13. Are Accountants Homo Accounticus?
I enjoy maturity and evolution models of all kinds, especially for business. There is a stages of maturity model for information technologies and others such as for sales teams and their customer relationships. What I like about stages of maturity models is they provide confidence that regardless what stage one is at – low or high – there is a next step further up that can be attained in an evolutionary way.
In biology there is an evolution of humans that has in earlier stages Australopithecus, then Homo erectus, then Neanderthals, and our current stage Homo Sapiens. Examples of important changes are brain size, hand grip, and a larynx for speaking.
Just to have some fun I will take the position that some accountants are primitive Homo Accounticus. Just as with humankind there are overlap periods where primitive accountants co-exist with more sophisticated ones with more capabilities and skills.
This implies they have evolutionary steps in their future. A stereotype of an accountant is as a bean counter. These are the Homo Accounticus. In the evolutionary ladder they can become bean growers. They can add value beyond just reporting to assisting their organization to gain insights and make better decisions.
I mentioned the brain as an important change in this evolutionary ladder. There has been excellent research about the brain by Daniel Kahneman, recipient of the Nobel Prize in Economic Sciences for his seminal work in psychology, that challenged the rational model of judgment and decision making.
In his recently published book, Thinking, Fast and Slow, Kahneman explains the two systems that drive the way we think.
System 1 is fast, intuitive, and emotional; System 2 is slower, more deliberative, and more logical.
System 1 is largely unconscious. It makes snap judgments based upon our memory of similar events and our emotions.
System 2 is painfully slow. Itis the process by which we consciously check facts and think carefully and rationally.
An example that Kahneman illustrate System 1 and System 2 thinking is this. Suppose that a bat and ball together cost $1.10 and that the bat costs $1.00 more than the ball. How much does the ball cost? Many people, relying mainly on System 1 thinking, will quickly say $0.10, but the correct answer is five cents. Here are the equations:
Bat + Ball = $1.10
Bat ($1.05) – Ball ($.05) = $1.00
A problem Kahneman points out is that System 2 thinking (slow) is easily distracted and hard to engage and that System 1 thinking (fast) is wrong as often as it is right. System 1 thinking is easily swayed by our emotions.
An example he cites include the analysis that professional golfers are more accurate when putting for par than they are for birdie regardless of distance. Another example of a controlled experiment observes that people buy more cans of soup in a grocery store when there is a sign on the display that says "Limit 12 per customer."
How do accountants exhibit System 1 and System 2 thinking?
What caught my attention is that System 1 thinking, which is deliberate and logical, is easily distracted. In our busy day there is little time for solitude and deep thinking.
An accountants’ day may be consumed with the monthly task of “closing the books” for financial reporting or analyzing product or standard service-line profitability. There is little time to consider the validity of the calculated information they are relying on.
Many companies continue to use the long-standing practice of standard cost accounting and allocate the indirect and shared expenses to products and services as a single “cost pool” with a single basis or factor such as sales volume, number of employees, or direct labor input hours.
There is no cause-and-effect relationship! In reality some difficult products to make or services to deliver are consuming relatively more of the total indirect expenses. Since cost allocations have a zero-sum error of the total, the easier products services must consume relatively less. The activity-based cost management (ABC/M) accounting method resolves this by disaggregating the single “cost pool” into its component work activity costs, and then traces and assigns each to the products using the quantity of an “activity driver” to resolve this problem.
Might you think that ABC/M should now be a commonly accepted practice by accountants? It was frequently written about in the 1970s.
However, research by Dr. Martijn Schoute of Vrije Universiteit in Amsterdam published in his dissertation thesis, Antecedents and Consequences of Cost System Design Choices, cites research that less than 20% of British firms use ABC/M.
Without applying the ABC/M method the consequence is that managers and employees are using flawed and misleading information for analyzing profit margins and operational costs.
Are most accountants Homo Accounticus?
Why would accountants who appear to be genetically born to seek precision, accuracy and detail rely on creating and worse yet using flawed information?
My belief is System 1 thinking, which is quickly accepting that their cost information is perfectly correct (because it reconciles with their firm’s total expenditures), is distracting the accountants from the deeper understanding of what they are doing.
Higher forms of the accountant species possess more Systems 2 thinking by being deliberate and logical.
12. Management Accounting 101, 102 and 103 Courses
Management Accounting 101
“Break the GAAP Rules to Find the Jewels”
Welcome, accounting class, to Management Accounting 101. No need to take your seats. All you need to know is this: Do not allocate indirect expenses to products and service lines using cost allocation factors like spreading butter across bread. Examples of factors are the amount of sales, number of units produced, number of employees, number of labor hours, or square feet. None of those comply with costing’s causality principle.
Trace and assign indirect expenses into calculated costs using driver quantities so that they are similar to direct costs. Your line managers and executives will appreciate you because you will have unhidden the costs by making them visible and substantially more accurate. This will enable your colleagues to gain insights and make better decisions. Class dismissed.
Management Accounting 102
Welcome back, accounting class, to Management Accounting 102. This brief lecture is intended to inspire you. It ends with a pop quiz.
Let’s reflect on the giants of the scientific revolution from past centuries. Copernicus shocked the world by placing the Sun rather than the Earth at the center of the universe. Galileo Galilei was the father of the scientific method and applied the telescope to test theories. Johannes Kepler then described planetary motion with our planets, including the Earth, orbiting around the Sun. His work helped Isaac Newton develop his theory about gravity that every particle attracts every other particle in the universe with a force that is directly proportional to the multiplicative product of their masses and inversely proportional to the square of the distance between their centers. Albert Einstein then refined Newton’s work with his general theory of relativity describing gravity as a geometric property of space and time - spacetime.
All of these advances replaced misconceptions with reality.
Pop Quiz – In what decade in this 21st century will accountants replace distorting and misleading cost allocations with reality based on cost accounting’s causality principle?
Please hand in your paper with your answer.
Management Accounting 103
Welcome back, accounting class, to Management Accounting 103. This is my final lecture. It will describe how to resolve the “cost allocation” problem I described in my 101 class and if what I now teach is followed will propel CFOs and accountants out of the 1960s into the 21st century. The solution is activity-based costing (ABC).
There has been a slow adoption by accountants to apply ABC as a replacement for the flawed and misleading traditional “cost allocation” methods for indirect expenses (commonly referred to as “overhead”) from standard cost accounting systems. As I mentioned in my 101 lecture, they allocate indirect expenses like spreading butter across bread using non-causal and broadly averaged cost allocation factors. Examples are the number or amount of direct labor input hours or currency, units produced, sales volume, headcount, or square feet/meters. None of those reflect the true consumption of expenses that unique and diverse products and service lines consume of the end-to-end processes and the work activities that belong to the processes.
After ABC decomposes the single and typically large indirect cost pool into multiple cost pools – the work activities – and traces and assigns them based on a cause-and-effect relationship there is no surprise to those managers who are suspicious. What is discovered, compared to the traditional costing, is that some of the products and service lines are being over-costed and the others must be under-costed because allocations have zero-sum error. Traditional costing does exactly reconcile the indirect expenses in total into the product and service line costs. That satisfies the auditors for external financial regulatory and statutory reporting, but the costs are wrong in the parts. This means that CFOs and accountants are providing their managers and executives with those flawed and misleading costs I mentioned which means the profit margins are also wrong.
The benefits from applying ABC in comparison to traditional cost allocation methods that violate “costing’s causality principle” are numerous. Key benefits are: (1) extremely more accurate profit and cost reporting of outputs, products, services, channels and customers; (2) transparency and visibility of the “drivers” for work activities and their magnitude; and (3) past period calibrated cost consumption rates that are essential to multiply against future forecasted demand volume and mix that determine resource capacity requirements – workforce headcounts and spending amounts. These rates are needed for what-if scenario analysis, make-versus-buy decisions, and capacity-sensitive driver-based rolling financial forecasts and budgets.
Causality is at the heart of ABC. For example, if the quantity of the activity driver increases 20% then its activity cost should also increase 20%. The work activities are what consume the resource capacity expenses. Any CFO, financial controller, or FP&A analyst who are using traditional cost allocation methods and are not using ABC where it is applicable (which is for most organizations) is being irresponsible in their duty to provide valid information to managers and employees. The information they are providing is faulty, distorted and deceiving. Line managers deserve better from their CFO to support their decisions.
Thank you for taking my management accounting 101, 102, and 103 courses. You will soon graduate. I wish you success as you join an employer to act not as an accounting “bean counter” but to be a “bean grower” to help your organization with insights and making better decisions than with stale and arcane cost allocation methods from the 1960s.
Class is dismissed.
11. Identifying and Measuring the Cost of Error and Waste
When managerial accountants and information system builders better understand the nuances for designing their cost measurement system, they are more successful.
One of the challenges for a cost measurement design team is to right-size the system.
This means to balance simultaneously its level of detail, relevance, and accuracy with the level of administrative effort made to collect data and report the transformed information.
Any managerial accounting textbook will proclaim that there are multiple purposes for managerial accounting ranging from......
The full article is available in the file attached below
10. Why Use ABC
Some organizations abandon pursuing activity-based costing (ABC) because they continue with the misconception that ABC is too complex to create and maintain.
They falsely believe the benefits from ABC’s information for insights and better decision support do not exceed the effort to create the ABC information.
There is a dozen more “barriers” that prevent pursuing implementing ABC. None are valid.
CFOs and accountants remain in the 1960s. They need to arrive in the 21st century.
These slides that I created describe why organizations should implement and use ABC.
9. Movie Sequel - "Accountant Pirates of the Caribbean"
Please forgive me for my persistent rant and criticism against accountants who budget poorly or continue to calculate the substantial and growing high indirect and shared costs originating from resource expenses such as salaries, supplies, power, information technologies, and travel. I cannot seem to hold back my frustration.
When I observe managerial accounting practices and methods that ignore driver-based budgeting principles or simply allocate indirect and shared expenses typically as large combined “pool” using a single broad-brushed cost allocation base (e.g., number of units produced, sales amounts, direct labor input hours, head count, square feet/meters), I do not know if I should laugh or cry!
Accountants as pirates
The cost allocation methods just described violate what should now be well known by accountants as the “causality principle.” Expenses should not be “allocated” implying using any convenient base denominator in the calculation that converts 100% of the expenses into 100% of costs. Expenses should be “assigned and traced” in proportion to how the expenses are consumed. This means that the various work activity costs that belong to end-to-end and cross-department processes should be disaggregated and re-assigned using a quantity or volume metric that reflects the consumption rate.
Now at this point some readers of this article have stopped reading and gone off to do other things like process journal entries and admire how elegant their debit and credit T-accounts look. Many of them suspect they are going to hear another heralding of the virtues of activity-based costing (ABC). That's fine. Let me write to the rest of you.
First, what were pirates and what is piracy? A definition for piracy is an act of robbery typically at sea but also applicable on land. It refers to raids across land borders. Can I use a pirate analogy for misguided accountants? I believe I can if you allow me to use some imagination.
When accountants mis-allocate calculating past period historical costs (e.g. product costing), the result is simultaneously over- and under-costing compared to the economic reality because re-assigning expenses and costs is a zero-sum-error calculation. Are the accountants “robbing” anyone? Yes. At one level they are acting like Robin Hood taking from some (i.e., product costs) to give to others. At a more personal level they are “robbing” managers and employee teams from having reasonable cost accuracy from which to draw insights for decisions such as product, service-line, channel, and customer rationalization. Accurate reported output costs and profit margins lead to a better understanding for determining how much and what types of resources to use to maximize the organization’s mission to stockholders (commercial companies) and stakeholders (in the government public sector).
What about “raids across land borders?” If you continue with this piracy analogy, one can substitute the borders of the organization chart with land borders. We all acknowledge that organizational silos exist at some level despite the lean and Six Sigma quality management community’s pursuit to eradicate the self-serving behavior of and organization’s departments. When accountants focus on departmental cost center reporting of actual versus budget spending, they make managers either happy or sad, but rarely any smarter. Managers rarely see or sufficiently understand the cross-departmental costs of activities. And the reported costs of the products and service-lines that consume these expenses are flawed and misleading due to non-causal broad-brushed averaging earlier described.
Unethical or irresponsible? Shame on versus shaming accountants
I recently posted a question in the website discussion group of one of the professional accounting institutes. Based on this institute’s definition of code of ethics, which is now has higher interest based on financial scandals like Enron, I asked if accountants are behaving unethically or just irresponsibly when they basically and most likely knowingly miscalculate output costs. There were a range of responses including several who defended accountants as simply just “doing their job” and that the total costs do perfectly reconcile without error. (Now there is an auditor’s mentality. Correct in the whole, and everywhere incorrect in the parts.)
What about my behavior in writing this article? Am I placing shame on accountants or shaming them. There is a difference. Shame exists when one admits they have a committed act and therefore are dishonorable. Shaming is an assault on the worth of an individual. Shame results in the accused diminished self-esteem and at the extreme to be dismissed and banished from the organization they were a member of – a harsh penalty.
If I am shaming an accountant for their lack of caring to provide their managers and workforce with reliably valid information for decision making, if they already have low self-esteem then I might cause them to have an irreversible downward spiral. I certainly do not want that to happen. But I will maintain my position and assign shame to those accountants who themselves know who they are. They know they are admittedly using misallocating cost calculations that violate costing’s causality principle. It is a principle. The causality principle is not a law like they can be handed a traffic ticket from a policeman.
Why does any of this matter?
Why am I standing my ground and persistent? Management accounting has an imminent important task ahead. Most commercial companies are shifting from being product-centric to customer-centric for a whole host of reasons including that customers now view most suppliers as selling commodities. This means a supplier’s competitive edge will come from offering differentiated services to increasingly granular micro-segmented types of customers. It is no longer about just increasing market share and growing sales. It is about growing profitable sales. If accountants do not have mastery on tracing expenses to channels and customers they place their company at peril and risk.
This article was previously published on www.information-management.com