3. American Big Business and Cost Accounting

The United States began as an agrarian economy, but manufacturing was well established early in the 19^th century. With vast resources, inventors and entrepreneurs, domestic and foreign investors, and a large domestic market for goods, industrialization exploded in the 19^th century. The Robber Barons were able to exploit monopoly power and lax regulations to build corporate empires. Carnegie, Du Pont, Rockefeller, and others used cost accounting techniques to help control their vast holdings. Alfred Sloan and Donaldson Brown early in the 20^th century at General Motors developed the classical cost accounting techniques that helped America become the world’s industrial powerhouse.

Johnson and Kaplan (1987) claimed in Relevance Lost that: "By 1925, American industrial firms had developed virtually every management accounting procedure known today". U. S. business was the world leader from early in the 20^th century until about 1970. By the 1970s and 80s, American production management and cost accounting seemed obsolete. Critics were predicting the demise of American leadership and a protracted economic slump, based on huge trade and federal budget deficits, large losses by American blue chip firms such as General Motors and International Business Machines, and poor overall economic performance. Global competition cut into domestic markets and U. S. firms were suffering from high cost production and lackluster quality. Fortunately, manufacturing and service firms and their accountants were back on track by 1990. Cost and management accounting was part of both American success and failure. U. S. firms began restructuring, focusing on quality and customers, productivity and cost cutting, and inventing new cost and management accounting procedures. The U. S. was back on top, although much of world economy found extreme economic problems. How did all of these events happen?

Early Developments in Manufacturing and Accounting

Considerable progress in manufacturing was made in Britain during the early part of the Industrial Revolution, as described in the previous chapter. Many of these early firms went bankrupt. Little credit went to manufacturing operations and continuing operations and expansion was funded primarily from retained earnings. During depressions declining demand led to liquidity crises that most firms could not deal with. Adequate cost accounting was useful in any circumstances, but essential in bad times. Surviving firms developed cost accounting systems to determine costs for all phases of their operations, including primitive analysis of overhead costs. Costs could be related to specific products and prices could be set differentially, based on product costs and potential demand for specific products. Costs could be altered to increase efficiency, based on factors such as material prices, differential wage rates, transportation costs. Policies could be modified when depressions hit to reduce costs and attempt to maintain product demand.

Under the mercantile system, American manufacturing was virtually nonexistent when independence was declared in 1776. The U. S. represented Jefferson’s ideal of an agrarian society. Prior to the factory system, textile production was done by individuals and subcontractors, priced at piece rates. Before 1800 entrepreneurs in New England began to follow Britain’s lead. In 1789 Samuel Slater, a British mechanic employed at Arkwright’s mill, immigrated to America to build the first mechanical spinning mill. This he did in Rhode Island. He produced only yarn, which he turned over to his partners, merchants William Avery and Smith Brown. By 1809 some 60 spinning mills were operating, apparently all built by Slater and mechanics he trained.

Francis Lowell introduced power weaving in 1814, based on plans obtained in Britain. Lowell built the first integrated textile mill in the U. S., as a Massachusetts joint stock company. Lowell made some use of cost reports, comparing different time periods, mills, and products. These were done sporadically, most likely when hard times hit the textile industry and thorough cost analysis was necessary for survival.

First textiles, then iron and steel, armaments and farm equipment. The factory system came to America. Firms started, grew, and prospered. As in Britain, the factory system required salaries and factory overhead. By 1812 eleven steam engines were operating, although water was the primary source of power.

The New York Stock Exchange (NYSE) began in 1792, initially to trade government securities. Insurance companies, banks, and New York State bonds were soon added. By 1827 the NYSE was trading the stocks of 12 banks, 19 insurance companies, and the New York Light Company, the first public utility in America. Early in the 19^th century, turnpikes, canals, and railroads started issuing stocks and bonds, all organizations with large capital requirements.

Cost accounting records are found from the early 19^th century for New England textile mills. At Lyman Mills, materials costing included freight and insurance, calculated on a first-in first-out basis. Payroll records were kept daily by employee hours for each process. Overhead was spread to mill accounts based on multiple criteria, such as floor space or number of materials and usually treated as a period cost. Unit costs were calculated to determine prices, initially with prime costs (direct materials and labor) and later including overhead.

Eli Whitney was a great contributor to economic growth in the U. S. in the 19^th century. After the invention of the cotton gin, cotton became the staple of Southern planters. By the time of the Civil War, the Southern economy was cotton-based, the West agriculture, and the North manufacturing. Even agriculture was mechanizing, with such inventions as McCormick’s reaper. The first transatlantic railroad was completed in 1869 when the Union Pacific and Central Pacific met at Promontory Summit.

The first American Railroad was the Baltimore and Ohio (B&O). Unlike most major merchandizing centers, Baltimore did not have a major river system into the interior. Baltimore merchants wanted access to raw materials and markets from the interior and across the Ohio River. How else could they compete with New York and Philadelphia? A vast infrastructure was needed: track base, track, rolling stock, and locomotives. Early in 1827 the Maryland legislature chartered and incorporated the B&O as a joint stock company. The projected cost was $5 million, to be completed in ten years. Financing included money from Baltimore and Maryland, Baltimore merchants, and London investment banks. Virtually all aspects had to be invented.

An engineering survey began in 1828 and construction began as soon the route was adopted—July 4, 1828. Early in 1830 a single track reached Ellicott’s Mill and by the end of 1830 locomotives were built and running on the Baltimore to Ellicott’s Mill route, flour being the largest revenue item. The track was originally iron placed on stone, soon replaced by wood. Track, locomotive, and passenger and freight car technology continued to improve—this was the high tech industry of its age. However, this meant obsolete fixed assets that needed replacement, which the railroad did not recognize as expenses. The building continued westward, but it was not until 1852 that the Ohio River was reached. It was 15 years late and $10 million (200%) over the original budget.

In addition to being the pioneer in railroad engineering in America, the B&O pioneered in tapping capital markets and financial reporting. Annual reports started immediately. Since capital and political markets were essential, substantial financial information was required. Professional management was hired and one method of control was the use of various reports. The railroad claimed profitability early; e.g., a profit of $102,152 on total receipts of $263,368. Since they were unaware of most real expenses such as depreciation, the company still skirted bankruptcy. By the 1840 annual reports were comprehensive and included obvious balance sheets (called "Statements of Affairs"), limited income statement information for specific routes, detailed cost information, and performance by passenger and freight miles. The information is understandable, quite detailed, and useful to investors.

Railroads were competitive and failure rates were high. But the railroads continued to operate, even in bankruptcy—usually by being acquired by a larger and more successful railroad. Virtually all depended on capital markets for funds and often presented detailed and useful financial reports. The most successful railroads developed useful cost accounting for these vast enterprises. The voucher system for reporting and controlling disbursements was a railroad invention. Cost per ton-mile became a unit for measurement for efficiency and comparison (invented by Albert Fink for the Louisville and Nashville), including evaluation of maintenance and overhead. Ironically, throughout the 19^th century they struggled with the analysis of fixed assets.

Rockefeller

Big business in America got a substantial boost during the Civil War—at least in the North. The vast supplies needed to supply the military and increasing demand provided a substantial business boom. Perhaps the most well known success story from this period was the rise of Standard Oil under John D. Rockefeller. Rockefeller took a three-month bookkeeping course at Folsom’s Commercial College, a proprietary college with branches in seven cities. He started as an assistant bookkeeper in 1855 at Hewitt and Tuttle, commission merchants in Cleveland. He claimed much of his success as the most successful capitalist to his bookkeeping training, to measure performance, determine fraud and demand increasing efficiency. Unfortunately, this information was used for internal analysis and not reported to investors.

Rockefeller invested merchant profits in an oil refinery in 1863; a new business based on oil drilling in Pennsylvania in the 1850s and the discovery of refining using sulfuric acid to produce kerosene. He became the biggest refiner in Cleveland and took steps to be the most efficient. He also negotiated favorable transportation rates. He stimulated technological innovation, standardized products (hence Standard Oil), continually lowered costs, developed world markets, and gobbled up competitors. He eliminated most middlemen by using his own sales force. He even issued certificates against stored oil, creating an oil futures market. He managed this decentralized empire by coordinating the financial data. As with the oil, the accounting was standardized. In sum, he turned a risky business opportunity into a gigantic industry. Petroleum products would figuratively and literally lubricate heavy industry.
  John D. Rockefeller, 1884
Rockefeller received huge rate concession from railroads. On the other hand, Rockefeller promised large daily shipments, owned the tank cars, and assumed responsibility for fire and other accidents. Thus, the railroads had a vested interest in this double oil-railroad cartel. These rebates would become illegal with the Interstate Commerce Act of 1887. Pipelines transported much of the oil.

Rockefeller and his partners incorporated as a joint-stock company called the Standard Oil Company (of Ohio) in 1870. It was illegal to own property outside the state, an impossible situation for a budding global power. In 1871 a shell company was created called the South Improvement Company to hold stocks in other states. He later used subordinates to hold stock in various subsidiaries as trustees. However, it was Samuel Dodd, Standard Oil’s solicitor, who in 1882 devised the oil trust—a scheme copied in dozens of industries (including Rockefeller’s own Natural Gas Trust). A separate Standard Oil company was incorporated in each state with major operations. A new trust agreement was drafted that created a board of trustees, which received the stocks of the subsidiary companies. With this board, superior cost accounting practices, and centralized control the modern corporation became a reality. [An 1889 New Jersey law allowed resident corporations to hold stock in other corporations, effectively allowing holding companies in place of trusts. After the formation of the Standard Oil Company of New Jersey in 1892, the Oil Trust was dissolved.] During the 1890s Standard Oil reached its monopoly power peak. It refined and sold some 85% of all petroleum products in the U. S. and pumped about a third of all crude oil.

In 1888 Standard Oil set up its first European subsidiary, the Anglo-American Oil Company. By this time about 70% of American oil production went overseas. Overseas markets continued to be significant growth areas, but also generated new competition. Major foreign competitors would fight Standard Oil on most of the continents for both oil production and refined oil markets.

Rockefeller was the quintessential robber baron. Standard oil engaged in predatory practices to eliminate competitors, bribed politicians, and after Rockefeller required from active management, increased the domestic price of kerosene. However, as pointed out by Chernow: "He was a stickler for the truth in presenting facts, never fudged or equivocated in discussing problems, and promptly repaid loans" (1998, p. 105). Rockefeller also claimed he honored all contracts and never watered stock. He was considered by some the best employer of his time, since working for Standard Oil included relatively high pay, hospitalization, and retirement. About 100,000 people were employed were employed overall by Standard Oil and its subsidiaries.

Standard Oil was sued by the Justice Department for antitrust violations under the Sherman Act in 1906. Standard Oil lost the case in 1911 and the company was broken into 34 separate companies. Rockefeller had never issued reports to shareholders. After the breakup the independent companies were listed by stock exchanges and formerly hidden assets were revealed. The value of the separate companies rose substantially and it was after the 1911 breakup that Rockefeller’s net worth hit a billion dollars.

Morgan and Carnegie

Many entrepreneurs in steel, tobacco, rubber, electricity, automobiles, and many other industries repeated the Rockefeller story. A major difference between Rockefeller and most industrial titans was Rockefeller’s use of internal funds for expansion, while most entrepreneurs relied on major banking houses for expansion—and sometimes failure. In the public imagination the greatest Robber Baron banker was John Pierpont Morgan. This is somewhat ironic, since many of his competitors used fraud and deception on a grand scale (Jay Cooke the most notorious). Morgan was relatively honest, but his Robber Baron credentials were established because of his success and the immense power he developed through the trust and interlocking directorates. These were not illegal, but commercial high tech a hundred years ago.

J. P. Morgan was the son of an investment banker and at the start of the Civil War became the U. S. agent for his father’s London firm. In 1873 Drexel Morgan (later J. P. Morgan and Co.) moved to the corner of Broad and Wall Street in New York City, the address that became synonymous with banking power. This was the year of the Credit Mobilier scandal that led to the failure of Jay Cooke over the financing of the Union Pacific Railroad, which resulted first in financial panic and then a depression. J. P. examined his firm’s cash balance every day and would personally audit the books each New Year’s day.

Morgan developed or perfected many techniques for profit and power. J. P. and other bankers organized large bond issues, but not with their own funds. A prospectus was issued for the bond issues, but provided little useful information. Perhaps a summary balance sheet. The typical prospectus was about four pages. The investment bankers charged huge commissions and other fees on these deals. The cash would be raised from domestic and foreign bond investors. In a voting trust, stockholders exchanged their stock for trust certificates. Morgan used the voting trust to become the nation’s most powerful businessman, allowing creditors virtually complete control of major clients. J. P. and his associated would be board of director members on over 80 companies. Morgan reorganized many bankrupt railroads, through consolidation and replacing liabilities with capital stock. They also would lend to countries, especially in times of war, using syndicates of many bankers for underwriting.

The New York banks worked together on a number of participating projects, especially foreign loans. They would be branded the Money Trust by the Pujo (House Banking and Currency) Committee in 1913. Generally, the banks didn’t compete against each other. Instead, a single bank would negotiate a deal and then syndicate it across the remaining banks. A major result of the Pujo hearings was the creation of the Federal Reserve System at the end of 1913. Such was Morgan’s power that an alliance was created between the Morgan bank and the Federal Reserve Bank of New York that would last to the Great Depression.

Thomas Edison was a Morgan client for a stock issue of the Edison Electric Illumination Company in 1878. Edison was eager to turn his invention of the electric light into a major utility. Morgan’s house became the first electrically lighted New York residence. General Electric was an 1892 consolidation of Edison General Electric Company and Thomas Houston Electric. It failed the next year, to be rescued by J. P.

Competition between railroads could force them toward bankruptcy. The railroads were accused of overbuilding. They blamed investment bankers for issuing too many securities, which led to too many competing lines. Morgan was involved in several big railroad mergers, including the New York Central with the Pennsylvania Railroad and the Philadelphia with the Reading Railroad. Typically, this involved new stock and bond issues (and sizable commissions) and board seats on the consolidated roads for Morgan partners. Morgan attempted a gigantic western railroad cartel to eliminate direct competition. This fell apart and many railroads failed—many of which Morgan reorganized. By 1900 virtually all U. S. railroads were organized into six voting trust systems controlled by Morgan and other New York bankers.

Andrew Carnegie was a Scottish immigrant to the U. S. in the mid-19^th century. He started as a laborer in a cotton mill. Later, Carnegie became a telegraph operator for Pennsylvania Railroad and rose through the ranks. His investments in the Pullman Company and oil properties started his fortune that he invested in Keystone Bridge Works, a steel mill. He was one of the earliest users in America of the Bessemer process and his success led to the acquisition of competitors, railroads, and iron and coal mines. Carnegie used both horizontal and vertical integration to build his steel empire. By the end of the century Carnegie Steel produced a quarter of U. S. iron and steel.     Andrew Carnegie

The accounting system used by Carnegie exploited cost information. A voucher system, which he saw as a railroad executive, accumulated materials and labor (or prime) costs through each department and was used to prepare monthly cost reports. The focus was on prime costs, those associated with and traceable to specific products. These monthly reports were used to check the usage of materials, the evaluation of potential improvements, and output prices. Carnegie compared costs for each operating unit to previous months and those of competitors when available. Cost sheets also were useful for evaluating process improvements, development of by-products, and pricing of finished goods. A primary strategy was to reduce costs below competitors. During recessions he could price products below competitors’ costs, operate at capacity, and still be profitable.

Carnegie sold out to J. P. Morgan in 1900 when offered $480 million, more than the book value of Carnegie Steel. Carnegie’s $300 million share made him the richest man in America. Morgan used the high tech financial analysis techniques of the period to determine value based on the earnings potential of the firm. Carnegie later admitted selling out for $100 million less than the real value of the company. Using Carnegie Steel as the base, Morgan established the colossal United States Steel. The purpose was to gain economies of scale to lower prices to compete internationally. Not to mention the $57.5 million underwriting fees paid in stock. U. S. Steel was the first billion dollar corporation (capitalized at $1.4 billion), the largest merger of the time, producing 90% of American steel capacity. To measure the scale of this deal, the total capital of all manufacturing firms at the time was $9 billion. By 1904 12 trusts had a total capital of $7.2 billion. This was the beginning of American big business.

Cost Accounting in the Era of Big Business

Many of the basic approaches to cost accounting were developed after 1880. The Scientific Management analysis of mass production was a major factor. Engineers using job analysis as well as time and motion studies determined "scientific" standards of material and labor to produce each unit of output. Complex machines required complex engineering and efficient use of workers to perform specialized and repetitive tasks. Standard costs became a significant efficiency measure. Frederick Taylor analyzed the best ways to use labor and machines and standards were determined to minimize waste. The focus was on cost cutting rather than product quality. Actual costs could be compared to standard costs to measure performance and the variances between actual and standard analyzed to determine potential corrective action. Measuring and allocating overhead costs also were major concerns of Scientific Management.

By the turn of the century much of American business had followed the Standard Oil and U. S. Steel examples and became big by buying out the competition and expanding vertically, often with Morgan or other Wall Street money. Industry monopolies with relatively homogeneous products but often complex manufacturing could experience economies of scale, barriers to entry, and incentives to control markets. The result was often stable markets and prices and, according to critics, unfair competition and monopoly prices. Large size meant low cost operations, a cost advantage over competitors, and the ability to survive depressions. During a period of little effective regulation, most of these activities were within the law.

Big business would be organized around a centralized headquarters, with dozens of plants around the region and often across the nation or around the world. Standard products were mass-produced for a large domestic market. Many firms were multi-national. How were these operations controlled a half century before the first primitive computers? Organization control was based on simplification, specialization of jobs, and a management hierarchy. Second, costs and performance were coordinated using timely cost accounting reports developed over decades with the assistance of Scientific Management engineers.

The Du Pont Powder Company was a leader in using a centralized accounting system to control decentralized and geographically disbursed manufacturing operations. E. I. Du Pont De Nemours was founded in 1804. In 1903 three Du Pont cousins took over the business in what would now be called a leveraged buyout, and reorganized it. Sales, finance, and purchasing were separated from manufacturing (high explosives, smokeless gunpowder, and black blasting powder), and each department developed specialized strategies to maximize performance. Senior management focused on coordinating activities and long-term strategy. Performance measurement was a key factor and Du Pont accountants developed return on investment (ROI) as an efficiency tool and standard of performance. An asset accounting system based on a complete inventory of plant and equipment made the use of ROI possible. Thus, individual departments could be evaluated by local profit measurement. Daily time sheets and materials usage logs were used to prepare monthly mill production records to measure production operating efficiency. Net earnings were forecast based on product sales estimates and projected earnings per unit. Cash projections were based on net earnings forecasts, which were used to determine new project financing.

The automobile industry is the quintessential industrial success story in the 20^th century (including its near collapse and reemergence toward the end of the century). Part of this story is the American approach to production, labor, market strategy, and control. In the beginning dozens of competitors made cars by hand for the wealthy. Henry Ford changed the rules, inventing the moving production line and pricing cars that the average worker could afford. His labor force was predominantly unskilled and low paid. The Ford approach included low cost, mass markets, and a single design, the Black Model T. Fifteen and a half million would be produced. It represented almost half the auto market before declining in the 1920s to Chevrolet.

The Model T was first made in 1908. Each car took about 13 hours to produce. In 1913 production boss Charles Sorensen had a Model T chassis pulled across the factory floor, with standardized parts placed by the workers. This was the birth of the moving assembly line. Doubling the daily wage to $5 solved huge labor turnover because of assembly line monotony. By the end of 1913 a single car took only an hour and a half to produce. Model T prices dropped from $780 to $360 by 1917 and per car profit fell to less than $100. By 1914 Ford sold over a quarter of a million cars, almost half the market. The result was net income kept rising.

Henry Ford hated accountants and fired the entire department every so often: "They’re not productive, they don’t do any real work". Ford was a production genius, not a cost accountant. Ford achieved low cost through economies of scale. At the huge Rouge River plant only one automobile was produced, the Model T. The system flowed continuously from iron ore delivered by ship to finished vehicles, using conveyor belts. But in 1926 Ford sales dropped for the first time, while Chevy sales rose. The Model T was dumped for the new Model A, but Ford no longer had the competitive and technological edge. Ford would hover near bankruptcy during the Great Depression and World War II.

William Durant created General Motors in 1908 by buying out auto companies and suppliers. Beginning with Buick, he quickly acquired Cadillac, Oldsmobile, and the Oakland. His administrative skills did not equal his organizing skills and a banking syndicate replaced him. He then produced a low-priced car with Louis Chevrolet and used the profits and Du Pont support to regain GM. Durant created the General Motors Acceptance Corporation to finance new car purchases.

GM was close to bankruptcy when saved by Du Pont investments in GM stock in 1920. Alfred Sloan was brought in as president in 1923, a job he would hold until 1956. Sloan would make GM the largest manufacturing company in the world, as well as one of the most complex business organizations. He had a vision of a corporate structure with decentralized control around a domestic market of economic niches from Chevrolet to Cadillac. Each division acted independently, under top management coordination and control. The strategy included annual model changes, bigger cars, and rising prices. Price discrimination, treating each car line as separate products, became a strategy and a mechanism to reduce direct competition. Americans were persuaded to aspire to higher priced cars, eventually to a Cadillac to be traded in every year or two.

Sloan focused on a vast system, with organization charts and accounting reports on every aspect of the company. When Sloan started, sales information was inconsistent, out-of-date, and incomplete. He set up a standardized accounting system across GM and all dealerships. Standardization brought greater organization. Now, GM knew dealer sales and inventory. Sloan also visited dealerships regularly, which was where he got the insight to view a GM-dealership-customer partnership for customers to trade in and trade up to new, higher-priced models.

Donaldson Brown was an electrical engineer by training and initially an engineering equipment salesman at Du Pont. He rose to assistant treasurer in 1914. Brown was brought over from Du Pont as controller of GM, to develop a management accounting system to run this decentralized vertically integrated enterprise. The accounting system from Du Pont included most of the 20^th century’s arsenal of cost accounting techniques, which Brown called "centralized control with decentralized responsibility."

Return on investment (ROI) was developed by Brown and others at Du Pont to analyze product turnover and return on sales. At GM financial planning used an anticipated 20% ROI when operating at 80% of capacity, which influenced both selling and wholesale pricing, volume projections, and production decisions. ROI was a management standard that allowed standard comparison of the various divisions, based on overall corporate goals.

Flexible budgeting also was a GM innovation, where budgets were compared to actual results at all production and sales levels across divisions. First, sales were projected for the forthcoming model year and retail prices established. Production was estimated based on the sales projections. Standard price and volume data were used to coordinate division plans. Revenue forecasts (based on selling price and sales estimates), costs, and ROI were division manager responsibilities. Forecasts were made using past production, sales and cost data, adjusted for expected changes in input prices and production efficiency. Calculations were based on variable and fixed costs, although fixed costs were particularly difficult to forecast. Eighty percent of capacity was considered the production standard, although actual volume was erratic in the short run. Overproduction in 1924 produced a financial crisis for the company, caused by production schedules not based on actual sales. Because of this, dealers submitted sales reports ever ten days. Using flexible budgeting, costs and profits could be estimated for all levels of output for each division. The integration of ROI and flexible budgeting, adjusted for short-term production levels was a complete management system in use at GM by 1925.

Brown wrote a number of articles on cost accounting beginning in 1924 and the cost procedures of Du Pont, GM, and other companies were adapted and modified, were taught as part of the accounting curriculum, and many procedures were codified as part of generally accepted accounting principles and tax accounting. The GM system became the norm, but much of the emphasis shifted to financial accounting and reporting rather than management control.

Alfred Sloan’s perspective for a prosperous society with status determined by GM cars was stopped cold by the Great Depression and then World War II. The perspective returned after V-J Day. At the end of World War II, with much of Europe and Asia in ruins, America was the economic powerhouse, with half the wealth and industrial production of the world. This was described as the American Century, with the focus on industrialization, mass production, and high productivity. There was no claim of pure competition; instead, big labor and big government were big business partners in what Galbraith called countervailing power.

GM had half the domestic auto market and American producers 99%. During the decade of the 1950s some 70 million cars were sold in the U. S., half from GM. The U. S. led the world in exports and Detroit would maintain a net export surplus in cars until the late 1960s. The American production system and market strategy of Brown and Sloan continued, with the assumption that continued success was assured. The system viewed labor as a commodity to the hired and fired (but at a high price), big inventories were necessary to assure against production bottlenecks, and quality meant checking for defects and reworking rejects. America was the leader in mass production and mass production spread to such unlikely products as hamburgers (such as McDonalds) and homebuilding beginning with Levittown in the late 1940—where construction was divided into 27 steps using 27 separate construction teams. Despite a shortage of skilled workers, Levittown was building 36 houses a day.

Alternative Systems in Asia and Europe

After World War II Europe and Asia were rebuilt, partly with U. S. funding—such as the Marshall Plan. Industrial systems differed from the American model. This was partly cultural and partly economic. Both Germany and Japan were in ruins and occupied by allied troops. New governments and constitutions were established. Economic recovery, with populations skilled in industrial development, was rapid.

Economic development became national policy with an emphasis on exports. Japan became the world’s second largest economy. America was Japan’s largest trading partner, but one-sided as exports doubled imports. The Japanese economy would grow at a 10% rate until about 1990. West Germany (Germany after the 1990 reunification) produced about 35% of Common Market output and became the largest trading nation in the world.

The Japanese used the process now called competitive benchmarking, borrowing technology and ideas from leading global companies—much of it from the U. S. One of the most respected consultants was the American engineer W. Edwards Deming. The U. S. Census Bureau sent Deming to Japan in 1946 to improve their census capability. Deming’s perspective included statistical quality control, a focus on customers, group participation, and continuous quality improvement. Since 1951 Japan awarded the Deming Price each year to companies with the best level of quality. Japanese automobile companies were among the Deming Prizewinners.

According to Cooper (1995), Toyota developed "lean production" in the 1950s. Cars could be produced at lower volume levels while maintaining high quality. Toyota always focused on cost, including value engineering to design products to be manufactured at target costs and continuous improvement costing. Considerable technology sharing is common across firms in Japan, a reason for high competition levels, where strategy typically focuses on market share rather than short-term profit.

Japanese companies focused on market share and used return on sales as a primary measure of financial performance, tenaciously relying on increasing volume, improved quality, customer satisfaction, and decreasing costs. Target cost planning included reducing costs not only in the design phases, but also after products have gone into production. "Totally flexible" production maintained both craft traditions and modern technology. Inventories were minimized to reduce cost, with inventory turnover often at 100 times annually, typically much higher than U. S. companies. About 1990 Toyota had about two hours of inventory compared to two weeks inventory for GM. Toyota assembled a car in less than half the time as GM (Howell and Sahurai, 1992).

Japanese firms focused on differential products associated with market segmentation, emphasizing speed of new products and flexible manufacturing, and the ability to shift production from one model to another. Close contact with customers and suppliers is essential, with a competitive price down, cost down approach. Japanese companies enter specific markets, generally at the low-cost end, with an increasing market share strategy. During the 1970s Japanese firms dominated the American compact car market, then expanded into larger and then luxury cars.

German production strategy differed from both American and Japan, stressing product diversity and advanced technology. German autos stressed luxury. German education emphasized vocational training with apprenticeships of about three years and continuous retraining.

The relationship of business, labor and government differed across countries. U. S. relations could be friendly or hostile, with labor peace or massive strikes and "corporate welfare" or antitrust suits. Government agencies have different roles that include protecting consumer, workers, investors, or business. Historically, labor often was treated as a commodity by business, with the result of labor unions with more political power to protect workers. In other countries, more cooperation existed among the groups. The Ministry of International Trade and Industry (MITI) coordinates economic planning in Japan. Big business is conducted through large conglomerates called keiretsu. Until recently, workers and managers assumed they had lifetime employment.

Relevance Lost: The Critique of Johnson and Kaplan

Prior to the 1950s management used cost accounting information primarily for planning purposes, while operating control normally was based on non-accounting information. For example, Du Pont used ROI for planning but control was based on factors such as timeliness of delivery to customers and product quality. Multidivisional business organizations became more pronounced in the post-war period. Since the 1950s there has been a trend for managers to focus on top-down accounting for control. Consequently, Johnson called the 1950s-80s the "Dark Ages of American Business (1992, p. 19).

Production variety was necessary in the post-war period—the Model T no longer satisfied the consumer. Business turned to decoupling—different production processes took place at different sites, perhaps thousands of miles away. Large capacity was needed to achieve economies of scale, with output pushed out quickly to inventory. This worked because volume increased with the booming domestic economy and little foreign competition existed. In the long run this reduced flexibility, caused quality problems, and had little to do with customer demands or satisfaction. Overhead costs increased, resulting in allocation problems. The perceived solution was increased volume to spread out fixed overhead over more units.

In Relevance Lost (1987), Johnson and Kaplan criticized American cost accounting of the post-World War II period. American industry was not competitive in the face of lower cost and higher quality products from Asia and Europe. American industries in the 1980s seemed uncompetitive and incapable of high quality products. Foreign competitors had the ability to dominate U. S. markets and drive American firms toward bankruptcy. In the Johnson and Kaplan critique, cost accounting was part of the problem.

Cost accounting, according to Johnson and Kaplan developed a financial accounting mentality, where the focus on inventory and cost of goods sold was more important than precise cost information. The mentality was that short-term profit is crucial, but a long-term focus on customers, employees, and suppliers was not. Early in the century direct labor and direct materials often were 90% of total cost and allocating overhead based on direct labor was reasonable. Late in the century, direct labor could represent only 10% of product cost with 60% representing overhead. Therefore, allocating overhead based on direct labor made little sense. And for most of the century there was little or no consideration of total quality control or the goal of zero defects—common practices of Japanese and other foreign producers.

However, even during the doldrums of the late 1980s the U. S. lead the world in productivity and during the entire post-war period, productivity increased—although at a slower rate than much of Asia and Europe. Many industries including aircraft, chemicals, and computers were net exporters. But problems were real and severe. About 70% of American manufacturing faced direct foreign competition. A substantial trade deficit existed in steel, automobiles, textiles, and electronics. American firms were virtually wiped out in some industries, with consumer electronics the most infamous example. The problems of the U. S. system cam face-to-face with global competitors with better ideas.

The American Response

The economic problems in the U. S. were severe by the end of the 1980s. Customers often viewed Japanese and other foreign goods as superior to American competitors. Businesses were losing both domestic and foreign markets with resulting falling profits. Automobile companies posted amazing billion dollar losses. Restructuring in autos was aimed at cutting costs and improving quality. Ford started the quality program with the slogan "quality is job one", but then brought in Edwards Deming and really made serious quality strides. By 1987 30% of car sales were imports and autos posted a net $60 billion trade deficit. By the mid-1990s the domestic companies regained a 75% market share and respectable profitability. U. S. autos approached Japanese quality and enjoyed advantages in trucks, van, and short utility vehicles. What happened?

According to Johnson (1992), key components to become globally competitive include long-term relationships with customers, process flexibility including employee empowerment and the elimination of constraints, and the refocus of accounting information. Accounting numbers provide almost no information about customers or product quality. Rather than controlling operations operations, cost data should play a supporting, but significant, role. Useful accounting techniques include target costing, just-in-time (JIT) inventory, and activity based costing (ABC). With target costing, prices that customers should be willing to pay less the projected company return becomes the upper bound for long-term costs.

JIT focuses on near-elimination of inventory, since excess inventory is an expensive way to handle imperfect manufacturing operations. Implementation was difficult, with machine breakdowns, existence of poor quality, long setup times for equipment, and delivery uncertainties. Suppliers became a key component in supplying high quality parts at exactly the right time and place.

Zipkin (1991) stated three tools for satisfactory JIT implementation: (1) engineering techniques including simple product design, clean plant layouts, and improved maintenance; (2) the concept of continuous improvement; and (3) material control procedures. Supplier "partnerships" and employee involvement also are important factors. Although many American companies suffered disastrous results associated with unreliability of suppliers, bottlenecks, quality control and coordination, progress was made.

ABC was an American invention and simple in concept. With increased manufacturing complexity, direct labor declined in importance. Major costs were part of overhead. How should these costs be related to product costs? ABC collects and analyzes business activities as a comprehensive map of industrial operations.

General Electric used an ABC-type analysis in the 1960s to get a better handle on overhead costs. GE tried to relate costs to specific activities, the cost or activity drivers, and trace activities across departments. With this information, activity costs per unit could be estimated. GE developed standardized cost drivers. From the 1970s ABC product costing systems sum total costs of activity drivers for each product line. As stated by Johnson: "Companies systematically undercost the low-volume products that have tended to cause most overhead growth … and systematically overcost high-volume products … which give a misleading picture of an individual product’s margins" (1992, p.29).

The American response has worked well in the 1990s, with more emphasis on quality, customer satisfaction, and employee empowerment. U. S. labor costs are similar to Japan and lower than Germany. Productivity and cost of capital were similar. Corporate net income and stock prices rose substantially. Particularly important, U. S. businesses are competitive globally. The auto industry is an example, as are computers and semiconductors. The role of cost accounting has been an important component in this global success. While the U. S. economy has boomed through the 1990s, American rivals have fallen on hard times, especially Japan and other Asian countries.

Information Revolution Update

The importance of computers and other information technologies cannot be underestimated. Computer systems including enterprise software and the internet are dramatically changing business practices and management accounting. See Chapter 7 for the details.
 
 
 

What is a Cost? According to Concept Statement No. 6 (SFAS6) of the Financial Accounting Standards Board (FASB), cost is an economic sacrifice. The National Association of Accountants defines cost as "the cash or cash equivalent value required to obtain an objective…" (1983, p. 25). Since the purpose of recognizing cost is to make profit, most costs are matched to revenue as expenses. Costs "left over" at the end of the year such as inventory are assets. The recording of costs and assets are based on generally accepted accounting principles (GAAP).  Cost accounting is the set of procedures to determine costs, especially production costs. Cost data can be combined and manipulated in different contexts and analysis can get complex. Accounting information for firms can be split into financial and managerial accounting. The purpose of financial accounting is to prepare annual reports and other financial information, based on GAAP. This information is provided primarily to investors and creditors. Managerial accounting is used internally by firms and is subject to no direct regulations. The purpose is to provide information useful for internal decision making.  Cost accounting procedures developed in America at the start of this century borrowed earlier procedures and developed new concepts adapted for large organizations. These worked well at the time and refinements continued into the post-war period. The primary focus was on large manufacturing operations with standardized products and a large labor force. By the 1960s these procedures were less meaningful with a shift to services, less standardization, higher fixed costs and less direct labor, competition was global, and Asian and European competitors developed alternative production strategies. Many cost accounting features became standardized as generally accepted accounting procedures (GAAP). U. S. GAAP requires absorption costing (which requires direct materials, direct labor and overhead incorporated in inventory costs), limits accounting choices such as inventory alternatives, and so on. GAAP and tax accounting procedures often became the norm for cost and management accounting, which might be less useful for management decisions.