Traditional management accounting is an insufficient and artificial proxy for decision-making that overlooks what is really driving cash flow on the factory floor and across business units. There it is: the elephant nobody really wants to talk about.
International accounting standards ensure that the financial statements from different companies are comparable. Without standards such as IFRS, businesses could interpret financial information in whatever way that suits them, potentially misleading investors. While one can agree that accounting standards are indeed needed and legislation must be followed, a closer look on different practices is however well motivated. To strive for one set of numbers in a company will most probably lead to sub-optimal decision making.
"There are a lot of external accounting principles that companies follow partly because they have to due to legislation, but also due historical reasons and lazy habits. Changing accounting practices is a cumbersome project, so organisations stick to old habits without really questioning if it makes sense", says Mats Danielsson.
The real problems arise when it's time to make business-critical decisions. If you turn to numbers from your management accounting, chances are you will not land on a sound decision.
“A so-called VUCA world is characterized by volatility, uncertainty, complexity, and ambiguity while traditional costing methods rely on historical data. In a stable environment the traditional methods work quite well but in a changing and volatile environment the relevance of your numbers will start to erode.” says Jonni Friman.
After more than 25 years of battling these questions, Danielsson in various CFO roles and Friman as the management consultant, the duo behind NoBSH has decided to talk about the elephant in decision-making: why accounting principles are a bad proxy for decision-making in manufacturing companies.
"The numbers only tell one part of the story. And sometimes even a completely different story than the underlying reality. When that happens, you will go wrong when it comes to predicting different outcomes and hence base your decision-making on the wrong parameters. Numbers used in decision making must be fit-for-purpose ", says Friman.
One problem with today's management accounting is the unit cost focus. While you need to do it for external accounting purposes, you should be careful to use this as a proxy for business-critical decisions in your company.
" If you only look at the cost per unit derived from your management accounting, you lose transparency and risk omitting products or product segments that seem unprofitable but can in fact be generating significant cash flow. You have to focus on identifying relevant cost structures and the effect on total cash flow", says Danielsson.
There are many real-life examples of how decisions have gone wrong when numbers have been interpreted in the wrong way. These may concern critical decisions regarding the assortment, capacity investments, make or buy decisions, or private label possibilities/threats.
"The unit cost calculation assumes capacity as a linear cost whereas in reality, the cost of capacity increases and decreases in steps. Allocating cost of capacity to a single product is theoretically correct but it doesn’t reflect the underlying reality, where an increases or decrease in produced volume doesn’t necessary impact the actual cost.", adds Friman.
What then can you do to get numbers that better reflect the underlying reality? Obviously, accounting legislation needs to be followed, but you can take a closer look at ingrained practices that organisations follow because it's perceived as too much hassle to change old habits.
"Once you have shown to your management group that a cash-flow oriented approach to management accounting leads to better decisions, it's easier to make the switch to more sound accounting practices, resulting in more common-sense decision making", says Danielsson.
A good first step is to start questioning. Bring in the elephant to your board meeting room