Traditional Management Accounting Systems Are Incompatible Accounting Essay

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Back to the old time, one could be very proud of owning a mobile phone which could be used to reach anyone at anytime. However, the time has changed. The advances in technology allow more than just communication but also other functions, for instance, pictures capturing and internet surfing. We can see that how fast is the technology advancing and this rapid change has led us to a new business environment.

Porter (1979) identifies five driving forces which, as following, shape an industry's competition and the resulted firms' competitive strategies.

The threat of new entrants into the new market;

The threat of substitute products or services;

Rivalry among existing competitors in the industry;

The bargaining power of suppliers;

The bargaining power of customers.

Drawing from Porter's Five Forces, one can see that the business environment does not only contain the threat from direct competitors but also the other threats from, for instance, potential new entrants and customers. The threats characterize the volatile and uncertain nature of the new business environment. This implies that businesses are now required to be more flexible and responsive to this changing business environment.

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Take the bargaining power of customers as an example, modern day customers demand a variety of choices and firms must be able to respond to and capture the customers' preferences or tastes. Besides, powerful customers negotiate and force the prices to be reduced and demand higher quality or quantity at the expense of firms. The threat arises when customers are free to switch to other substitutes at no cost, especially in retail industry. (Porter articles reference)

Very recently, globalisation also plays an important role in the changing business environment. Firms have started to expand their businesses into an international level. This means that firms will now have to face a much more comprehensive business environment, for example, a diverse workforce with employees from different cultures and customs or even international competitors. On the other hand, multi-national firms have to take into account of various economic and political considerations as well, such as fluctuations in exchange rate or even licensing problem.

Due to the above 5 threats and globalisation trend, Johnson and Kaplan (1987) raise the idea of 'relevance lost', saying that "today's management accountant information, driven by the procedures and cycle of the organization's financial reporting system, is too late, too aggregated, and too distorted to be relevant for managers' planning and control decisions." (Johnson & Kaplan, 1987) 

Johnson and Kaplan (1987) argue that traditional management accounting information system is irrelevant as it does not provide up-to-date and exact information about raw materials costs, competitors' products and services, production technology and customers' preferences. The failure to do so could mislead the managements and thus wrong decisions could be made at the expense of the firms. There are several breakdowns of traditional management accounting and 3 example issues are discussed as follows:

Planning and Control System

In terms of traditional planning and control system, static budgets are normally constructed and variance reports are, as a performance measurement system, to be done afterwards. Static budget is intended for only one particular level of activity which is usually close to the estimated activity level. The variance is the difference between the actual production amount and budgeted amount. For example, the budgeted amount is $20,000 to produce 100,000pens. Static budget is only useful when firm is producing at the exact expected production and thus it is unable to provide correct variance analysis when the actual production level is higher or lower than 100,000. Ultimately, the performance measure system could be distorted if the performance is measured based on the variance reports.

(Zimmerman, 2000 p.263)

Costing techniques - Single Indirect Cost Pool System

Conventionally, it is believed that costs are driven by the quantity produced and there is no strong identification of indirect costs. Indirect costs have no direct relationship to the products or services so cannot be traced to individual units of production. Under traditional costing system, indirect costs are then aggregated and to be allocated to the products or services by using overhead allocation rate which is:

The overhead allocation rate uses a single cost driver to allocate indirect costs to the products. Hence, the problems of under-costing or over-costing might emerge and thus result in product cross subsidization, especially when there are multiple productions. On the other hand, this cost pool system simply looks at the figures without further investigating how costs are influenced by the complexity of production processes. (Zimmerman)

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Return on Investment (ROI) and Performance Measurement

Return on Investment (ROI) is a commonly used investment center performance measure as it is compared with external market-based yields in order to provide a benchmark for a division's performance.

ROI has the difficulty of finding an appropriate investment cost figure and thus it may create the problem of overinvesting or underinvesting. It is because ROI is actually highly subjected to managements' manipulation. Underinvestment problem arises when managements are unwilling to invest so that they can show very high ROI as an illusion of good performance. As compared with the performance measurement of Net Income, ROI though is said to tackle the problem of overinvestment problem by holding the investment center manager responsible for earning a return on the capital employed in the center. It might also adversely result in overinvestment problem because managements would try to invest as much as possible to grow the numerator which is net income and thus increase the overall ROI. Consequently, using ROI as a performance measurement system for investment centers could therefore result in inappropriate reward and punishment given to managers.

From the above example issues, it is shown that the traditional management accounting system is not relevant for today competitive environment as claimed by Johnson and Kaplan (1987). The idea of strategic management accounting emerged, which is said to be a solution to the controversies of traditional management accounting. It matches resources to its changing business environment by following the direction and scope of an organization over the long term. Furthermore, strategic management account considers competitors' positions and thus acts as a tool to response to competitors' action.

An effective management accounting system must provide timely and accurate information for planning and control on production and performance evaluation. Most importantly, it must be useful for decision-making in order to response to competitors' pricing decisions. (Johnson & Kaplan, 1987)Most of the literatures have emphasized the decision-usefulness of, regarding competitors' plans and actions, strategic management accounting. As Roslender and Hart (2003) say, strategic management accounting is ''a generic approach to accounting for strategic positioning as it is the process of providing and analyzing management accounting data about a business and its competitors for use in developing and monitoring business strategy''.

Additionally, it is pointed out by Lord(1996) that strategic management accounting does not only focus on the internal but is now further extended to include external information about competitors.

It is the extension from the internal focus of management accounting to include external information about competitors.

SMA and techniques to solve the problem

Narrow down which topics would be focused in order to tackle the example issues mentioned aboved.

ABC and BSC