The Accountants Are Letting Us Down

Tom Peters

As if we didn’t have enough industrial challenges — such as
inflexibility and poor product quality — even our basic systems are
crippling us. For example, cost accounting systems routinely allocate
overhead costs, such as the accounting department, engineering,
utilities, machinery and management, to direct labor. In fact, each
typical “direct-labor hour” may carry an overhead “burden,” as the
accountants call it, of 1,000 percent. That’s why, when a manager is
pushed by higher-ups to cut costs, there is but one sensible target
under this accounting regimen — direct labor, which, on the books,
includes that huge burden charge.

Here’s what can happen. Suppose the manager decides to subcontract
production of a labor-intense part. He saves 100 hours of direct labor
at $20 per hour ($2,000 in all) But on the books, the actual direct-
labor savings plus the 1,000 percent burden (worth 10 times the
labor), adds up to credited savings of $22,000.

The subcontract to a smaller, low overhead, perhaps offshore operation
costs, say, $5,000. The net savings, then, is $17,000. Much applause
goes to the plant manager.

Unfortunately, the real story is different from the accounting story.
The actual factory overhead is not reduced at all by the act of
subcontracting (you can’t shut the lights out over one idle machine).
In fact, overhead is increased, because the plant manager has to
negotiate and administer a contract with the new supplier and handle
the incoming components, not to mention the increased initial
uncertainty of delivery and quality with any supplier.

So the real net savings is the $2,000 in direct labor minus the $5,000
subcontract cost minus, say, $1,000 in real, added overhead —
or a loss of $4,000! Nonetheless, thanks to the miracle of
traditional accounting, the plant manager takes a bow.

Such perverse outcomes are commonplace, say professors H. Thomas
Johnson and Robert S. Kaplan in their new book, Relevance Lost:
The Rise and Fall of Management Accounting. In fact the authors
report that some experts claim that “cost accounting is the number one
enemy of productivity.”

Industrialists trained in engineering, such as Andrew Carnegie,
perfected modern accounting to assist managerial decision-
making needs concerning the production process. But slowly, as
professionally trained accountants began to take control of the
systems, accounting’s emphasis shifted from management tool to
financial reporting. And it’s those financial reporting requirements
by various regulatory bodies that necessitate conventions such as
allocating all overhead costs to inventory and cost of goods sold,
leading to the type of distortion described above.

Johnson and Kaplan attack today’s system by outlining its two
principal sins — errors of commission and omission. A prime example
of commission is the “expensing” of activities such as research,
worker-skill upgrading and process improvement. Because these
investments in the future are treated, for accounting purposes
, as “expenses of the period,” they fall prey to the short-term
cost cutter.

Another error of this sort includes hidden cross-subsidies among
products that make it difficult to measure true product profitability.
A third such sin is our fixation on short-term measurements, which
make it almost impossible to assess long-term costs of developing a
product.

Bad as these problems are, the sins of omission are worse. Our
emphasis, the authors argue, on financial measurements leads us to
downplay or ignore less tangible non-financial measurements, such as
product quality, customer satisfaction, order lead time, factory
flexibility, time to launch a new product and labor skill accumulation
through time. Yet these are, especially today, the real drivers of
corporate success over the mid-to-long term.

For example, most purchasing departments still are evaluated
principally on the contract cost of procurement. Yet this fails to
factor in how the lousy quality of purchased goods can diminish final
product quality. Not only is the ultimate producer’s reputation
tarnished by suppliers’ poor quality, but hard dollar costs (fixing
defective supplier material, warranty work) soar. Still, these costs
are barely considered in most firms.

The authors sadly conclude that advances in accounting to improve
managing all but ceased in 1925. They add, “Ironically, [just] as
management accounting systems became less relevant to the
organization’s operations and strategy, many senior executives began
to believe that they could run their firms ‘by the numbers.'” The
problem mushrooms today, when those numbers so misrepresent new
realities. Many firms are gingerly exploring the use of non-financial
measurements; but the effort is in infancy while the urgency of need
is increasing daily.