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INDT 562 Financial Issues for Manufacturing

December 14, 2001
Book Review:
Relevance Lost: The Rise and Fall of Management Accounting
The Basics of Finance: Financial Tools for Non-Financial
By Anthony Cappucci

Relevance Lost: The Rise and Fall of Management

H.Thomas Johnson
Robert S.Kaplan

Relevance Lost describes the evolution of management

accounting in American business, from the early textile mills of New
England to present-day computer-automated manufacturers. But after
World War I, the management accounting system became subservient
to financial reporting procedures and requirements. Soon, internal
accounting systems were no longer providing relevant information to
allow manufacturing managers to make timely and cost efficient
The book begins by tracing the development of simple textile
mills in the early 1800’s. They were the first American business
organizations to development management accounting systems. They
used cost accounts to determine the direct labor and overhead costs of
converting raw material into finished yarn and fabric. The double-entry
cost accounts, among the earliest discovered anywhere, differed from
any accounting methods used before. Before the industrial revolution,
accounting was mainly a record of the external relations of one
business unit with another, a record of relations determined in the
market. But with the emergence of large scale manufacturing
operations, necessity arose for more emphasis upon the accounting for
interests with the competitive unit, and the use of accounting records
as a means of administrative control over the enterprise.
By the middle of the nineteenth century, great advances in
transportation and communication provided further opportunities for
gain to large, hierarchical organizations such as the railroads, steel
mills, and distribution firms. Accounting systems began to link a
company’s business when organizations combine two or more
separable activities in a single managed enterprise. Known as
vertically integrated firms, these businesses appeared in the United
States around 1900.
In the late 1800’s, a demand rose for new management
information that was not provided by conversion cost systems. The
demand originated in firms that mass produced complex machine

made metal goods. The complex manufacturing processes made it

difficult for managers to gather precise and accurate information about
the efficiency of workers engaged in specialized tasks. The search for
this information inspired a systematic analysis of factory productivity
that came to be known as “scientific management.” These “scientific
managers” focused their attention on predetermining standard rates at
which material and labor should be consumed in manufacturing tasks.
The methods they devised to determine standards for material and
labor inputs included engineering design of bills of materials and time-
and-motion study. Engineers and accountants used information about
standards for three very different purposes. Scientific management
engineers developed information about standards in order to gauge
the efficiency of tasks or processes. Detailed systems were later
developed by accountants for analyzing variances between standard
and actual cost performance to control their operations.
Accountants, not engineers, developed a third purpose for standard
cost information. Some financial accountants recognized that standard
costs greatly simplified the task of inventory evaluation.
The multidivisional structure and management accounting
procedures devised in the early 1920’s, enabled giant industrial firms
to overcome the inefficiency and bureaucratic disabilities that were
endemic to large-scale orginazations. In large, diversified enterprises,
the multidivisional organization sharply reduces the volume of
communication between divisional managers, thus enabling managers
to employ resources more efficiently and more effectively than if they
used centralized organizations. Internal accounting procedures
enabled top managers to transmit to managers in sharp, unambiguous
terms the goals for company-wide profits and growth.
Little evidence exists to believe that auditors after 1900
persuaded managers to substitute inventory cost accounting figures
for strategic product cost information. That managers were inclined to
compile accurate product costs data in the decades after 1900 likely
reflects their judgment on costs and benefits of such information, not a
lost sense of what information is relevant to management decision. Yet
having the accounts used to value inventories for financial reporting
purposes be the only source of product cost information undoubtedly
has affected how accountants and managers thought about cost
management during the past sixty years. Many accountants and
managers have come to believe that inventory cost figures give an
accurate guide to product cost, when they do not.
Contemporary academic literature on applying analytic
techniques to management accounting problems further led to lost
management accounting relevance. It was devoid of references to
“systems actually in use” or to “systems installed in well-known
organizations”. Instead, the references were to writings of other
university researchers’ knowledge of managerial issues derived not

from studying decisions and procedures of actual firms, but from the
stylized models of managerial and firm behavior articulated by
“theorists” in other academic disciplines. Thus, the models were not
developed for or tested on actual enterprises.
The obsolescence of contemporary management accounting
systems has likely created significant problems for the managers of
large, diversified organizations. Contemporary cost accounting and
management control systems are no longer providing accurate signals
about the efficiency and profitability of internally managed
transactions. Consequently, managers are not getting information to
help them compare the desirability of internal versus external
transactions. Without the receipt of appropriate cost and profitability
information, the ability of the “visible hand” to effectively manage the
myriad transactions that occur in a complex hierarchy has been
severely compromised.
The loss of relevance in most companies’ cost accounting
systems is particularly unfortunate for the global competition of the
1980’s. The consequences of inaccurate product costs and poor
accounting systems for process control and performance measurement
were not severe during the 1970’s since a combination of high inflation
and a weak dollar sheltered most U.S. companies from foreign
competition. High levels of worldwide demand for U.S. products during
that decade placed a premium on production throughput. Higher costs
and, and occasionally, goods of substandard quality could generally be
passed on to customers. The competitive environment for U.S.
manufacturers completely changed in the 1980’s. First, disinflation
reversed the previous inflationary psychology, and manufacturers
could no longer recover cost increases through higher prices. At the
same time, a sharp increase in the value of the U.S. dollar made
foreign produced goods less expensive to the U.S. consumer. Also
manufacturers in Japan started to place an emphasis on adapting
improved quality standards.
Current cost accounting systems attempt to satisfy three goals:
to allocate certain period costs to products so that financial statements
can be prepared monthly, quarterly, and annually; to provide product
cost estimates to product and business managers; and to provide
process control information to cost center managers. It would be
desirable to have a single systems satisfy all three cost accounting
objectives. But given the low cost and high power of information
processing technology, this should not be a necessary design criterion.
Of more importance is to perform each function well.
The obsolescence of management accounting systems has not
occurred overnight. The systems, whose intellectual roots can be
traced to events sixty to one hundred years ago, worked well for the
times in which they were designed. It has been speculated that the
dominance of financial accounting procedures, both in education and in

practice, has inhibited the dynamic adjustment of management

accounting systems to the realities of the contemporary environment.
These realities, including remarkable expansions of information
technology, a more virulent global competition, a shortened life cycle
of products, and innovations in the organization and technology of
operations, have all contributed to the new demands and new
opportunities for corporate management accounting systems.

The Basics of Finance: Financial Tools for Non-

Financial Managers
Bryan E.Milling

This book explains that effective financial management is

essential for business success. But financial management typically
remains the last concern for independent business managers.
Instead, they concentrate on their special interest or expertise—
sales or engineering or manufacturing, etc.—and turn to the financial
aspects of the business only when a crisis develops. A manager may
then become uneasy or intimidated when working with the analytical
tools essential for effective financial management, making decisions
that influence the profitability, and perhaps the survival, of the
business using information he or she doesn’t fully understand.
The Basic of Finance provides a remedy for that problem. This
book can be used as a primary source for the important formulas and
ratios that serve as the basic tools for business financial analysis. The
glossary offers concise definitions for terms used throughout the book.
The index helps you locate analytic tools quickly. But business
financial management requires interpretation as well as calculation,
and the book proceeds beyond the basic arithmetic to help you
understand and use the data that result from your calculation.
Some Examples

• Is a three-to-one dept-to-equity ration satisfactory for your

• How does inventory turnover rate affect your firm’s financial
• How does your sales volume relate to your need for working

The book helps your answer such questions, and you will find that
financial analysis is more than an interesting arithmetic exercise. You
can find numerous examples that illustrate the major principles of
financial analysis and the potential benefits from attentive financial
management. These examples can help you profit by applying the
principles to any business circumstance.

You can also find many of the major tenets of financial management
crystallized in a set of concise Financial Facts. For example, one
Financial Fact marks the current ratio that usually represents adequate
liquidity in a business. Another relates financing costs to the return on
a firm’s assets. Still another emphasizes the value of prompt trade
payment practices.
Unique business circumstances often qualify the management
tenets set forth in many Financial Facts, but collectively they provide
the foundation for effective management of a business enterprise.
To illustrate, a summary of the primary justification of the book:

Financial management is critical
to the success of every business.

Every chapter ends with a Financial Fact. The book doesn’t reveal
any secrets, but it should become a profitable management tool
whether you use it only as an occasional reference or as a primary
guide for making financial decisions. This book will allow non-financial
IT managers gain a basic understanding of a firm’s financial