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).
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 variance||900 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
| + ||----------
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.