that effective financial management is essential for business success. But financial management typically remains the last concern for independent business managers. Instead, they concentrate on their special interest or expertise— sales or engineering or manufacturing, etc.—and turn to the financial aspects of the business only when a crisis develops. A manager may then become uneasy or intimidated when working with the analytical tools essential for effective financial management, making decisions that influence the profitability, and perhaps the survival, of the business using information he or she doesn’t fully understand. The Basic of Finance provides a remedy for that problem. This book can be used as a primary source for the important formulas and ratios that serve as the basic tools for business financial analysis. The glossary offers concise definitions for terms used throughout the book. The index helps you locate analytic tools quickly. But business financial management requires interpretation as well as calculation, and the book proceeds beyond the basic arithmetic to help you understand and use the data that result from your calculation. Some Examples • • •

Is a three-to-one dept-to-equity ration satisfactory for your business? How does inventory turnover rate affect your firm’s financial structure? How does your sales volume relate to your need for working capital?

The book helps your answer such questions, and you will find that financial analysis is more than an interesting arithmetic exercise. You can find numerous examples that illustrate the major principles of financial analysis and the potential benefits from attentive financial management. These examples can help you profit by applying the principles to any business circumstance.

5 You can also find many of the major tenets of financial management crystallized in a set of concise Financial Facts. For example, one Financial Fact marks the current ratio that usually represents adequate liquidity in a business. Another relates financing costs to the return on a firm’s assets. Still another emphasizes the value of prompt trade payment practices. Unique business circumstances often qualify the management tenets set forth in many Financial Facts, but collectively they provide the foundation for effective management of a business enterprise. To illustrate, a summary of the primary justification of the book: FINANCIAL FACT 1: Financial management is critical to the success of every business. Every chapter ends with a Financial Fact. The book doesn’t reveal any secrets, but it should become a profitable management tool whether you use it only as an occasional reference or as a primary guide for making financial decisions. This book will allow non-financial IT managers gain a basic understanding of a firm’s financial management.