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Traditional Managerial Accounting

Ir. M. Geense
(Delft University of Technology)

History of Accounting

Information on commercial transactions has existed for as long as people have traded with one another. Ancient civilizations engraved bookkeeping records on stone tablets. More than five hundred years ago, Luca Pacioli, a mathematician monk, described the basics for a double-entry booking system. With this double-entry system traders could determine the results of the transactions they made in the market and could also determine their assets and debts.
During the industrial revolution a lot of production was transfered from individuals to large companies (texile mills, steel factories, etc.). The whole production and selling of products consisted of several conversion processes which were all performed in these large companies. Conversion processes that formerly were supplied at a price through market exchanges became performed within one organization. A lot of internal transactions occurred as conversion processes supplied their output to a next process within the organization instead of selling their output on the market. Owners of these large companies devised systems to summarize the efficiency by which labor and material were converted to finished products. These early managerial accounting systems produced efficiency measures such as cost per hour or cost per pound produced per process and per worker. These measures were used to motivate and evaluate the workers and their managers (Johnson and Kaplan, 1987, pp 6-12).

Early Cost Accounting Systems

In order to calculate the costs of a product, the direct labor costs and direct material costs ('prime costs') of a product were summarized. At the end of the nineteenth century companies also included indirect costs ("overhead") when calculating the costs of a product. According to Church and Mann, most companies determined the indirect costs of a product as a percentage of the direct labor costs (Solomons, 1952, pp 22-23). In 1910 Church wrote "it is a very usual practice to average this large class of expense (red. indirect costs), and to express its incidence by a simple percentage either upon wages or upon time. That this plan is entirely misleading there can be very little doubt, because few of the expenses in the profit and loss accont have any relation either to each other or to wages or to time. To rely upon an arbitrary established percentage .. is valueless and even dangerous" (Church, 1910 pp 79-81).
When determining the costs of a product, Church advocated dividing the factory into a series of 'production centers' (e.g. a machine and a group of workers). In this production center method, the costs of each production center are summarised. The hourly rate of each production center expresses the total costs of the production center per hour. The costs of a production center is then loaded on to the work passing through it, at an hourly rate. (Solomons, 1952, pp 25-27).

Early Budgetary Control Systems

Budgeting as a tool to forecast expenses is an old practice. Joseph in Egypt made a budget of corn supplies and planned Pharao's investment and consumption policy in the light of it. In Great Britain the practice of drawing up a government budget each year is about 250 years old. In 1911 Bunnell described that each item of overheads was to be budgeted and compared with the actual expenditure under each head as a way to control costs. This budget for each item of overheads was a fixed budget, which was not adjusted for changes in the number of products produced. In 1903 Henry Hess described the basic idea of what we now call a flexible budget. Hess used a graphical method to compare the budgeted expenditure and actual expenditure. For each main group of expenses (for instance direct production labor costs) he plotted a straight line, representing the relationship between expenses and output. Thus the budgeted expenses were adjusted for changes in levels of output (Solomons, 1952, pp 45-49).
Traditional Managerial Accounting

Scientific Management

At the Springfield Armory in Massachusetts, Tyler developed performance standards for employees, which were determined scientificly. Already in 1842 Springfield Armory implemented Tyler's system and recorded the peformance, and deviations from the performance standards per employee (Ezzamel, Hoskin and Macve, 1990, pp 159-160). Several years later, the US Railroads, used the 'operating ratio' (revenues / costs) to measure the performance of managers (Hoskin and Macve, 1988, pp 39-50). At the end of the nineteenth century, several engineers in metal working firms, developed standards for the use of materials and labor in manufactoring tasks. They used scientific methods (such as time-and-motion studies) to determine these performance standards. One of these 'Scientific Management' engineers, Taylor, created a system which compared the actual use of labor and material with the performance standards in order to monitor physical labor and material effiencies (Johnson and Kaplan, 1987, pp 48-51). According to Ezzamel, Hoskin and Macve, 'The Springfield workers were the first to become accountable under the new system; then in the railroads it were managers who became accountable' (1990, p 161). And according to Miller and O'Leary, 'Tyler's achievement was to invent Taylorism avant le mot' (1987, p. 287).

Managerial Accounting Standard Costs and Variances

At the beginning of the twentieth century companies started to use performance standards to determine the standard costs for processes and products (Solomons, 1952, pp 38-49). The standard costs of a product or a process are predetermined measures of what costs should be. The standard costs of a product for instance are determined by multiplying the standard use of labor, materials, machines, etc. per product by the standard price of labor, materials, machines etc. These standard costs might be compared with the actual costs in order to monitor the efficiency in companies. The difference between standard costs and actual costs are analysed in a variance analysis. Already in 1920, G. Charter Harrison wrote a set of formulas for the analysis of these cost variances. (Solomons, 1952, pp 50). Today companies still compare their predetermined or budgeted costs with their actual costs in a variance analysis. In a complete variance analysis companies also compare their budgeted sales with actual sales. A simple example of a variance analyis is given below:

budgeted sales volume * budgeted selling price:1,000 products * € 50.00= €50,000
actual sales volume was lower: only 900 products: 900 products * € 50.00
- ------------------------------
sales volume variance:- 100 products * € 50.00= - €5,000
the actual selling price of the product was also lower:
€ 48.00 instead of € 50.00: variance = - € 2.00 lower
selling price variance:900 products * - € 2.00= - € 1,800
the standard use of labor per product is 1.0 hour and
the standard price of labor is € 40.00
in this simple example no other costs are involved
the total standard costs allowed (flexible budget):900 products * 1.0 * € 40.00= - € 36,000
the actual use of labor per product was only 0.9 hour:900 products * 0.9 * € 40.00
- ------------------------------
efficiency variance900 products * 0.1 * € 40.00= €3,600
the actual price of labor however was higher:
€ 41.00 instead of € 40.00 = € 1.00 higher
labor price variance: 900 products * 0.9 * - € 1.00= - €810
+ ----------
actual result:€9.990

Return on Investment

Around 1900, many mass producers, acquired there own distribution channels and own sources of raw materials and other inputs. These firms performed several activities which were formerly performed by individual companies. Manufacturing, purchasing, transportation and distribution became integrated in these multi-activity firms. In these vertically integrated firms, many individual departments still relied on their own measures of efficiency. Most of these efficiency measures however could not be related to overall company profit. In order to monitor the contribution of each activity to overall profit they developped a new performance measure: return on investment. The return on investment (income / invested capital) ratio helped top management to monitor the profitability of each individual activity (Johnson and Kaplan, 1987, pp 61-93).


- Church, A. H.,'Organisation by Production Factors', Engineering Magazine, April 1910.
- Ezzamel, M., K. Hoskin and R. Macve, 'Managing It All By Numbers: A Review of Johnson & Kaplan's 'Relevance Lost', Accounting and Business Research, vol. 20, 1990, pp 153-166.
- Hoskin, K. W., and R. H. Macve, 'The Genesis of Accountability: The West Point Connections', Accounting, Organizations and Society, 1988, pp 37-73.
- Johnson, H. T. and R. S. Kaplan, 'Relevance Lost: The Rise and Fall of Management Accounting', Harvard Business School Press, 1987.
- Jorissen, A., 'Management accounting: een revolutie op de drempel van de 21ste eeuw?', Economisch en Sociaal Tijdschrift, december 1993, pp 551-590
- Miller, P. and T. O'Leary, 'Accounting and the Construction of the Governable Person', Accounting, Organizations and Society, 1987, pp 235-265.
- Solomons, D., 'Historical Development of Costing', Studies in Costing, Sweet & Maxwell, 1952, pp. 1-51.


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