Back to the future: innovation in manufacturing accounts
The authors gratefully acknowledge the support of the Research Foundation of the Chartered Institute of Management Accountants
Professor David Dugdale
Professor of Management Accounting
Bristol Business School, University of the West of England
Dr T Colwyn Jones
Professor in the Sociology of Accounting,
Faculty of Humanities, Social Sciences and Languages, University of the West of England
Stephen Green
Research Associate
Bristol Business School, University of the West of England
Presentation Abstract
This paper reports a survey of 34 UK manufacturing companies. The project was stimulated by visits to manufacturing companies and the observation that some of these companies employed P&L formats that were clearly not influenced by either external reporting or "mainstream" standard absorption costing theory. Funding was therefore sought from the Chartered Institute of Management Accountants (UK) to further investigate internal reporting in manufacturing companies. The method used involved review of documentation and interviews. All the companies taking part in the study provided a specimen of their profit and loss account format used for internal reporting and this provided the basis for a structured telephone interview (typically of half-an-hour to an hour duration).
There is no claim that the sample is representative and, if a "response rate" were calculated it would be low because many companies were contacted in order to find 34 that were willing to participate. The aim of the research was not generalisation but the identification of innovations in manufacturing accounting reporting. The main findings are summarised below.
Budgets and Forecasts
The typical P&L format includes a comparison of actual results with budgeted figures. Almost all (33 from 34) of the companies asked reported that they employed budgets and the vast majority of these also routinely produced forecasts. Of 29 companies that described their forecasts most (20) reported that their forecasts were to the end of the current financial year. Most of the rest (7) generated 12 month “rolling” forecasts.
There is some evidence of the impact of financial regulation because of the emphasis placed, in a number of companies, on forecasting to the end of the financial year. And there is also some evidence of budgets giving way to forecasts in importance. Almost half of the companies that expressed a preference said that the forecast was more important than the budget in financial reporting.
Bonus Schemes
Most of the companies in the study employed either executive and/or staff bonus schemes. Executive bonus schemes tend to focus on “profit versus budget or target” as a performance measure or on individual performance objectives. Staff bonus schemes again often employ “profit versus budget or target” as a key measure while some schemes are based on profit sharing or “efficiency of production”. There were no examples of residual income or economic value added performance measures in this study.
Standard Costing and Variances
Standard costing was prevalent in the companies studied. Most (70%) of the companies set standard costs and, for some of those that did not, the nature of their business meant that it was unlikely that they would be interested in standard costing. However, analysis of the variances calculated and their use in financial reporting led to serious reservations concerning the extent of use of standard costing systems. Several companies indicated that the main use of these systems was as a convenient means of valuing stock but standards and variances were not particularly important in managing the business. And this observation was confirmed by analysis of the way financial results were presented. We concluded that half of the 24 “standard costing companies” were rather half-hearted in their use of standard costing and variance analysis. These companies reported actual labour and overhead costs in their Profit and Loss accounts and employed various combinations of actual and standard material costs.
Although variances were often not integrated into the profit and loss presentation most of the standard costing companies did calculate material and labour variances of various types. However, only 11 of the 23 companies that routinely calculated variances reported overhead variances and 5 of these reported only variable overhead variances. Of those companies that did calculate fixed overhead variances none subdivided the volume variance into “capacity” and “efficiency” elements. We conclude that, while material and, to a lesser extent, labour variances are considered valuable in some field study companies, overhead variances and, especially, fixed overhead volume variances, are generally not considered useful. Although the use of standards is commonplace there may be less emphasis on the use of variances for management by exception. Several companies seemed to want to report "actual" revenues and expenses, and, in some cases, in relatively simple formats.
Contribution Reporting
More than 50% (23 from 34) of the companies interviewed employed a contribution format. However, this finding depended on careful interviewing and interpretation. In several companies the term “margin” or “gross margin” had to be carefully analysed in order to establish that these companies were “really” employing contribution reporting. Although full absorption costing is commonplace, a significant number of companies in this study follow academic advice and employ contribution concepts in internal reporting.
There is some evidence of disillusion with sophisticated standard cost variances and absorption costing. However, typically, the reaction has not been to employ activity-based costing but rather to simplify the P&L presentation, sometimes by the use of variable costing. As such presentations need (in theory) to be adjusted for external reporting they provide evidence that (some) manufacturing companies are not dominated by financial reporting requirements.
These findings have implications for the “relevance lost” thesis because a key plank of the Johnson and Kaplan analysis is that external financial reporting requirements influenced internal financial reporting. Since the use of marginal or variable costing methods for stock valuation is not permitted in the UK for external reporting purposes it seems that more than 50% of the companies surveyed are not inhibited (in this key respect) by external reporting standards. It is not so easy to determine whether these companies had thrown off the shackles of external financial reporting requirements since the 1980s or whether they had always adopted marginal methods. However, there were some examples of companies consciously choosing to adopt marginal costing approaches. Interestingly, very few of the companies surveyed had adopted activity-based methods so, while J&K might have been right that companies needed to adopt internal business oriented methods, there is little evidence in this study that their “activity-based” recommendations to replace traditional absorption costing have found favour.
"Direct", "marginal" or "variable" costing presentations have been a textbook recommendation for many years but previous research indicates that absorption costing presentations have dominated in manufacturing industry. Perhaps this research indicates a reversion to simpler methods: back to the future.