MY SONS AND ME AND
MANAGEMENT ACCOUNTING

By Roger K. Doost

Having practiced accounting for 20 years and taught it for 15 years--primarily management accounting--I naively thought that I would have no problem being advisor and counselor to my son, Omid, about to start his mail and printing business, and later to my younger son, Saba, who became his partner. During a strategy session, I told Omid something about financial plans, budgets, forecasts, cost accounting, forms, and reports. When asked for feedback, he responded that this is his business and that currently he is not asking for management advice, or management; he just wants advice on accounting. At the time, I was too hurt to deal with his logic.

Lesson 1. Management advisory services are not accounting. Sometimes, as accountants, we want to prepare the plan and projections rather than just quantifying them. Management accounting and management are not the same. The latter is involved with managing resources while the former provides information on what management has done.

At our next meeting, I asked him about his projections so that I could compile forecasts and budgets. He hesitated and responded politely that he did not have any. He had guessed at a few numbers, jotted them down on a piece of paper, but didn't need anything formal and didn't want to be bothered with accounting fantasies. He wanted to get down to his real business. This was the second blow to my self confidence!

Lesson 2. It does not make sense to develop forecasts and budgets if good data is not available. Sometimes, a business needs to get its feet wet before meaningful forecasts and projections can be formulated.

A month later, we got together again. I had designed requisitions, purchase orders, and receiving report forms. He attempted not to offend me, but made the point that he would rather shift paperwork to the suppliers in order to save costs. When he needs supplies, he calls the supplier who faxes him an immediate confirmation. If the order is for less than $400, the supplier just ships it and encloses a bill for payment. Receipt is confirmed on a packing slip or enclosed invoice and passed on to accounts payable.

Lesson 3. Discard unnecessary forms that will not result in a loss of control and where the resulting benefits exceed the costs associated with maintaining those forms.

The following week, I told Omid that he should know the cost of each product and how much he could sell them for. He should account for the direct cost of labor and material on each job and apply overhead to each job based on overhead pools for production management, utilities, phone expense, depreciation, rent, property tax, etc. He wanted to know what to do if, according to my accounting, a product cost more than what he could sell it for. I wanted to tell him to raise his price to cover his costs and overhead, but I was afraid to hear the response that market determines the sales price and not cost. Instead I told him that he would know that he had to bring his cost down to be able to compete. His response was that he will sell, as long as he can cover direct costs--labor and material--his price contributes to overhead, and overall ends up with some profit. Then, he wanted to know if it isn't ridiculous to charge rent, phone calls, depreciation, plant management, etc. to a job based on some arbitrary measure, no matter how carefully you calculate it based on accounting knowledge. At this point in time any arguments I might have on behalf of activity-based costing (ABC) would take me no where with this thought pattern. I decided to save these for a later try.

Lesson 4. Arbitrary cost allocations for determination of product costs only contribute to confusing management rather than helping when deciding whether or not to sell a product.

As Omid got his feet wet in business, and I, to some extent, put aside perceived insults to my academic and professional knowledge, I designed a series of daily, weekly, and monthly reports including cash balances, labor efficiency, daily production, an income statement, and balance sheet. I stated that these kinds of reports are a must for accounting and accountability. In retrospect, what I really may have told him was that because I am an accountant, if I don't produce those kinds of reports and do not participate in management, what purpose do I serve by being there? He would have none of it. For cash reports, he was convinced that a weekly adding-machine total of outstanding payables compared with a cash register total of his receipts is all he needs to process his payments. What if he runs out of cash? He thought of that too. He had arranged overdraft protection with his bank when disbursements exceed receipts.

What about daily efficiency reports? Omid didn't want any of that either. According to him, all he has to do is employ conscientious people, pay them well, and expect them to do their jobs within reason and with flexibility. He thought that asking workers to spend 2.5 minutes on job code 1 or 3.75 minutes on job code 2 was not only offensive, but inhumane. He was not going to count how many times his employees used the bathroom, went for coffee, or talked to each other. His people were going to be treated with respect and without the accountability prevalent in typical factories.

As to a monthly income statement and balance sheet, his unequivocal response was, "no, no, no." I tried to explain that the monthly income statement will show how much he sold, how much his expenses were, and whether he made or lost money. At the end of each month, the balance sheet would show his financial position; what he has, what he owes, and his ownership in the firm. He was not convinced particularly as to the need for monthly, rather than annual reports.

Omid suggested that accountants often work with irrelevant numbers and confuse, rather than help, an entrepreneur. For example, he would report as sales all the work completed and delivered to customers, but also wants to know about the completed but as yet undelivered work, as well as the work almost completed that customers will pick up tomorrow. Also, what about the work partially complete and those customers who have not paid for what they received? I told him that I would account for these as work in progress, finished goods inventory, and accounts receivable. He, in turn, proposed to account for all this stuff in a much less complicated fashion--his cash register shows his collections, his checkbook how much he spent, and his bank balance how much money he has. The open invoice file shows what needs to be collected and the foreman will tell him what jobs are still in progress and who has not picked up their completed work. He argued that month-to-month accounting of revenue and expenses with all the estimating, deferrals, and accruals entailed does nothing but confuse his real bottom line.

As to the monthly balance sheet that I had proposed, Omid had the following comments:

* Finding the exact cutoff for what is sold, not sold, in inventory, and in work-in-progress is tedious, difficult, and not worthwhile.

* Not accounting for undelivered purchase commitments does not make sense.

* Counting as solid assets what is uncollected is questionable. And estimating what may not be collectible is vague and uncertain.

* Counting equipment purchases at historical cost as assets and subjecting them to some method of depreciation such as ACRS provides no indication of the value of such assets.

* Equity is what the company can be sold for, less the company's potential liability, and not an accountant's determination of this number, which has little relevance to reality.

* Deferred and accrued costs are subject to interpretations that may not be totally convincing.

* Historical costs, in general, may not be a good indication of value.

Lesson 5. Reports should have meaning and relevance to the user and aid in decision making.

At this point I asked Omid, to tell me what kind of accounting he wants.
He responded with the following:

* Daily and monthly cash reporting--beginning cash balance, cash receipts, cash disbursements, and ending cash
balance.

* Periodic physical counts of raw material, work-in-progress, and finished goods inventories.

* Periodic appraisals of how much his company is really worth.

* Periodic reviews of his outstanding customer and supplier invoices.

* Periodic assessment of where he is and in what direction he is going in terms of his activities, customer satisfaction, and supplier selection.

* Advice on minimizing his taxes.

Lesson 6. Small businesses, in particular, care little about all we do as accountants. They need proper cash basis reporting of accounts complimented by other nonfinancial reports.

Almost five years passed. I watched Omid from a distance, what he did, and how he did it. He was OK and able to pay his bills. My younger son, Saba, joined him as his partner, and once again I looked for opportunities to sneak into the business. By this time, ABC had caught on, and I wanted to experiment with newly acquired knowledge. At our meeting I did my best to review the pitfalls of old allocation systems, with which I knew they would readily agree, and then the merits of ABC. I started my discussion around the suggestion that cost accounting, as we knew it has become irrelevant. Accountants had believed that all costs are driven by volume and charged overhead to products based on direct labor hours, machine hours, direct labor dollars, material costs, or number of units produced. If a product used more of those resources, it got charged for a higher share of overhead costs such as utilities, maintenance, purchasing, the personnel department, and other items of overhead.

This time, both sons offered up less than complimentary comments to the effect that the information prepared in this fashion is not useful for determining whether to produce or not produce, sell or not sell, discard or expand any particular product line. They could not comprehend how personnel costs, receiving costs, production related costs, rents, utilities, etc. can be added together and a base allocation made on one factor.

Lesson 7. The way accountants compile and allocate overhead costs to products can conceivably have no value for management.

I then explained that ABC offers a better costing system that has been developed where different cost pools are created. For example, employee benefits may be allocated based on direct labor costs, utility costs on floor space, or maintenance on machine value. ABC costing finds further association between product costs and its various cost drivers. My sons argued that all costs aside from material, supplies, and other directly identifiable product costs are common costs and they are fixed costs. When a decision is made for example, to invest in a certain capacity, buy a certain machine, or employ a certain work crew, there is not much else that can be done until and unless that investment is retired. It is true that a higher production volume probably requires increased space. It is also true that a supervisor whose job is divided among several different products may establish some association between those supervisory costs and the product costs but they are at best arbitrary. Even I know that ABC advocates, despite their eagerness for accuracy, often agree to set aside facility-related costs such as rent, plant management, taxes, and insurance, from product costs, because they are also convinced of the arbitrariness of such allocations. To argue that ABC costing is necessary to improve pricing decisions, therefore, does not hold a lot of water. No one can reasonably charge common costs to different products with any measure of exactness. This is precisely why they are called common costs. And, if accountants, with our innate desire for exactness, could leave such items alone, life might be a little simpler for managers.

According to my sons, to maximize profit we should produce products that have the highest margin and take the least amount of time to produce. We must focus our attention on smooth production runs, elimination of bottlenecks, and maximizing our return given a certain level of fixed resources.

Lesson 8: Most costing systems can be simplified by accounting for clearly identifiable direct costs such as, material costs, and adding a share of overhead based on lead time. The longer it takes for a product to be completed, the more resources it uses.

I continued to argue that attaching costs to products in a reasonable way leads to better decisions in producing and selling products. My sons argued that pricing decisions, long-term or short-term, after the investment is made, should be based on incremental profit. Whenever incremental revenue exceeds incremental costs, those products should be produced. This is the way that profit is maximized.

Lesson 9. Before an investment is made, we must determine the potential profitability. After an investment is made, we must continue with the incremental profit concept until the asset is retired or replaced, and that's the bottom line. *

Roger K. Doost, is a professor in the school of accountancy at Clemson
University.

Editor:
Michael Goldstein, CPA
The CPA Journal