Tijdschrift voor Economie en Management

Vol. XXXVI, 3, 1991

Management Accounting
and Control Systems

by H.P. HOLZER4' and H. NORREKLIT'"'"

I. INTRODUCTION

Management accounting in the US and elsewhere has recently recei-

ved more publicity than usual. Outdated management accounting sys-
tems were found to produce misleading cost numbers and performan-
ce measures. Radical changes in manufacturing technology and phi-
losophy, combined with intensified global competition, had made
many traditional systems obsolete. In response, significant efforts
have been made in both industry and academy to conceive and apply
new costing systems that meet the requirements of the changed en-
vironment.
In addition to this impetus arising from developments in industry,
there are ongoing academic research efforts in the discipline. The goal
of this paper is to discuss and analyze the developments motivated
by the important changes in management accounting's environment
and to describe the status and progress of scholarly research in the
field.

11. BRIEF HISTORY O F MANAGEMENT ACCOUNTING

Modern management accounting has a rich history going back almost

200 years. The need for cost accounting and tools for planning, coor-
dinating, and control, first arose during the industrial revolution

" Uiliversity of Illinois at Urbana-Champaign, U.S.A.

*"arhus School of Business, Denmark.
The authors would like to thank Professor Timothy O'Leaiy of the University of Illinois
for reviewing the paper and for his helpfill suggestions.
(Johnson (1972)). A common view is that modern management ac-
counting began in the 1920's, although the term became widely accep-
ted only in the late 50's. During the twenties and thirties a control-
lership function emerged in many important corporations that assu-
med increasing importance during subsequent decades. The most im-
portant and influential academic contributions to the developing dis-
cipline were made by Clark (1923), Dean (1951) and Anthony (1965).
Clark discussed and popularized the concepts that underlie modern
cost accounting ; Dean popularized discounted cash-flow models for
investment planning ; and Anthony developed a widely recognized
conceptual framework for control systems. The most significant prac-
titioner influence came from the publications of the National Asso-
ciation of Accountants and the Controllership Institute (now the Fi-
nancial Executives Institute). The latter sponsored many excellent re-
search studies, including the noteworthy Solomon's Divisional Perfor-
mance : Measurement and Control (Solomon (1965)), which provides
an excellent overview of existing practices and their underlying ratio-
n a l e ~Starting
. in the 70's, the environment of many management ac-
counting systems underwent important changes. These include the in-
troduction of new management philosophies and new technologies.

111. NEW UFACTURING PHILOSOPHY AND TECHNO-

LOGY
A major impetus for new practices in costing, production planning,
and control has come from recent developments in manufacturing
philosophy and technology. The driving force behind this develop-
ment is the greatly increased global competition in the manufacturing
sector that has forced manufacturers to seek more efficient produc-
tion methods and to produce products of better quality.

A. Just In Time (JIT)

One recently and widely applied production system in the manufac-

turing sector is the just-in-time technique made famous by Japanese
manufacturers, notably Toyota. JIT's principal objectives are conti-
nuous improvement in productivity and quality. JIT is a so-called
"pull" system that tries to minimize inventories. Ideally, products or
parts are delivered or produced just when they are needed for a pro-
duct or service : the demand for an item triggers production or de-
livery of the item. The signal which triggers may be verbal or it may
be by means of a "Kanban" (Japanese for card) (Huge (1988)). The
goal is to maintain a constant flow. Since there are no inventories bet-
ween consecutive stages of a production process, a stoppage at any
stage, for whatever reason, will bring the entire process to a halt. The
fact that defects and errors lead to a stoppage of the entire production
process forces management to a high level of quality awareness. One
of the leading theses of the JIT philosophy is "simplicity and do it
right."
Under JIT philosophy, inventories, especially work-in-process in-
ventories, are viewed as a liability that should be minimized as much
as possible. In addition to lower inventories, the advantages of ap-
plying the JIT philosophy to a manufacturing process include reduc-
tion in time (smoother and faster flows), less space (fewer inventories
to be stored), better quality (defects are corrected immediately), and
better service to customers (reduced lead times). JIT should be vie-
wed as a company-wide continuous effort to improve productivity and
quality, not limited to the factory.

B. Advanced Technologies (AT)

A number of new technologies have recently been widely applied in

industry in addition to the JIT philosophy. A basic understanding of
these technologies is necessary to appreciate their implications for
management accounting.
Material Requirements Planning (MRP) systems employ compu-
terized methods for coordinating detailed production plans in multi-
stage manufacturing systems that require a large number of materials
parts and subassemblies. The system starts with a master schedule of
the timing and quantities of finished products to be produced. A bill
of materials lists the quantities and timing of all materials and parts
requirements, which is used for preparation of complete production
schedules. MRP systems that go beyond manufacturing and include
capacity, purchasing, marketing, and financial planning are referred
to as Manufacturing Resource Planning I1 (MRP 11). Under MRP sys-
tems, the time of production is determined by a production schedule,
and in that sense it can also be viewed as a "push" system. MRP sys-
tems have been widely used, although there are far fewer applications
of MRP 11.
 Soon after the introduction of computerized MRP systems in ma-
nufacturing, use of the computer in the design of products (Computer
Assisted Design--CAD) and in the engineering of production proces-
ses (Computer Assisted Engineering--CAE) developed. CAD led to
tremendous improvement in the productivity of designers and in the
quality of designed products. In many cases combining CAD and CAE
not only led to better quality of products at a lower cost, but also to
a significant reduction of the time required for these functions. Com-
bining or closely linking the two functions permits simulation of pro-
cess design changes before the product is produced, which may greatly
improve the product's manufacturability and reduces production cost.
Computer Assisted Manufacturing (CAM) uses the computer for
planning, implementation, and control of production processes.
Total Quality Control (TQC) has as its premise that everything
done in the manufacturing process should be done right the first time.
Usually, but not necessarily, this involves statistical process control
(STP), a statistical procedure that monitors critical factors in a ma-
nufacturing process. The process is shut down when a critical factor
falls outside an acceptable range.
Numerical Control (NC) employs machines that are programmed
to run by a set of codes ; nowadays they are usually programmed and
controlled by computers, and we speak of computer numerical control
(CNC). Numerical Control machines are flexible ; they can do diffe-
rent jobs, and because they can switch from one job to another in a
very short time, they significantly reduce setup costs. Other advan-
tages are improved quality and reduction in direct labor hours.

C. Flexible Manufacturing Systems

Flexible Manufacturing Systems comprise all the techniques that fa-

cilitate flexibility by reduction of setup time in order to reduce inven-
tories. Three techniques are usually discussed under this heading :
Just in Time (JIT), Islands of Automation (IA) and Computer Inte-
grated Manufacturing (CIM). The JIT approach discussed above may
be viewed as a first step in simplification and the elimination of waste
in a manufacturing process. Islands of Automation, a second step, ap-
plies automation to individual processes or functions, usually a group
of machines dedicated to the production of a family of products, with
the use of robots and automated vehicles for manipulating and moving
the product. While IAs require large capital investments, JIT can be
implemented with almost no capital investments. Costs related to the
investment in high technology equipment replace the cost of labor.
Computer Integrated Manufacturing is the final step on the road to
automation, and links the AIs into one integrated system. In its ul-
timate form, CIM will provide computerized links from product de-
sign, to production engineering, to the actual manufacture of a pro-
duct. In the manufacturing process the shift from labor to technology
costs is complete and we approach a factory without people.

D. Consequences of Developments in ~anufacturin$

Consequences of these developments for the manufacturing organi-
zation can be shown in Figure 1,where we compare the features and
functions of traditional manufacturing with those of modern high
technology.
Note that advanced technology affects all functions in the factory.
It will drastically reduce hierarchical levels in the organization. This
has important implications for control. AT will also change the firm's
relationships with suppliers through the establishment of JIT delive-
ries with an ideal of zero defectives.
AT must also aim at improving customer service through signifi-
cantly shortened lead times. In the words of Drucker : "in the future
the factory is not a place at all, it is a stage in a process that adds
economic value to materials" (Drucker (1990))'.

E. The Impact of Advanced Technologies on Cost Functions

Introduction of JIT will lead to important changes in a firm's cost

functions. CAD and CAE have greatly reduced the time required to
introduce new products, which, in conjunction with increased global
competition, has shortened the product life cycle. Because of a pro-
duct's shorter life, the relative importance of design and development
costs is much greater. As much as 90% of a product's life cycle costs
are committed before production starts (Berliner and Brimson
(1988)). Management must therefore pay more attention to planning
these costs ;not only are they relatively more important, but they must
be recovered much faster than in the past.
Rapid technological change also shortens the useful life of many
manufacturing facilities, which may be obsolete long before their phy-
sical exhaustion.
 FIGURE 1
Conseq~ler~ces
of Developments 111 Man~~fnctz~rirzg

Features & Traditional Modern Advanced

Functions Manufacturing Technology

Process & Many Dedicated Machi- Flexible Machine Centers

nes
Facilities Multiple Setups Zero Setups
Large Warehouses No Warel~ouses
Lal-ge WIP Areas Drastic Decline in Space
Required
Mainframe Multiple networks of
Hardware Mini Mainframe, Mini,
MicroIPC Micro & PC
Constant Demand Fluc- Demand Stabilization
Control tuation
Frequent Rescheduling Minimum Rescheduling
Many Engineering Chan- Zero Change
ges

L
Weekly Planning Hourly Planning
Long Lead Times Zero Lead Times
Large Lot Sizes Lot Size of 1
Vendor Difficulties Vendor Synergies
Product Life Cycle Declining Life Cycle Much Shorter
Design Many Engineering Chan- Few Engineering Change
ges
Many Complex Cornpo- Few Complex Compo-
nents nents
Quality Improvement Zero Defects
over Cycle
Infinite Options Limited Options
Financial Labor Efficiency Product Profitability
Control Full Stream
Little Emphasis on Investment Intensive
Investment
Shop Orientation Product Cost is Incurred
Focus on Variable Cost Minimum Variable Cost
Beyond Material
overhead Spreading Zero Direct Labor
Cost Measurement Cost, Flexibility, De-
pendability and
Quality Measures
Functional Interfaces Product Teams
Long Lead Times Flexible and Rapid
Decision Making
Hierarchical Fewer Levels
 FIGURE 2
L+ Cyc!e &TT, arid Matched Co.~t(Berliner and Brimson (1988)).
Crrrh F~OKI

Changes in cost functions as we move from traditional to AT ma-

nufacturing affect direct labor. The relative importance of direct labor
has long been declining, and in many AT facilities it has already
disappeared as a distinct cost category. The disappearance of direct
labor means that only material cost remains as a direct cost and that
all conversion costs now fall into the indirect cost category. Direct la-
bor has been widely used as one of the bases for the allocation of over-
head costs ; new bases for allocating the enlarged pool of indirect costs
to products will need to be developed if serious distortion in product
costs are to be avoided. A further important related trend is the re-
placement of variable costs by fixed costs. Direct labor, a variable cost,
is replaced by machines and fewer highly skilled workers, whose wages
should now be considered as falling into the fixed cost category. Ow-
ning and operating AT facilities therefore leaves us only with mate-
rials as a direct and variable cost, with all other manufacturing costs
being indirect and fixed. Figure 3 shows the changing cost behavior
patterns.
In the following section we shall discuss the implications of these
developments on product costing, planning and performance evalua-
tion.

F. Product Costing

The change from direct to indirect, and variable to fixed costs, indi-
cates that many traditional costing systems may be producing cost
 FIGURE 3
Clzangng Cost Behavior Patterns

W
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V)
0
0 TECHNOLOGY
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0
3
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0
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Q.

ISLANDS OF
AUTOMATION MFG

numbers that are misleading if used for decision making. Many sys-
tems are integrated with financial accounting and are used for costing
inventories and cost of sales. Inaccurate costs for that purpose are not
overly serious. But most managers want to use costs for performance
evaluation, pricing policy and long run product profitability evalua-
tion. Before selecting a method to be used for costing a product, the
purpose and use of the resulting numbers should be clearly stated.
Evaluating the profitability (or a pricing policy) of a product over its
life cycle clearly requires different costs than those required for a
short run make or buy decision. In multi-product situations in AT en-
vironments, the increased amount of fixed period costs, a good part
of which will be joint in nature, and the incurrence of development
costs (both CAD and CAE) prior to manufacturing and marketing
of the product, make product costing a challenging task. It should be
obvious that different cost models will have to be used for different
purposes.

1. Activity Based Costing (ABC)

Activity Based Costing (ABC) has become the accepted term for the
recently widely advocated methods for obtaining more accurate costs
in circumstances where knowledge of accurate costs is important for
decision making.
 The initial focus of ABC is on the activities performed to produce
a product. Costs of these activities are identified and traced via a so-
called cost driver for each product, based on the product's use of each
activity. Activity based accounting is : " .... a collection of financial and
operational performance information dealing with significant activi-
ties of the business. Activities represent repetitive tasks performed by
each specialized group within a company as it executes its business
objectives". (Romano (1989)).
It is not surprising that the first reported uses of ABC were in in-
dustries with multiple products in a highly competitive environment.
In such situations profit margins are thin, prices are dictated by the
competition, and product profitability is judged on the basis of inter-
nally developed costs. If these costs are distorted, management may
be unaware that some products are sold at a loss. A cost driver should
present the best available measure for the consumption of overhead
activities by a product. The most frequently cited cause for the dis-
tortion of product cost is that many traditional costing systems ignore
the fact that many overhead costs of activities are not related to the
volume of products manufactured.
Setup costs are still an important cost, even in many AT manufac-
turing plants. They are not related to volume but to such drivers as
number of setups or setup hours. In a multi-product situation there
are usually significant differences in volume among products. Setup
costs for low volume products should therefore be higher on a per
unit basis for the low volume product and lower for the high volume
product. Ignoring these relationships in a costing system will lead to
overcosting of high volume products and undercosting the low volume
products.
Another indirectly volume-related activity might be materials
handling (cost may be related to weight or bulk); if assigned to pro-
ducts on a volume basis, such as direct labor or machine hours are,
they would, of course, distort unit costs.
The objective of ABC is the measurement of more accurate pro-
duct cost by careful consideration of activities that are not driven by
(related to) conventional volume measures such as direct labor hours,
machine hours, material dollars, or weights. A simple example in the
appendix illustrates activity costing and shows the distortions in re-
ported costs resulting from purely volume based traditional systems.
Summarizing, we can say that obsolete cost systems may lead to
dysfunctional decisions (Holzer and Norreklit). Symptoms that sys-
tems have become obsolete include the following :
- line managers lose faith in the cost figures produced by the cost sys-
tems and use their own cost estimates ;
- competition's prices for some product are below your reported costs,
and reported profit margins are hard to explain.
We have said that the introduction of AT is one of the environ-
mental factors that affect cost functions and therefore lead to changes
in costing systems. Other external factors include increased compe-
tition brought about by the globalization of markets and domestic de-
regulation.
2. Life Cycle Costing

Because of the shortened life cycle for many products, and the increa-
sed importance of design and development costs, more attention is
now paid to shifting cost patterns over the life of a product.
Today, product life cycle management attempts to integrate mar-
keting and engineering perspectives of a product's life cycle. From a
marketing perspective, the product life cycle comprises the shifts in
the product revenue curve. From an engineering perspective, the pro-
duct life cycle incorporates the types of activities that constitute a pro-
duct's life cycle, i.e., production engineering, design, production, and
distribution.
In life cycle costing, cost is measured at each stage of the product's
life cycle, and it is also accumulated by stages over development and
production. Product design and development, process analysis, pro-
gramming and prototyping constitute the cost of the first stages. They
are followed by procurement, manufacturing, and distribution.
Life cycle costing is used to establish pricing policy and for con-
trolling product contribution margins during different stages. Espe-
cially in the early stages of product design and engineering, commit-
ments are made with regard to materials, product specifications, and
manufacturing equipment and processes. These commitments largely
determine cost during the production and distribution stage of a pro-
duct (see Figure 2). Cost and revenue factors will also determine the
length of a product's life cyclc.

G. Strategic Cost Analysis

Although Anthony (1965)), more than 25 years ago, clearly defined

and described management accounting's role in the strategic planning
beer: rekindled, proba b 1.j ., . .
process, interest in the strategic aspects of management has recently
, * ,a, ,
+b-
fn- L ~ .-e
- asons that led to the need
for changes in costing systems. Global competition and rapid tech-
nological developments made the need for strategic planning more
obvious. Strategic cost analysis implies the use of cost information in
developing strategies. The widely published ideas of M. Porter (Porter
(1979), (1985)), especially his analysis of competitive forces, have
been very influential in the academic world, as well as in practice. Ac-
cording to Porter, competitive advantage can be achieved either
through lower costs or through product differentiation. To achieve or
maintain a competitive cost advantage, a firm must have a good un-
derstanding not only of its own cost, but also of the costs of its sup-
pliers, customers and competitors (Jones (1988)). To diagnose any
firm's competitive advantage, one must take a disaggregated view of
the firm, which Porter calls the value chain. Figure 4 shows the main
activities of the value chain. For a more comprehensive analysis of
a firm, its activities may be disaggregated even further so that all ac-
tivities affecting products' values can be analyzed. "...Profit results if
the value created through performing the required activities exceeds
the collective cost of performing them." (Porter (1986)).

FIGURE 4
Value Chain (Porter (1985)).

FIRM INFRASTRUCTURE
I

HUM!AN R E S O U R C ~M A N A G E ~ E N T
I I l
TE~CHNOLOGYD'EVELOPME~T

INBOUND OPERATIONS OUTBOUND MARKETING SERVICE

LOGISTIC LOGISTIC SALES

Strategic Cost Analysis may involve the following steps (Shank,

Govindarajan and Spiegel (1990), (Govindarajan and Shank (1990),
Shank and Govindarajan (1989), McGaughey and Starly (1990)):
- define the firm's existing value chain and assign costs and assets to
 value activities ;
- identify the cost and prices of all important c~mpetiters'value
chains ;
- determine who the buyers are, what needs they have, and what the
impact of the firms' products and activities on those buyers is. Iden-
tify the diverse strategic positions of different products. In the pro-
cess, look for and evaluate cost differences, value differences, indus-
try and market evolution and changes;
- investigate the cost drivers regulating each value activity and what
changes can make the buyer's cost lower andlor enhance the buyers's
satisfaction. Examine possibilities to build sustainable competitive
advantage either by controlling cost drivers or by reconfiguring the
value chain.
Strategic cost analysis uses the principles of ABC when allocating
costs to value creating activities. It tries to link costs to the value added
for customers in each of the activities a company performs and com-
pares it with competitor performance. It focuses on reduction of ac-
tivity costs by controlling, changing or removing cost drivers. The focus
is on finding the right price and segment in the product's value chain.
Although Functional Analysis or Value Analysis is a very old tech-
nique, it is quite similar to Strategic Cost Analysis. In functional ana-
lysis, which is widely used in Japan, the cost of different product func-
tions is established and compared to the value of the function for the
customer : "Value analysis is a systematic interdisciplinary examina-
tion of factors affecting the cost of a product or service in order to
devise means of achieving the specified purpose most economically
at the required standard of quality and reliability." (Yoshikawa, Innes
and Mitchell (1990)).
Target costing is a tool for reducing the overall cost of a product
over its entire life cycle with the help of the production, engineering,
R&D, marketing, and accounting departments. The idea is to manu-
facture a product to a specific price. Cost becomes the output of the
pricing decision, not the input to it. Target costing is used in the plan-
ning and design stage. Value engineering is central for target costing.
It is "an activity to design a product from different angles at a lower
cost by reviewing the functions needed by customers." (Sakurai
(1990)).
H. Capital Irlvestment Analysis

Justifying investments required for CIM and FMS is often difficult

when conventional tools for analysis are used. Investments in CIM
lead to a fall in R 0 1 in the short run, but a rise in long run. When
R 0 1 goals are important performance measures, there are no short-
run incentives to invest in CIM and FMS:
" R 0 1 time spans are typically set at three to five years. CIM pro-
jects usually take two to three years to implement, so positive cash
flows may be excluded from the analysis. However, CIM benefits may
continue for up to ten years. Time horizons of ten to twelve years are
required to compare CIM with long term alternatives." (Nobel
(1990)).
However, the long term consequences imply that payback is an
inappropriate judgment criterion. Instead, expected net present value
should be used. In this context, many writers question the use of high
discount rates for this kind of investment analysis :
"Hurdle rates for R 0 1 can be anywhere from 15-40 percent to al-
low for risk and ensure that investments yield a high return. However,
the real cost of capital is estimated to be about 8 percent. Due to com-
pounding, hurdle rates severely discount benefits received in later
years." (Nobel (1990)).
The discount factor should be the weighted average of the cost of
equity and the cost of debt capital. The cost of debt capital should
use the nominal cost of long and short term debt after tax. The cost
of equity capital should be the opportunity cost of capital for the in-
vestors :
"One can estimate the cost of equity capital in either of two ways :
use the historical nominal return on corporate stocks of between 12
and 13% per year or use the real return (net of inflation) of about
8% to 9% and add the expected future inflation rate over the life of
the project. Either method is reasonable and would be a dramatic im-
provement over the practice of some firms using rates in excess of
20%. " (Icaplan and Atkinson (1989)).
Discount factors should not be adjusted for risk, because the dis-
count rate usually uses a geometrical compounding, and the risk effect
will also be treated as geometrical. Kaplan and Atkinson (1989) claim
that riskiness of a project is considerably reduced after a high tech
project's early years. Instead of including risk in the discount rate, he
suggests the use of sensitivity analysis.
 FIGURE 5
Valzle Added Activities
Value Added Activities Center
(Includes Direct 8c All Support Activities
Related to the Shop Area)

Value Added Activities Non value Added Activities

Machine. Sorting, Checking, Analyzing,
Fabricate, Troubleshooting, Repairing,
Assemble. Expediting, Storing; Counting.
Accumulating, Auditing,
Inspecting, Recording,
Reporting, Moving, Supervision

Another major problem when evaluating investments in CIM or

FMS is measurement of the benefits. Looking only at cost savings un-
derstates the benefit from higher quality products and improved cus-
tomer satisfaction. These benefits are real and should be quantified.
The lost benefits of not investing must also be taken into considera-
tion because not investing may mean loss of market share and may
even threaten survival of the firm.
Three steps are recommended when evaluating investment in new
technology :
- strategic justification ;
- cost justification ;
- benefit analysis.
The investment must be appraised with regard to its impact on mar-
kets and customers, competitors, and the internal organization.

I . Pe$ormance Measurement

A brief examination of the objectives of the JIT philosophy will show

that such traditional performance measures as labor efficiency, ma-
terial and budget variances are of limited use. The long-run goals of
JIT are reduction or elimination of inventories and enhancement of
total quality. JIT also suggests that non-value-added activities should
be minimized. Non-value-added activities include moving the pro-
duct, storing it, and inspecting it (see Figure 5 ) . The goals of zero in-
ventory and total quality are mutually reinforcing. Elimination of in-
ventories is possible only when there are zero defects, because defects
would cause inventories ; having no inventories to fall back on forces
you to do it right the first time. Performance measures should there-
fore be designed to motivate people to move in the direction of no
inventory and total quality.
In the JIT environment, controls must move from periodic control
to on-line measurements. Cost control will be done primarily by the
personnel on the factory floor through SPC (statistical process con-
trol) and observation of other non-financial variables.
Garrison (1991) distinguishes five areas for performance measu-
rement : quality control measures, material control measures, inven-
tory control measures, machine performance measurement, and de-
livery control measurement.
Quality control measurements include : number of warranty claims,
number of customer complaints, number of defects, and cost of re-
work.
Material control measurements include : material as a percentage
of total cost, lead time, scrap as a percentage of good pieces, scrap
as a percentage of total cost, and actual scrap loss.
Inventory control measurements include : inventory turnover of
raw materials and finished goods, and number of inventory items.
Machine performance measurements include : percentage of ma-
chine availability, percentage of machine downtime, setup time, ma-
chine stops, preventative maintenance, and use as a percentage of
availability.
Delivery performance measurements include : percentage of on-
time deliveries, delivery cycle time, throughput time or velocity, ma-
nufacturing cycle efficiency, order backlog, and total throughput time.
With the goal of continuous improvement, these measures should
not be viewed as static standards but as evidence of a trend toward
the ultimate goal of perfect quality and no inventory.
We also need performance measures for important and indirect
functions such as engineering. Some of these may include:
- lead time from a product's conception to the start of production.
- percentage of product that meets target objectives after a given pe-
riod of production, average number of engineering change notices
in the initial period of production, average days to process an en-
gineering change notice from request to production implementation,
and so forth.
Product costing will be done outside the production cost control
system.
IV. SCHOLARLY RESEARCH

In our discussion of scholarly research in management accounting we

will first describe the more practice oriented approach of mainly Har-
vard Scholars. We will then touch upon efforts dealing with the be-
havioral aspects of management accounting followed by some analy-
tical modelling approaches.

A. Management Control

Merchant's research follows the practice-oriented research of such

Harvard scholars as Anthony, Dearden and Vancil. In Control in Bu-
siness Organizations (Merchant (1985)), he develops new concepts in
management controls as a step toward the integration of different
control concepts into a control theory. Merchant classifies control ac-
cording to the object to be controlled, and distinguishes : result con-
trols, action controls, and personnel controls.
Establishing result controls requires :
- knowledge of the result desired ;
- controllability of the desired result ;
- measurability of the controllable result.
Result controls are used in decentralized organizations for rewar-
ding individuals for accomplishing particular results or outcomes. At
the management level result controls are established for example
through the ROI as a performance indicator. At that level it should
be possible for management to control sales, costs, and assets. At lo-
wer levels result controls can be established through targets or stan-
dards. At that level it should be possible to control either sales or ex-
penses. Result controls may be effective in motivating employees to
work toward stated targets.
Action controls are used to ensure that individuals perform in a
certain way. Action controls can take four basic forms:
- behavioral constraints ;
- preaction reviews ;
- action accountability ;
- redundancy.
Behavioral constraints aim to make it more difficult for people to
do something unauthorized or undesirable. This can be accomplished
with passwords, identification, card readers, centralization or sepa-
ration of duties. Preaction reviews include an examination of work or
plans with the individuals doing it before their work is done. Action
acceuntability requires defining what actions are acceptable, tracking
what happens, and rewarding or punishing deviations. Redundancy
involves assigning more people or machines than necessary to a task,
so that the probability that a task will be accomplished increases.
Action controls are only feasible when knowledge exists about
which actions are desirable/undesirable, and there is an ability to
make sure that action occurs.
Personnel controls develop employees who are self-directed. They
may encourage either individual self-control or social control. Person-
nel controls work by encouraging and facilitating positive forces
through selection and placement, training, cultural control, group-
based rewards, and provision of necessary resources.
When a manager can rely on others or make them reliable (e.g.
through training or socialization), then personnel control is feasible.
If he can not, but knows the desired action and is able to make sure
that the desirable action is taken, then action control is feasible. If
neither of these is feasible, but the manager knows the desirable re-
sults and results are controllable and measurable, then result control
is feasible. As we adopt the new manufacturing philosophy, practices
will move more towards personnel control, although result and action
control will continue to be important.
Financial accountability control is a special form of results control,
which holds managers accountable for financial figures, such as net
income, earnings per share, or return on investment, assets, or equity.
The advantages of financial accountability include the facts that po-
sitive financial results are one of a firm's most important objectives,
and that they are inexpensive and effective when top management is
unsure of what is right.
On the other hand, financial accountability controls may induce
non-goal-congruent behavior and management myopia. Several pos-
sible mechanisms minimizing the shortcomings are discussed. In the
final chapter of this book, Merchant discusses the use of his control
concepts in the design of control systems.
Merchant's Rewarding Results --Motivating Profit Center Managers
(Merchant (1989)) builds on his previous work and should be viewed
as a significant theoretical contribution to Management Accounting,
with great practical value. Vancil's foreword to the book views it as
closing ".......the loop on management control systems (Merchant
(1989))" that began with Chandler's Strategy and Structure (Chandler
(1962)), and was extended by Anthony (1965), Vancil (1978) and
others in the management control area. Merchant's book reports the
empirical results of a field study, which used questionnaires and per-
sonal interviews with profit center managers and corporate execu-
tives, of twelve companies over a number of years. The study com-
pared the ideal motivational contract for profit center managers de-
veloped by the author with the actual contracts in use in the compa-
nies studied. The ideal contract for most employees should have six
primary characteristics :
- performance measures that are congruent with the overall corporate
goal of maximizing shareholder value ;
- controllable results measures ;
- accurate results measures ;
- preset and challenging performance standards ;
- rewards that are meaningful, but at minimum costs ;
- and simplicity (Merchant (1989)).
As one might expect, actual contracts in 54 profit centers studied
by the author deviate from this ideal.
Deviations from the ideal contract design are the result of three
constraints : I . the inability to measure shareholders' value directly ;
2. the inability to isolate the profit center manager's unique contri-
butions to results ; 3. the desirability of using some motivational con-
tract elements for other than motivational purposes (Merchant
(1989)). These constraints lead to trade-offs.
Constraint 1, for example, leads to the use of short-term accounting
earnings as a proxy for measuring shareholder value. Contract desig-
ners will, however, try to offset the inherent short-term bias, and try
also to direct the manager's attention to long-term results.
Constraint 2 is caused by the difficulty of finding performance mea-
sures that consist exclusively of factors controllable by the profit cen-
ter manager. Accounting and other performance measures are usually
distorted by non-controllable factors and contract designers will en-
deavor to neutralize or minimize them.
Constraint 3 reflects the fact that there are contract elements that
have little to do with motivation but serve other organizational pur-
poses such as retention of qualified managers or corporate risk re-
duction.
The author tabulates and analyzes his findings within this con-
straintsltrade-off framework. This work is an important contribution
to the managenlent accounting literature and an important step to-
ward a comprehensive management control theory that is based on
,.,p'r;,al
pro l,r findings.

B. Behaviol-a1 Accountirzg and hzfomatiorz Processing

Behavioral accounting research accounts for a major part of current
academic research in management accounting. "Behavioral accoun-
ting concerns itself with human behavior as it relates to accounting
information problems. Its basic objective is to explain and predict hu-
man behavior in all possible accounting contexts." (Belkaoui (1989a)).
The principal research approaches (Duncan and Morres (1989)) used
as paradigms in behavioral accounting include contingency theory,
functional and data fixation, slack, language, participative budgeting,
human resource considerations, cultural determinism, and social for-
ces within the organization. We will briefly mention only the approa-
ches, which are most widely discussed in the literature.

1. Contingency theory

Contingency theoiy assumes that there is a match between the design

of various components in accounting systems and specific contingen-
cies. Contingency theoretical studies have investigated how techno-
logy, organization structure, competitive environment, and other va-
riables affect accounting systems. Despite numerous studies using this
approach, no conclusive results of real practical significance have
emerged. There is still a need for more research about the effecti-
veness of the relationship between contingency variables and accoun-
ting systems.

2. Slack

Slack concerns the excess resources that can be accumulated from su-
perior performance in one period, to be used to compensate in full
or in part for inferior performance in the subsequent period. Two
kinds of slack are mentioned: 1. organizational slack, which refers
to a resource which is not used to its full capacity ; and 2. budgetary
slack, an understatement of budgeted revenues and an overstatement
of budgeted cost. Slack is a generally recognized phenomenon in or-
ganizations. Lewin and Wolf criticized the slack concept because it
"explains" too much and "predicts" too little ; slack has to be better
determined. "Further investigation into the potential determinants of
organizational and budgetary slack remains to be done. This effort
is an important one, as the behavior of slack is highly relevant to the
achievement of internal economic efficiency in organizations." (Lewin
and Wolf (1976), Belkaoui (1989a))~.

3. Participative Budgeting

Empirical research in psychology supports a hypothesis that specific

hard goals produce better performance then medium, easy, do-your-
best, or no goals (Locke, Shaw, Saari and Latham (1981)). Other fac-
tors that influence the effects of goal setting are : direction, efforts,
persistence, strategy, feedback on progress, rewards given for goal at-
tainment, and participation in the setting of goals (Belkaoui (1989)).
Accounting research has examined the relationships between high
budgets, direct reward, and feedback on performance. Other studies
examine the interaction between goal setting, task uncertainty and
performance.
Some research seems to indicate that budget participation impro-
ves performance, while other studies show only a weak association or
even negative relationship. Other research shows that influence on
decision making may influence performance positively, leading to the
conclusion that budget participation is important for increasing per-
formance. Moderating effects on the participation effect are motiva-
tion, leadership style, task uncertainty, role ambiguity, reward struc-
ture, cognitive dissonance, authoritarianism, locus of control, and the
upward influence of a superior on his or her relationship with subor-
dinates.
Goal-setting research seeks additional variables that can mediate
the link between goal setting, participative budgeting, and task per-
formance. Research in this field continues. For an excellent discussion
and analysis of budgeting research see Birnberg, Shields and Young
(1990)~.

4. H u m a n Information Processing

Accounting information is used for decision making. Human infor-

mation processing research tries to understand and improve the de-
cision process when it is based on accounting information. Psycholo-
gical accounting studies of professional experts' and managers' deci-
sion and judgment behavior show (Macintosh (1985)):
- experts tend to be surprisingly unreliable ;
- individual experts tend to be consistent in their judgment over time ;
- the degree of consensus among experts tends to be low;
- more information after a point does not improve expert judgment.
Studies of "cognitive style"%how "individual differences influence
the way managers gather, process and utilize information in making
decisions ; or, to put it another way, individuals with different cog-
nitive structures should prefer and work better with different types
of accounting and information system." (Macintosh (1985)). A re-
cently published book (Belkaoui (1989b)) provides an excellent over-
view and summary of the published research in the field.

C. Information Economics
Information Economics treats information like any other economic
commodity for which there is a demand. Information Economics in
the accounting context has been developed by Demski and Feltham,
who produced a systematic cost benefit analysis for the evaluation of
information and measurement alternatives.
"The information-economics approach attempts to measure the
demand for information, a demand based on the value of the infor-
mation and the cost of supplying it, including the perhaps higher cost
for more accurate or more timely information." (Kaplan and Atkinson
(1989)).
The accountant is the constructor, who has to take the utility of
the manager into consideration. For an excellent discussion of the ear-
ly developments of information economics for management accoun-
ting see also Mattessich (1980).

D. Agency theory

The Agency Theory approach goes back to basic concepts presented

by Jensen and Meckling (1976). Agency theory studies the contractual
relationship between two parties : the principal, who has a property ;
and the agent, whom he hires to manage it. The principal delegates
some decision making authority to the agent. The role of the principal
could be imputed to the owners, shareholders, superiors or insurers
of an agent. The agent may be the manager, the department head,
subordinate or the insured of the principal. Accordingly, the owners
or shareholders can be viewed as the principal hiring the top-manager
to be their agent in managing the firm ; or the top-manager may be
viewed as the principal hiring the department head as his agent in
managing the department.
Principals and agents act in their self-interest and try to maximize
their profit andlor utility. It is assumed that the principal and the
agent care about financial compensation and wealth, and the agent
values prerequisites such as attractive working conditions and flexi-
bility in hours worked. Because agents are thought to be lazy and more
risk averse than the principal, they require monitoring and incentives
to minimize these differences. Other assumptions deal with the exis-
tence of differences in the principal's and the agent's risk attitudes
and their private information about the environment.
Shareholders could simply tell managers to implement an optimal
solution of a problem if they knew what the optimal action was and
if monitoring the action were costless. Because the principal has li-
mited information about the best action (the agent knows more about
the environment) and the observability of the agent's action is limited
and costly, owners give managers an incentive to take actions that are
in the best interest of the shareholders. That is the contractual re-
lationship. Agency theory focuses on the design of performance mea-
sures and rewards that will induce subordinates to act in the interests
of the whole organization.
The relationships and variables in the contract are expressed ma-
thematically :
"The appropriate form of this contract is said to be governed by
the interaction of several variables, and these relationships are expres-
sed in a mathematical model." (Anthony (1989)).
"This analysis requires a formal specification of the economic
agent's preferences and risk attitudes (as modeled by a utility function
of wealth) and beliefs (as modeled by the agent's subjective proba-
bility distributions for random outcomes) as well as possible states of
the world, actions and outcome functions." (Kaplan and Atkinson
(1982)).
Some view the agency theory as a natural extension of information
economics. Information systems and signals play a key role in agency
theory. Major research efforts have been based on this theory, and
the enthusiasm with which many researchers continue to embrace it
shows no signs of abatement.
Horngren (1989) thinks that agency theory has reinforced the real-
world phenomenon that different levels of managers bear different
risks, that subordinates tend to be risk averse, and that different sets
of information are processed by various levels of managers. Many
agency researchers believe that the design of management control sys-
tems is largely a problem of evaluating performance and using re-
wards so that risks are shared among managers and owners in the op-
timal way. Horngren also has his doubts concerning the realism of cur-
rent agency theory models. He considers agency theory as an excellent
conceptual framework but states, "One big challenge is to move from
the simplified settings of agency theory to the complicated settings of
real organizations." (Horngren (1989)). Much needs to be done be-
fore any practical results can be expected.
Agency theory also has its detractors. The theory has its roots in
neoclassical economics, inspired by Coase (1937), who saw the trans-
action as the analytical starting point instead of the marliet and the
firm.
"Indeed, in agency theory the firm can effectively disappear as a
meaningful aspect of the analysis. Instead, the contractual relation-
ship between parties takes its place, and the firm is reduced to the
status of a phantom." (Puxty (1985)).
Other critics has been more concerned about the theory's lack of
realism. It is more rational than reasonable :
"More importantly, I see no way that the relationship between ma-
nagers and subordinates can be stated realistically in a mathematical
model. In the real world, the relationship depends on human perso-
nalities and how human beings react to various incentives." (Anthony
(1989)).
"The aversion to work may not be a realistic assumption for senior
members of organization. Usually these people have risen in the or-
ganization because of their demonstrated skills and their willingness
to put extra effort into their work ......" (Kaplan and Atkinson (1989)).
"In spite of a great deal of published research, to date agency theo-
ry models have been so simplified that we do not see any practical
use of them. However, some of the concepts may eventually lead to
improvements in the real world management control systems."
(Anthony, Dearden and Bedford (1989)).
We would also claim that agency theory is in contradiction with the
JIT philosophy, which stresses cooperation among workers and asses-
ses an atmosphere of confidence and trust. Reduction of hierarchical
levels under JIT not only reduces the number of supervisors, but also
greatly diminishes their influence.
 In a recent paper Baiman, a wellknown advocate of agency theory,
surveys the recently published agency research rela-ted to manageria!
accounting. In it he distinguishes three branches : The principal-agent
literature (largely identical with what was discussed above), the trans-
action cost literature and what he calls the Rochester literature. The
interested reader is referred to the Baiman paper which includes an
excellent critical analysis of the agency theory literature and the theo-
ry's potential for future contributions to management accounting
theory and practice.
APPENDIX
ACTIVITY COSTING - EXAMPLE (Cooper (1988))
The following information is available for costing the four products made in ARTWELL
CO's factory. The four products differ in volume and size. P1 and P3 are low volume pro-
ducts. One of which is small and the other large, P2 and P4 are high volume products, again
one is small and the other large. All products are manufactured on the same equipment
by similarly processes. The total conversion cost (overhead and direct labor ) for all products
is 10,000.
ACTIVITY AND COST DRIVER INFORMATION :

Number Direct Material Machine Number Number

Product of Units Labor Cost Hours of of part
No. Produced Hours per Unit Setups Numbers
P1 10 5 6 5 1 1
P2 100 50 6 50 3 1
P3 10 15 18 15 1 1
P4 100 150 18 150 P
3 P
1
220 220 8 4
Conversion cost of 2,500 3,300 2,200 2,000
cost drivers

CONVENTIONAL PRODUCT COSTING :

Number Direct Material Total

Product of Units Labor Cost Cost by Cost per
No. Produced Hours per Unit Product Unit
Pl 10 5 6 287" 28.73"
P2 100 50 6 2,873 28.73
P3 10 15 18 862 86.18
P4 100 150 18 8,618 86.18
220 12,640
Conversion cost pr. direct labor hour:
10,000/220 = $45.45455
a : (10 X 6) + (5 X 45.46) = 287.3
b : 287,3110= 28.73
ANALYSIS OF COST DRIVERS (ACTIVITIES) FOR CONVERSION COSTS:

Number Direct Machine Number Number Total

PI-oduct of Units Labor Hours of of part Conversion
No. Produced Hours Setups Numbers Cost
P1 10 5 5 1 1
P2 100 50 50 3 1
P3 10 15 15 1 1
P4 100
- -150 150 3 1 -
220 220 220 8 4
Conversion
Cost of 2,500 3,300 2,200 2,000 10,000
Cost-drivers
Cost pr.
Cost- driver 11.36 15.00 275.00 500.00
Unit

PRODUCT COST ANALYSIS WITH ACTIVITY COSTING :

No. of Mate- Direct Cost of Setup Cost of Total Cost

Pro. Units rial Labor Machine Cost Part Cost per
No. Prod. Usage Nos Unit
P1 10 60.00 56.82 75.00 275.00 500.00 966.82 96.68
P2 100 600.00 568.18 750.00 825.00 500.00 3243.18 32.43
P3 10 180.00 170.45 225.00 275.00 500.00 1350.45 135.05
P4 100 1800.00 1704.55 2250.00 825.00 500.00 7079.55 70.80
220 2640.00 2500.00 3300.00 2200.00 2000.00 12640.00

COMPARISON OF UNIT COSTS - CONVENTIONAL vs. ACTIVITY COSTING:

Conven- Activity Differences

tional Costing Amount Percent
28.73 96.68 67.95 236.51%
28.73 32.43 12.88%
86.18 135.05 48.87 56.71%
86.18 70.80 (15.38) (17.85%)

NOTES
1. The figure is adapted from C.J. McNair a.o., p.24-25.
2. See also our discussion on the value chain.
3. For detailed discussion see: Prentice Hall Editorial Staff (1983).
4. The reader who is interested in an overview of this kind of research is referred to Belkaoui
(1989a) en Ferris (1988).
5. For some recent research in the contingency area Macintosh and Daft (1987), Rockness
and Shields (1988), Simons (1987). Earlier work includes Watterhouse and Tiessen
(1987), Gordon and Miller (1976), Burns and Stalker (1961) and Burns and Watterhouse
(1975).
6. The concept of slack is discussed by many authors. The interested reader is referred to
Cyert and March (1963), Lewin and Wolf (1976) pp. 648-654, Bourgeois (1981) pp.29-39,
Schiff and Lewin (1970) April pp.259-268 and (1968) May pp.51-62, Merchant (1985)
May pp.201-210 ad Belkaoui (1985) Fall.
7. Recent research in Budget~ngParticipation is Aranya (1990), Fall pp. 67-77 ; Hirst (1987),
October pp 774-784, Brownell P. and M. McInnes (1986) October and Chenhall and
Brownell (1988) pp.225-233. Earlier research is Hofstede (1968) Argyris (1952) and Hop-
wood (1972).
8. Cognitive style : "determines the way each individual processes, tranforlns and restruc-
tures the stimulus information from the environment to shape the resulting behavioral
response." Macintosh (1985) p.87.
9. For in depth treatment of this approach refer to Demski (1980) and Magee (1986).

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