By Dennis Caplan, University at Albany (State University of New York)



CHAPTER 2: Relevant Concepts from the Fields of Strategy and Operations Management, and a Brief History of Management Accounting


This chapter describes some concepts and characteristics from the fields of strategy and operations management that are relevant to the study of management accounting. Because management accounting is a management support function, management accountants need to be aware of emerging trends, issues and techniques in the field of management. Also, because many of the most challenging management accounting problems occur in the manufacturing sector of the economy, management accountants must have a solid understanding of the terminology and basic characteristics of common manufacturing processes. This chapter also provides a brief history of the development of management accounting.



Manufacturing Processes:

Manufacturing industries can be categorized according to the extent to which individual units of output are distinguishable from each other during and subsequent to the production process. We describe four points on a continuum.


Job order: In a job order process, each unit of output is unique. Examples include a custom home builder and a custom furniture-maker.


Batch process: In a batch process, identical (or very similar) units of output are produced in groups called batches, but the units in one batch can differ significantly from the units in another batch. The units within each batch usually remain within close physical proximity throughout the production process.


Apparel factories often use a batch process. For example, different styles of pants are produced in separate batches. Each batch might consist of 50 or several hundred pairs of pants. Within each batch, there might be minor differences, such as different waist and inseam sizes. At any one time, the factory might have work-in-process related to several different styles of pants, and numerous batches of work-in-process for each style.


Assembly line: In an assembly-line process, similar units are produced in sequence, usually in a highly-automated operation. The automobile industry is a good example. An automobile manufacturer makes only one model car on any one assembly line. The assembly line allows for some product differentiation. For example, cars produced on the assembly line can differ from each other with respect to such features as color and upholstery, and perhaps in more substantive ways such as the size of engine, and two-wheel versus all-wheel drive. However, to change an assembly line from one model to another usually requires significant expense and down-time.


Continuous process: In a continuous manufacturing environment, the manufacturing facility produces a continuous flow of product during the operating hours of the facility. A classic example of a continuous process is an oil drilling operation. The distinguishing feature of a continuous process is that any grouping of output into individual units is arbitrary. For example, oil can be divided into barrels or gallons or any other measure of liquid volume. In order to determine the cost of production in a continuous process, it is necessary to select a period of time, collect costs incurred during that period, determine the amount of output produced during that same period, and divide total costs by total output.


There is no presumption that a continuous manufacturing process is a one-product facility (drilling operations often extract both crude oil and natural gas), or that it runs 24 hours a day.


Overview of manufacturing processes: Distinguishing manufacturing processes along this continuum is helpful, because where a process falls on this continuum influences the types of management accounting issues that arise, and the design of the management accounting system. However, it is often difficult and seldom helpful to classify any particular manufacturing process precisely into one of the four points of the continuum described here. Also, any one company might operate over several points on this continuum.




An important issue in the management of firms is the extent to which decision-making is centralized or decentralized. Many large companies operate in a highly decentralized fashion, and have numerous responsibility centers and responsibility-center managers with considerable autonomy. Important types of responsibility centers include the following:


Cost centers: Managers of cost centers are responsible for costs only. Most factories are cost centers.


Profit centers: Managers of profit centers are responsible for revenues and costs. The Jeans Division of Levi Strauss & Co. might be a profit center.


Investment centers: Managers of investment centers are responsible for revenues, expenses, and invested capital. The Canadian Division of Levi Strauss & Co. might be an investment center.


Following are important benefits of decentralization.


1.                  Decision-making is delegated to managers who are often in the best position to understand the local economy, consumer tastes, and labor market.


2.                  Autonomy is inherently rewarding. Job positions that are characterized by a high degree of responsibility and autonomy are likely to attract and retain more talented, experienced and capable managers than positions that provide managers minimal decision-making authority.


3.                  Companies that delegate responsibility deep within the organization create a training ground where managers gain experience and prepare themselves for higher-level positions.


4.                  Decentralization places fewer burdens on top management. Highly-centralized companies impose on top management the responsibility for numerous routine decisions.


Following are important costs and risks of decentralization.


1.                  The incentives of responsibility-center managers do not always align with the incentives of owners or top management. There is the obvious risk that managers might consume perquisites at the expense of corporate profits (e.g., expensive business lunches and office furniture). Also, there is evidence that managers will attempt to increase the size of the units for which they are responsible (called the manager’s span of control), even if doing so does not increase the profitability of the company.


2.                  Economic theory suggests that managers prefer for the responsibility center under their control to accept less risk than owners would like. This theory builds on the observation that higher-risk projects generate higher returns, on average, reflecting the trade-off between risk and return, which constitutes a building block of finance theory. Shareholders prefer riskier projects than managers, because shareholders can diversify their portfolios by owning shares in numerous companies. However, the manager’s career is closely connected with the performance of his or her responsibility center. Consequently, managers of responsibility centers of decentralized companies might reject risky projects that shareholders would favor.


Although there are both benefits and costs to decentralization, it would appear that by any objective measure, most large corporations operate in a highly-decentralized fashion. As a benchmark, one might wish to compare the extent of decentralization in modern corporations with the extent of decentralization in such entities as the military or the former Soviet economy.


The Origins of Management Accounting:

Management accounting first emerged as a significant activity during the early industrial revolution, in the leading industries and enterprises of the day. As such, management accounting arose after financial accounting, which can trace its origins to its stewardship role in European merchant trading ventures beginning in the Italian Renaissance, and to tax records that governments apparently have required for as long as governments have existed. Double-entry bookkeeping had been used for more than 300 years by the time management accounting first emerged as a recognizable field.


Two leading industries of the industrial revolution that played important roles in the early history of management accounting were textiles and railroads. Textile mills used raw materials and labor to make fabrics and associated products, and the mills developed methods to track the efficiency with which they used these inputs. Railroads required significant investments of capital over long periods of time for the construction of roadbed and track. Once operational, railroads handled large volumes of cash receipts from numerous customers, and developed both financial and operational measures of efficiency for moving passengers and freight.


By the end of the 19th century, new industries and types of businesses were becoming important to the economies of the United States, Great Britain, and other industrializing nations. These enterprises included steel producers, mass producers of consumer products such as foodstuffs and tobacco, and mass merchandisers such as Sears, Roebuck & Company. Leading companies in these industries developed accounting systems to meet their needs for operational control.


In the first two decades of the 20th century, the fields of industrial engineering and management accounting developed in tandem. During this period, industrial engineers developed methods to control production that included a “scientific” determination of standards for inputs of materials, labor and machine time, against which actual results could be compared. This development led directly to standard costing systems, which are still widely used by manufacturing companies. Management accounting concepts and techniques continued to evolve rapidly throughout the rest of the first half of the 20th century, and by 1950 most of the key elements of management accounting as practiced today were well established.


These developments occurred in a decentralized fashion, inside large companies that were using common sense and commonplace bookkeeping and analytical tools to meet their internal reporting requirements. Companies that business historians have identified as innovators in management accounting practice during this period include DuPont, General Motors and General Electric. However, an innovator is not necessarily a leader. There appears to have been relatively little communication among companies regarding the management accounting methods that were developed. Perhaps managers and accountants viewed these accounting systems and techniques as proprietary, a possible source of competitive advantage. Also, there was no institutional or regulatory impetus for sharing information. In the early 1900s, there was no association of management accountants to hold annual meetings in Chicago or Boston for continuing professional education and revelry. There was no government oversight of management accounting practice. With very few exceptions, management accounting itself was not required for regulatory purposes until the Foreign Corrupt Practices Act of 1977, which mandated that large companies maintain adequate systems of internal control. Even today, companies have a great deal of discretion in the design of management accounting systems, and management accounting looks very different from one company to another even within the same industry.



Key Developments in the Past 50 Years:

The economic, business and technological developments that have probably had the greatest impact on management accounting over the last 50 years are the following:


The information revolution: Those of us born in the second half of the 20th century have difficulty appreciating the enormous hurdle that the collection and processing of information once posed to management accounting systems, and the impact that the cost of information had on management in general. Today, information technology makes possible sophisticated database accounting systems that are both powerful and flexible in terms of the accounting information that they can collect, organize and report. Even today, however, the cost of designing, implementing, and running cost accounting systems is a substantial obstacle in many organizations; a fact probably underrepresented in business schools.


Proliferation of product lines: If a company makes only one product, many cost accounting issues are moot. When companies significantly expanded their product lines beginning in the 1950s, to gain market share and increase profits, the difficulty and importance of obtaining accurate cost information on individual products increased. It is generally agreed that in the 1970s and 1980s, some U.S. companies were allocating costs among products in a manner that led to poor production and marketing decisions. A management accounting tool called activity-based costing was developed to help correct this problem, by improving the accuracy with which costs are allocated among products.


Globalization of the economy: Globalization has several implications for management accounting. First, globalization has resulted in a more competitive environment, which encourages the implementation of accounting systems that provide the most accurate, relevant, and timely information possible. Second, the growth of multinational corporations has increased the importance of transfer pricing. A transfer price is the amount one division of a company charges another division for an intermediate product. Transfer pricing plays a role in taxation, international trade negotiations, and production and marketing decisions within decentralized firms. Finally, globalization has increased the pace of change within the management accounting profession. Many recent innovations in management accounting, as well as in the fields of strategy and operations management, originated in Japan. Direct competition between Japanese and U.S. companies has led many U.S. companies to adopt these Japanese management practices.


Increasing importance of the service sector: Prior to the 1970s, most innovations in management accounting techniques, and the most sophisticated management accounting systems, were found in manufacturing firms (although as discussed above, railroads played an important role in the early development of management accounting). As the service sector became a larger part of the overall economy, and as competitive pressures within service sector industries increased (in some cases brought about by deregulation), many service companies invested substantial resources in management accounting systems tailored to meet their needs. Service sector industries noted for significant developments in their management accounting systems include transportation, financial institutions, and health care. Customer costing (determining the cost of servicing an individual customer), and improving the timeliness of accounting information, are two issues of particular importance to many service sector companies.



Innovative Management Practices:

In addition to the four economic and technological trends described above, the following innovations in the fields of strategy and operations management have influenced management accounting systems and practices over the past several decades.


Total quality management (TQM): Quality programs go by several names, including TQM, zero defect programs, and six sigma programs. The focus on quality has had a significant impact on many organizations in all sectors of the economy, beginning with the automobile industry and some other industries in the manufacturing sector of the economy about forty years ago. Sophisticated quality programs are found today in many areas of government, education and other not-for-profit organizations as well as in for-profit businesses.


The impetus for TQM programs is the assessment that the cost of defects is greater than the cost of implementing the TQM program. Advocates of TQM claim that some costs of defects have been underestimated historically, particularly the loss of customer goodwill and future sales when a defective unit is sold. Some advocates of quality programs believe that the most cost-effective approach to quality is to eliminate all defects at the point at which they occur. If successful, these “zero defect” programs would not only result in higher levels of customer satisfaction, but would also eliminate costs associated with more conventional quality control procedures, such as inspection costs that occur at the end of the production line, the cost of reworking units identified as defective, and costs associated with processing customer returns. The focus is on preventive controls to prevent the defect from occurring in the first place, as opposed to detective controls to identify and correct the defect after it has occurred.


Just-in-time (JIT): During the last two decades of the 20th century, many companies implemented just-in-time programs designed to minimize the amount of inventory on hand. These companies identified significant benefits from reducing all types of inventories—raw materials, work-in-process, and finished goods—to the lowest possible levels. These benefits consist principally of reduced inventory holding costs (such as financing and warehousing costs), reduced losses due to inventory obsolescence, and more effective quality control.


The relationship between JIT and TQM is important. Many defects in raw materials or the production process can be ignored indefinitely if high-quality materials can be substituted for defective materials, and if additional first-quality units can be produced to replace defective units. In a non-JIT environment, defective materials and half-finished units might be set aside in a corner of the factory. However, under a JIT program, if raw materials received at the factory are defective, there might be no first-quality materials on hand to substitute for the defective materials. In extreme cases, the production line might be shut down until first-quality materials are received. Hence, a JIT program can focus attention on quality control in ways not generally possible in a non-JIT environment.


The challenge in a JIT environment is to avoid stock-outs. To meet this challenge, some companies have found ways to decrease production lead times. Shorter production schedules result in less work-in-process inventory, and also allows companies to maintain lower levels of finished goods inventory while still maintaining high levels of customer satisfaction.


Early in the 21st century, acts of terrorism (such as the destruction of the World Trade Center in New York City) and natural disasters (such as Hurricane Katrina) prompted some companies to rethink the practice of maintaining extremely low levels of inventories. These companies are concerned that future incidents could result in the disruption of inventory pipelines, particularly for imported materials. Consequently, the advantage of maintaining safety stocks of inventory is receiving renewed interest.


Theory of constraints: The theory of constraints is an operations management technique that decreases inventory levels and increase throughput in a manufacturing setting. Eliyahu Goldratt, a business consultant, is largely responsible for the development of the theory of constraints. Goldratt popularized his ideas in a business novel that he coauthored with Jeff Cox called The Goal: A Process of Ongoing Improvement. The basis of the theory is to identify bottlenecks in the production process, and to focus all efforts on increasing the capacity of the bottleneck operations. Typically, bottleneck operations are easy to identify, because large amounts of inventory back up at these operations waiting to be processed. The theory of constraints also advocates setting the speed of the entire production process at the speed of the bottleneck operation, because otherwise excess work-in-process will inevitably build up. This “pull” system should replace traditional “push” systems, where every operation processes inventory at its maximum capacity.


Like most new ideas, the theory of constraints has a basis in earlier techniques and ideas. As early as the 1970s or 1980s, engineers and production managers used a tool called critical path analysis to predict the time required to accomplish major new objectives, such as introducing a new product or bringing a new facility on line. Critical path analysis involved identifying the sequence in which various steps were required, and identifying at what point, and for how long, the entire project would depend on the completion of any particular step.


Lean production and the lean enterprise: In recent years, the term “lean” has been adopted by some organizations to describe the organization’s comprehensive effort to apply state-of-the-art management practices to improve quality and customer satisfaction, reduce costs and production lead-times, and increase value-creation. “Lean” is an umbrella term that includes such techniques as JIT and TQM as component elements. Some accountants credit Toyota as the originator of lean production. The term “lean” was originally applied to manufacturing settings, such as in the phrases “lean production” or “lean manufacturing.” But the term is now used more broadly, and sometimes describes lean initiatives in the distribution and support functions of a manufacturing company, lean initiatives in service-sector companies, and even initiatives in other types of organizations such as governmental entities. The term lean accounting has been coined to describe accounting systems that either support lean production, or that are, themselves, “lean.”




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Management Accounting Concepts and Techniques; copyright 2006; most recent update: November 2010


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