Accounting Concepts: Why are they necessary?
Accounting was invented to provide a fair answer to the question – how does one evaluate the performance of firm in a given specific time period?
The question was complex as business of a firm is ongoing and does not start and stop with the period start and end dates. The orders or projects at any point of time would be at various stages of maturity which means that order arrival, execution, closure, payments and revenues, can span across measurement periods. As a result there were following dilemmas.
- If purchase of raw material is made in one period, which is then converted to finished goods and sold in next period. In which period should the revenues and expenses be accounted
- Any error might give an incorrect assessment of the period performance of the firm.
- If the actual money received for an order, sold in year 1, is in year 2, when should we account the sales to provide a fair picture about performance of the firm?
- If the money to be given to a vendor, after receipt of the service and its use in delivery of end products in same period, is actually paid in the next period, when do we account for the expenses?
Improper expense accounting in above cases can lead to situations where a firm shows very high profits in one period ( period with all revenues but no expenses for the revenues) and then very low profits in next period (where all expenses are accounted without revenues). At the end we would not have any clue on how the firm performed in the period.
To solve the above problems and provide fair assessment for the period, following principles were invented
- Matching Concept
- Accrual Accounting
The matching principle indicates that the expenses should be matched with revenues. They are not recognized until the associated revenue is also recognized. For instance, wages paid to manufacturing workers are not recognized as expenses until the actual products are sold. When the products are sold, the expenses are recognized as cost of goods sold. Similarly, depreciation was invented to spread the cost of purchasing a fixed asset is spread over the period in which it is expected to generate revenue.
Accrual Concept is used to enable the implementation of matching principle. For example if a supplier supplies material in month 1 but is paid in next month and the final goods are sold in first month, then accounting of material expenses in month 2 will show an abnormal profits. Accrual concept will help account the raw material costs in month 1. Similarly revenues are recognized when they are earned or are realizable, even though cash is not received.
Did they simplify the problem? The matching concept and the accrual concept did solve the dilemmas. Now one can reasonably evaluate the performance of a firm. However, another mathematical problem cropped up during application of the matching concept. Expenses are of two types. One is truly variable expense (like raw material costs) which can be easily traced to the per unit product sales. However, the other form of expense belongs to a category, (like labor salary, maintenance expenses, rental etc) which cannot be traced back to the product directly. They are mostly period expenses. How does one match the period expense with the product revenue? In order to solve the problem, the period expenses was artificially allocated to the product using labor hours as a basis of allocation of period expenses to the product cost. So now one could measure what is known as product margins or product profitability in cost accounting.
In era when accounting was invented, bulk of the cost of a product was truly variable as labor was also paid by per piece output, so the mathematical assumption of allocating notionally, the period costs, did not create many problems.
However in the current era, labor salary has become a period expense. (Labor does not draw compensation on per piece basis.) So the period expense has become very significant in many organizations. When a significant portion of expenses is artificially allocated to a product, it creates many problems when these variables are used as measurements for decision making.
People in organization behave in the way they are measured. Wrong measurements can lead to erroneous behavior.
Cost Accounting: Driving erroneous behaviors?
Inventory Profits in Made to Stock Organizations
In made to stock companies, when part of the inventory is not sold, matching concept tells us that part of period expense may not be shown in the P&L. So, part of the period expense (allocated to inventory) has to “wait” in the balance sheet as assets. They can only be shown in the P&L account when inventory is actually sold.
However, in real world most of the period expenses are incurred regardless of volume sold. So now one could actually show artificial profits by producing to stock. So even if sales is less likely , excess production does help in moving some period expense out from the P&L account. What is the damage of having excess inventory as finished good inventory? Excess stocks affect working capital requirements, creates pressure to reduce prices, delays launch of new products (as old ones is occupying the pipeline). If the product has limited shelf life, then write-offs is also prevalent. In most of the cases, with excess production, company actually loses money than making more money.
Production mis-alignment with sales
Most of the production units are measured on efficiency factors (helps reduce the product cost – more produced less is the allocated cost per unit). As a result the production department will be driven more towards sequencing items on a machine, in way, that reduces setups and improves efficiency rather than as per requirements of order due dates. Even production will be tempted to produce certain items which may not be required in the immediate term. This creates a conflict between marketing and production.
Poor reliability for made to order companies
For made to order companies, it would “help” accounts to have more work-in-progress as it helps in moving away some of the manufacturing expenses from the accounting period. In a high WIP environment, priorities are not clear which in turn causes lot of expediting and poor on-time delivery performance. In many job shops, products are not loaded even on empty machines because “products will become expensive” whereas it is considered ok, even if it is standing in a queue in front of a less expensive machine, thus increasing the wait time in order execution. The routing of a product can affect its “profitability”. But does really, the processing of a product in an expensive machine increase the costs? How much are the extra payouts made by the company with this decision? Nil.
Erroneous outsourcing decisions
Using cost per piece or product margin can lead to erroneous make or buy decisions. If a product is less profitable to make it inside, then it is better to buy it from outside? Will it improve the overall profits of the organization? If the plant has excess capacity, the decision can actually lead to lower overall profits. How? In most cases the overhead expenses do not reduce. (Have you ever seen a person drawing lower salary or rental of a building reduced because of a product being sourced out?) With the outsourcing decision, the payouts increase by more than the raw material costs. So the net result is extra payouts by the company. If the operation being outsourced is a bottleneck, then the actual gains by the company is many times the “margin” gain as shown by cost accounting numbers.
Erroneous investment Decisions
Machine investment decisions are usually made based on comparisons of reduction in cost per part as compared with the investment, to calculate the payback period. The reduction in cost per part is almost a myth, if the equipment is a non-bottleneck machine. While for a bottleneck machine, the actual payback period is much less than what is calculated using the traditional method.
Erroneous Product viability decisions
There have been numerous cases where a company has not accepted a “loss order” despite having excess capacity. It is interesting to know that many loss making companies actually do not take loss making orders. However they still make losses at end of the year! How?
Not taking a “loss” order while having excess capacity also takes away the opportunity to recover some portion of the total operating expense. As a result, at the end of the year, sum of contribution from all “profitable” orders are not enough to cover the total fixed expenses.
Of late, cost accounting has been criticized by many. In fact cost accountants have been advising against the blind use of numbers for decision making. Activity Based Costing was invented to take care of the problems with cost accounting.
Activity Based Costing – Does it really solve the problem?
Proponents of Activity Based Costing argue against cost accounting due to “arbitrary” use of labor hours for allocating overhead expenses. They argue that the allocation method is incorrect when different product use resources in varying ways. So they argue, the resource cost allocation, should be based on how much the product has actually used the resource. This will help make a “correct” comparison of products. ABC advocates a better allocation method.
The fundamental question: Is allocation itself a correct method?
What is wrong with cost accounting based on absorption principles?
- Cost accounting assumes that we can measure the impact of an area on the company’s profitability, by measuring how much money this area “absorbs” or “frees”. This way of analysis can only be correct, if we assume the importance of a resource in an organization is dependent on the cost of the resource. However, the “physics” of a shop floor, tell us that importance of resource is based on whether the resource is a bottleneck or a non bottleneck machine. The bottleneck resource limits the output of a company. It has nothing to do with how much the machine costs. An hour lost on the bottleneck is an hour lost to recover the total operating expense, whereas, an hour saved on the non-bottleneck is just a myth.
- Allocating what is essentially a fixed costs creates a mirage that fixed cost can actually be changed in direct proportion of the sales volume but reality is very different. In reality fixed expenses are fixed for specific volume interval. Definitely, for an order or an output in a short horizon, fixed cost does not change with change in volume produced or type of order processed.
- Many argue that eventually in the long run, capacity can be matched with demand or in other words in the long run everything is variable and decision based on cost accounting will help in aligning capacity with demand and prevent the wastages. While this looks good in theory, but in real business world, market fluctuates in much faster pace than capacity additions. Capacities can be procured only in blocks. In an environment of uncertain demand, coupled with complex synchronization across resources and varying product mixes, it is impossible to align capacities with demand in any time horizon.
- In stable organization, with reliable operations, it is important to maintain excess capacities in most resources and not match capacity of all resources, exactly as per the demand. In an uncertain environment, for reliable operations, it makes sense to always have an un-balanced line
Throughput Accounting: Relevance Regained?
Allocation of what are essentially period costs can lead to erroneous decisions like the examples discussed. The Theory of Constraints advocates argue that bulk of the manufacturing expenses are actually period expenses. So it makes sense only to allocate what is truly variable with a unit of sales. (For example raw material costs, sales incentives etc).
At the product level, what needs to be measured is only throughput( Sales-Truly variable expenses)
The important measures in throughput accounting are:
- Throughput = Sales – Truly Variable Expenses: Throughput (TP) is also defined as the rate at which the company makes money from sales.
- Inventory: The money tied-up in the organization. Since the period expenses are allocated to the product, the inventory is only valued as per the truly variable expenses.
- Operating Expense: All the money the organization spends generating throughput. It includes all expenses, other than the truly variable expenses.
So profits of a company = ∑ TP (from all products) – OE
(Products do not make profits. It is the company which makes profit so the profit has to be calculated only at the company level. Products bring thru-put and the total thru-put from all products should be more than enough to cover the total period expenses and give the desired profits.)
Return on Investment = (TP-OE)/I
Productivity = TP/OE
Decision making under the throughput accounting
As already discussed, many cost accounting decisions at a local level can actually cause damage to the company at the global level. So now we need a tool which helps connect the local decisions with the global objective (making more profits for the company.)
Any business decision like outsourcing, investments in new equipments, accepting a large order can impact either the throughput, or the operating expense ( at organization level), or the total inventory. So it makes sense to analyze the impact on these 3 variables.
So the three important questions to be answered are:
- What is the impact of a decision on the company’s total throughput?
- What is the impact of a decision on the company’s total operating expense?
- What is the impact of a decision on the company’s total investment?
The change in throughput (because of the decision) should be compared with the change in total operating expense (because of the decision). This will provide us with the change in profits which in turn can be compared with the change in investments to determine the ROI.
Throughput accounting does not assume operating expenses to be fixed. It assumes it is not truly variable. So any decision (for any time horizon) has to check the changes in the 3 variables to arrive at a correct decision for the company as a whole.
The above analysis can only be done if one understands the relationship between the constraint of the organization, the non constraints and the output of the company. The focusing steps of TOC have to be used to analyze the company before one can measure the impact of a local decision on global impact using the 3 questions.
The focusing Steps:
- Identify the organization’s constraint(s)( resource which limits the output)
- Decide how to exploit the constraint(s)
- Subordinate to the above decisions
Let us apply the focusing steps and the 3 questions of thru-put accounting in following scenarios.
If the output of an organization is controlled by the constraint machine, what will be the payback
period of an investment made for a non constraint resource?
- Either there will never be a payback at all or the payback could be only from reduction of work in progress in shop floor. ( if the investment is made for protective capacity of a non-constraint
What will be the payback period when we analyze the decision for investment on constraint
machine? How will it compare with payback period calculated using the traditional method?
- Any minor reduction in machine hours per job will not be entertained in the old way of accounting, as the payback period will be very large. However, using thru-put accounting, the payback period ( even for a minor reduction) will be much less as throughput gained would be significant ( which is ignored in traditional calculations)
Which products to focus on?
- In a plant with dominant bottleneck, thru-put per constraint resource is used to identify the lucrative products. If there is no dominant bottleneck, throughput per time period is used to decide on lucrative products.
Criticisms of throughput accounting: Are they valid?
There have been following criticism of throughput accounting. Most of the criticisms are due to lack of complete understanding of throughput accounting.
1. Criticism : It is same as direct costing
- Direct costing assumes contribution margins of products as difference between revenue of a product and direct expenses (raw material and direct labor). It considers all other costs as fixed. Throughput is not same as contribution margin. Throughput is equal to difference between revenue of a product and truly variable costs. In many cases labor is not considered a truly variable expense as the payouts are in form of period expenses. All other costs are not considered as fixed in throughput accounting.
2. Criticism : It is only valid when there is a bottleneck in production
- For any decision , regardless of the environment, the relevant costs and revenues have to be calculated and compared using the 3 questions of throughput accounting.
3. Criticism : It is short term focused
- The 3 questions can be analyzed for any time horizon. However for long term, the risk and scenario analysis also has to be incorporated in the decision making process.
Should thru-put accounting replace the current accounting practices?
The accounting practices developed for statutory reporting helps the investors in a company, to analyze the financial performance of a company. It provides a fair picture of the performance of company in a time period. It should not be changed as it serves the purpose for which it was created. However, it should not be used for decision making by managers of an organization. Managers should use throughput accounting for internal decision making. The results of an organization using throughput accounting will always look good in the book of accounts published for the stakeholders.