Cost Accounting, R.I.P.

"Innovation requires builders not bean-counters, and the last person who should be running something is the man who controls the costs. Sure, you need that man in there somewhere to keep a rein on things, but he shouldn’t be at the top."

—James Dyson, Against the Odds: An Autobiography

Andrew Carnegie’s favorite saying was, “Watch the costs and the profits will take care of themselves,” but in an intellectual capital company, it should be, “Watch your value and price, and the profits will take care of themselves.

In 1987, H. Thomas Johnson and Robert S. Kaplan published Relevance Lost: The Rise and Fall of Management Accounting, which was named in 1997 one of the 14 most influential management books to appear in the first 75 years of Harvard Business Review’s history.

The book is credited with launching the activity-based costing revolution. Yet, these two thinkers have gone down very different paths since then: Kaplan going on to pioneering work in the field of performance measurement, creating the Balanced Scorecard, and Johnson moving on to what he calls “management by means.”

Toyota—No Cost Accounting?

Johnson’s later book, Profit Beyond Measure, is a seminal work, although not yet fully developed. And while I have severe misgivings about some of his environmental rants, when he profiles Toyota and Scania as two manufacturers that do not have a standard cost accounting system, he is on firm ground.

As Glenn Uminger, a financial controller at Toyota Motor Manufacturing-Kentucky (TMM-K) since 1988, says, “TMM-K has never had a standard cost system to track operating costs, and we probably never will.”

So how do they do it? How can a manufacturing company run without a standard cost accounting system? The answer lies in the subjective theory of value I explained in this post, and how Lee Iacocca priced the Ford Mustang. Toyota understands price drives costs, not the other way around. Here is how Johnson explains it in his book, Profit Beyond Measure:

None of these comments is meant to imply that Toyota does not have accounting and production planning information systems. Of course it does. Toyota has a comprehensive array of information systems, accounting and otherwise, with which to plan, in advance of operations, and to report results of operations after the fact. But information from such systems is not allowed to influence operational decisions.

"Toyota management discharges its responsibility for costs not by taking arbitrary steps to manipulate operations, but largely in the vehicle planning stage. During the design stage, long before the first penny has been committed to making a vehicle, Toyota has always placed enormous importance on setting and achieving cost targets. To do so, over the years Toyota has developed a famous technique for target costing. Simply stated, target cost is the maximum cost the company can afford to incur to produce and sell a vehicle and still earn a required profit at the price customers are expected to pay."

Johnson goes on to explain his theory that Toyota operates under “management by means” rather than “management by results,” which views the organization as a living system, based on interdependent relationships, and those are nearly impossible to quantify.

He notes Dr. Edward Deming’s observation that over 97 percent of the events that affect a company’s results are not measurable, while less than 3 percent of what influences final results can be measured:

Managers who adopt the new thinking offered here will accept as second nature the idea that what decides an organization’s long-term profitability is the way it organizes its work, not how well its members achieve financial targets.

"Management accounting simply takes accounting revenue, cost, and profitability information, which is appropriate for measuring the overall financial results of a business, and inappropriately attempts to trace it to the particular activities and products of the business that gave rise to those results. Assigning such quantitative measures to parts of a mechanistic system makes sense. However, the parts of a natural living system cannot be so treated. Accounting measures are unable to penetrate the organic, multifaceted union between customer and company that ultimately is the source of a company’s financial results.

"Because cost and profit are not objects, but are properties that emerge from relationships, quantitative measures can only describe them, they cannot explain them."

I suspect that Peter Drucker would agree with Johnson:

I do not believe that one can manage a business by reports. I am a figures man, and a quantifier, and one of those people to whom figures talk. I also know that reports are abstractions, and that they can only tell us what we have determined to ask. They are high-level abstractions. That is all right if we have the understanding, the meaning, and the perception. One must spend a great deal of time outside, where the results are. Inside a business one only has costs. One looks at markets, at customers, at society, and at knowledge, all of which are outside the business, to see what is really happening. That reports will never tell you."

The Price-led Costing Revolution

The lesson is that a company needs to start with value, then determine price, which finally dictates the costs that can be profitably incurred to produce a good or service desired by customers.

It seems so obvious to constrain your company with a final price before you begin to incur any costs, yet this practice is not widely followed, despite its proven successes. Costs are, no doubt, important to consider, but the crucial distinction is when they are considered.

By its very nature, cost accounting is a historical function, but what is important for pricing are planned costs, not past costs. Furthermore, cost accountants usually pay far too much attention to sunk costs, which should have no influence over pricing or value considerations.

As Henry Ford pointed out, no one knows what a cost should be. Yet, cost accounting has held hegemony for far too long over the pricing strategies of businesses everywhere, embedding the conventional wisdom that costs determine price. Merely because a practice is widely adopted and utilized does not make it optimal, not to mention true.

One of Peter’s Principles is bureaucracy defends the status quo long past the time when the quo has lost its status. Cost accounting, and its more modern cousin activity-based costing, does not deserve to be the apotheosis of pricing, let alone running a business. No doubt, it has its role in any organization, but that role is very specific and historical, not one that should have a major influence in production and pricing decisions.

This may sound like the ultimate apostasy coming from a recovering CPA and cost accountant, but like the ancient mythological Greek Cassandra, I must speak the truth even if no one is prepared to believe.

Photo: kenny1 / shutterstock