Chapter l0 Behavioral Aspects of Accumulating and Controlling Costs lot

from comparing actual performance results with budget allowances set for
an activity level that is different titan the one actually attained. The ACC
Company’s dilemma is a case in point.
it is therefore quite clear that the information provided by traditional cost
systems is incompatible with modern control objectives. They also provide
little useful information for managerial planning and decision making. Their
greatest weakness is the inherent danger of inducing unwanted and destructive
behavioral responses when used in evaluating the performance of the
individuals charged with carrying out the various activities within budgetary
constraints.

Standard Cost Systems

Their Scope
Recognizing the shortcomings of the traditional cost systems. many orga-
nizations adopted "standard cost systems.” Standard cost systems represent
a potentially effective blending of accounting with the control concepts of
modem organization theory. Standard costs are scientifically predetermined
cost goals per unit of product or service which have been developed through
engineering and accounting studies. They represent detailed and sophisticated
estimates of what it should cost to carry out a particular task or to produce
a certain product. The inherent control aspect of standard costing is its capa-
bility to compare. as part of the regular data flow. actual performance with
predetermined standards and to highlight variances (favorable or unfavorable)
between the two levels of costs. Standard cost systems are even capable of
determining causes for the deviations. To produce optimum control benefits
and to retain their relevancy. the standard costs must be continuously updated.

Their Compatibility with Modem Organization Theory Concepts

In developing a framework for a standard cost system that is compatible
with modern organization theory concepts, the following control steps as
discussed by Edwin Caplain ' are essential:
l . The establishment of organizational obicctivcs.
2. The designation of appropriate responsibility centers and the assignment of
functions to each.
3. The staffing of responsibility centers wrth individuals who haVe sufficient
ability, motivation. and knowledge for the performance of their functions.
4. The creation of channels of communication between the responsibility cen
tcr and other units of the organization and. where necessary. the eatemal
environment.
5. The development of procedures that assure adequate. relevant. and timely
information moves along the communication channels
to: tan ”l‘wo Behavioral Implications of Management Accounting

6. The design and implementation of control mechanisms that measure and

evaluate performance in terms of organizational objectives and provide feed-
back concerning necessary adjustments in objectives and/or performance.

Standard cost systems are designed to serve simultaneously as a source

of information. channels of communication. and control and performance
evaluation devices. As a source of information for the responsibility centers.
they inform the individuals in charge what is expected from them costwise.
As a communication channel. they transmit cost expectations and attainment
levels. The control over responsibility center operations is accomplished
through periodic standard cost repons that provide the feedback about past
performance results and their deviations from standard to the appropriate
individuals. Predetermined tolerance limits can be designed to perform a
filtering function. thereby permitting concenuation in areas in which variances
are significant and warrant immediate attention (management by exception).
Because performance reports are programmed in advance with respect to
when they will be prepared and what data they will contain. it is difficult
to bury important information. A well-designed standard cost system also
provides the assurance that the required information will, in fact, reach the
accountable individual. Furthermore. the insight gained through developing
and evaluating cost and performance standards has proven to be of valuable
assistance to management in formulating. testing. and revising the objectives
of the organization.
Standard cost systems have the potential to be used either as aids in
increasing motivation and goal congruence or as devices to achieve high levels
of autocratic and coercive control. To achieve their greatest possible control
value. most systems in use will hav: to undergo certain modifications—
modifications that affect not so much the techniques themselves as the attitudes
and philosophies of the people who operate and use them.

DIRECT OR VARIABLE COSTlNG

Its Underlying Philosophy
All traditional cost accounting methods. in compliance with the coat concept.
charge units of products or service with full costs. Direct material and direct
labor is charged directly to product or service units. while fixed and variable
overhead in most instances is absorbed on the basis of an estimated rate based
on predetermined volume. Whenever the basis used for absorption differs
from the predetermined capacity level, the absorption procedure will result
in overabsorption or underabsorption of the manufacturing (or service) over-
Chapter IO Behavioral Aspects of Accumulating and Controlling Costs 16)

head. Supplementary analyses are required to identify the various components

causing overabsorption or underabsorption.
The traditional cost accounting methods also disregard the fact that oer-
tain overhead costs will remain constant regardless of the quantity of units
produCed or service rendered, while others will fluctuate with volume. To
overcome these shoncumings. devices such as flexible budgeting and cost-
volume-profit analyses were introduced.
To facilitate decision making and cost control without the necessity of
preparing time-consuming supplementary reports, a new costing philosophy
was introduced in the 19305. This method. called direct or variable costing.
was credited with providing more meaningful results to management and those
faced with day-to-day decisions on the basis of cost accounting results. One
of its most acclaimed attributes is that it avoids the confusing accounting
terminology explaining the cost-volume-profit relationship.
Direct or variable costing disringuishes between the costs of producing
(direct material. direct labor. and the variable portion of overhead) and the
costs of being ready and able to produce (fitted overhead or period costs).
Only costs that result from current production or services rendered (the vari-
able costs) are classified as product or service unit costs and capitalized until
the items are sold or the service is rendered. According to John A. Beltett,
costs that “result from the long-term preserving and availability of productive
potential are said to be period costs"2 and are charged against revenues in the
period when their service potential expires.
Direct costing advocates consider the division of overhead according to
their cost structure a basic necessity for effective cost control and meaningful
decision making. They claim that the conventional practice of assigning the
fixed portion of overhead to products confuses management by obscuring their
true nature and behavior. By excluding capacity or fixed costs in valuing
inventories and coats of goods sold. it places manufacturing and merchandising
companies on a similar basis as far as the costs of products are concerned.
Production volume, they argue. does not affect the procurement costs of either
company. One manufactures its products at known variable costs: the other
purchases its merchandise at definite purchase prices. The only difference is
that manufacturing companies. when determining their monthly contribution
margin or the spread between variable costs and selling prices. have to provide
for the fitted manufacturing overhead as one of the costs of doing business
along with administration. warehousing, and selling expenses.

Its Behavioral lnducements

Accounting concepts. principles. and practices influence the measurement of
managerial performance and. consequently. management decisions. This does
lot Part Two Behavroral Implications of Management Accounting

not always lead to desirable results since many performance measures have
built-in biases that motivate managers to select action alternatives that may
not be in the best operating and/or financial interest of the company.
Through its authoritative bodies. the accounting profession is presently
reexamining accounting‘s basic concepts. principles. and practices in the light
of their possible behavioral implications.
In the process of their reexamination. questions such as the ones asked
by David Hawkins seem appropriate:

What might this accounting concept. principle. or practice moti-

vate managers to do in their own selfish interests?
Could this possible action obscure actual managerial perfor-
mance. give the illusion of performance where none exists. or
lead to unsound economic actions? 3
If any part of the second question calls for an affirmative answer. the
use of such accounting concept. principle. or practice should be discouraged.
although it might be sound from a technical viewpoint.
Hawkins maintains that accounting concepts. principles. and practices
are behaviorally and technically sound if they:

Inhibit managers from taking undesirable operating actions to

justify the adoption of an acounting altemative (and if they]
Inhibit the adoption of accounting practices by corporations
which create [only] the illusion of performance, 3
This leads us to the following questions: Is direct or variable costing
truly superior in controlling costs and in providing information that will lead
managers to more meaningful decisions? Is this practice technically and
behaviorally better than generally accepted traditional approaches?

Cost Control
Dividing costs into variable and fixed components provides a better basis
for cost control. It enables the preparation of contribution margin income
statements. which emphasize cost behavior patterns and provide management
with details as to engineered. committed. and discretionary costs. This dis-
tinction is important to management since each type of cost requires different
control procedures.
Engineered costs include direct material, direct labor, and variable over-
head costs such as fuel and electricity. According to Charles Homgren they
have an “explicit. specified relationship with a selected measure of activity.”
They are readily controllable at the lowest organizational level through the
use of flexible budgets and standards; their feedback time is short and they
Chapter 10 Behavioral Aspects of Accumulating and Controlling Costs loS

are physically observable by the managers responsible for the activity that
causes their occurrence.
Committed fixed costs or capacity costs "are all those organization and
plant costs that continue to be incurred (regardless of the activity level) and
which cannot be reduced without injuring the organization‘s competence to
meet long-range goals."5 Controlwise. they are the least responsive fixed costs
and they can be controlled in the short run only by attempts to improve the
utilization of the committed facilities.
Dircrefianan' costs (also called managed or programmed costs] are those
costs “(I) that arise from periodic (usually yearly] appropriation decisions
regarding the maximum amounts to be incurred and (2) that do not have a
demonstrable optimum relationship between inputs (as measured by costs) and
outputs (as measured by revenues or other objectives)"6 They include costs
such as advertising. auditing and management consulting services and human
resource training. in cunu-ast to committed fixed costs. they can he reduced
or even entirely avoided in dire times and they are controlled by negotiated
static budgets.

Decision Making
Besides stressing the distinction between variable and fixed costs and
providing differential cost infomtation, in certain decision situations. direct
or variable costing provides managers with another important piece of infor-
mation. We are referring to contribution margins of products. product lines.
service activities. divisions. and the like. Knowledge of differential or van-
able costs and of contribution margins will influence the behavior of managers
and will lead them to better decisions. Some typical decision situations fol-
low.
Product Mix Decisions. When faced with product mix decisions. sales
managers who know the contribution margins of their products will be better
able to decide which product to push and which to dcemphasize or to tolerate
only because of its sales benefits to other products. in case of limited resources
te.g.. machine time. materials. etc), the contribution margin will provide
management with information for choosing the desirable mix. which would
result in the largest total contribution to profit. Knowledge of the desired
contribution margin for a product line will enable management to price a
certain product below full cost. as long as the complementary products can
be priced to yield sufficient profit to keep all products in the product line.
New Product Pricing. New products are generally accepted in the market
only after they are extensively tested by reputable firms in the industry. To
enCourage companies to use the product on a trial basis. management may
sell it at variable costs. Once the product is sufficiently tested and accepted
176 Part Two Behavioral Implications of Management Accounting

repetition is coupled with intrinsic or extrinsic rewards. The type and degree
of response to specific rewards differ from individual to individual and may
vary over time. (For more details see Chapter I I on Performance Evaluation.)
Since there is a psychological feedback effect between the various factors
of the control policy and future performance. the ideal control policy will have
to be tailor-made and will vary from situation to situation. The investigation's
premise that cost variances are independent of the control policy is therefore
untenable. it is no surprise that VlD models are not applied more frequently
in practice.

DIAGNOSTIC REVIEW OF THE AMERICAN

CONCRETE COMPANY’S DILEMMA
On a Monday aflemoon in early May. the phone in Mike Monelli's office
rang. Monelli was the partner in charge of the management consulting group
of the Prince and Whales CPA firm. On the line was the president of the
American Concrete Company. a long-time audit client. who seemed very
annoyed about the planning. control, and performance evaluation problems
his company was experiencing and the behavioral turmoil they had caused.
He told Monelli that his top management team believed that the present cost
accounting system seemed to be the root of the problem. He requested that
Monelli investigate the present system. modify it if at all possible. or design
a new one that would end the frictions and animosities. ACC's president also
requested early action so that by October. the start of their planning cycle,
the new system would be in place.
Since Monelli had no expertise in these areas. he assigned the investi-
gation to Aldona lvet'son. the group’s cost and systems specialist. lverson
holds a master's degree in management accounting from a leading university.
and she is both a CPA and a CMA. She had held various upper-level man-
agement positions prior to joining Prince and Whales and was the director of
the information system when her company merged with another company and
her position disappeared.
The present assignment was tailor-made for her and she was looking
forward to getting involved. When she arrived at ACC. she was briefed by
the company's controller. Kurt Nicssen. since the president was out of town.
Niessen told her that he had been trying for a number of years to convince the
president that their manufacturing process (mass production of a single
product) was ideally suited for a standard cost system. He said that such
a system w0uld not only enable them to improve their cost control and
performance evaluation. but would also provide the basis for more effective
budgeting. His suggestions were ignored and the reasons given for the denial
were that such a system would be too complicated. too time consuming.
Chapter lo Behavioral Aspects of Accumulating and Controlling Costs ”7
and too cosdy for their simple production process. The controller also com-
plained that his role in the budget-making process was only clerical and
involved only the consolidation of the submitted detailed budgets. He found
it outrageous to be blamed for the inefficiencies of the budget when he played
only a minor role in its preparation.
Iverson asked the vice-president in charge of sales. John Miller. why the
sales budget was not adjusted as soon as he became aware that the chosen
capacity assumptions were completely unrealistic. He told her that revisions
were the controller's job and that he had to use his time to secure sufficient
sales to keep the company alive. When asked how he could use the erroneous
total cost (produced by the unrealistic capacity assumptions) as basis for
pricing. John replied that even if he knew what the exact cost per pound
was, he could not use it. because the price for the concrete was dictated by
their competitors.
The vice-president in charge of production, Patrick O'Mallcy, was dis-
gusted with both the sales manager and the controller. He blamed the sales
manager for not undertaking any market research or using at least a more
objective quantitative forecasting technique when deciding on the actually
attainable capacity level for the planning cycle. He was convinced that the
poor quality of the forecasted sales was the only cause of his serious problems
in production scheduling. The difficulties in controlling the various manufac-
turing costs on the basis of enoneous performance reports bothered him very
little since he was convinced that he could readily spot inefficiencies on his
daily walks through the factory. He blamed the controller for not noticing the
poor quality of the sales estimates and for not insisting that a more objective
forecasting method be used.
When reflecting on the results of the various interviews and the animosi-
ties observed, lverson decided to scrap the present system and design a new
one. Since it was very unlikely that she Would be able to convince the sales
manager (who was the president’s brother-in-law) to undertake either serious
market research or to use a formal forecasting technique when determining
the sales volume to be expected for the future year. she decided to introduce
a standard cost system. Such a system. she reasoned. Would provide more
meaningful performance evaluation data for the manufacturing process. in
its variance analysis step, it adjusts the budget allowances for material and
labor costs, as well as the variable portion of factory overhead. to amounts
allowable at actual capacity and standard capacity. The resulting variances
are realistic indicators of the efficiencies or inefficiencies in the manufacturing
process and provide a dependable basis for effective control. A standard cost
system would also isolate the gains or losses incurred through overabsorption
or under-absorption of fixed factory overhead cost caused by idle or excess
capacity variances for which top management and not the production manager
In Part Two Behavioral Implications of Management Accounting

would be held responsible. This. she hoped, would remove the reasons for
the production manager‘s frustrations and might even induce him to pay more
serious attention to the performance variances in the future. The only costs
that would be exclusively controlled through the budget would be tlte selling
and administrative expenses. and for those she hoped to find a special solution.
After securing the president‘s permission for the new system and his
commitment, lverson met with the members of his management team and
explained the reasons for her choice and the benefits it was to provide. She
told them that she considered her role in the construction of the new system
as that of an advisor and technical expert and that they. as the future users.
had to make the various decisions that would determine the structure and the
output of the system. She then assigned to the controller and the production
manager the task of setting standards for direct material, direct labor. and
factory overhead use per pound of cement produced. The overhead was to be
broken down into fixed and variable components on the basis of historical data
from the past five years. At that meeting. she also instructed the two managers
to involve the foremcn of the various production departments in the standard-
setting process. The foremen were to make sure that the final control and
performance evaluation standards were perceived by the controlled individuals
as realistic and attainable. It was decided to use pounds of output as the basis
for rate determination and absorption of the overhead in the product since
ACC's production process was highly automated and people performed only
minor supporting tasks.
At the meeting. it was further decided to charge the sales and produc-
tion departments for all centrally provided services such as data processing.
accounting. legal services. product development. and quality control. The
fixed portion of the total service costs was to be allocated on the basis of
assets employed. The variable portion was to be absorbed by the users on the
basis of actual use. Through such allocations. it was hoped that the providers
would exercise special care since declines in service quality or timeliness
would undoubtedly cause immediate user complaints. People pay more atten-
tiott to the quality and the timeliness of services for which they have to pay
and that affect their own performance evaluations. The allocations were used
as proxies for transfer prices since it was believed that the costs of a full-
fledged transfer-price system would nor be justifiable for a company of their
size.
After a heated discussion. it was decided to zero-base all major selling
and administrative expenses at least once every other year to insure more
realistic budgeting. The sales department's efficiency was to be evaluated.
in addition to the present budget variance analysis. on the basis of industry
averages for sales generated per dollar of selling expenses.
All executives were to have their assigned tasks completed by mid-
August. at which time a progress meeting was to be held. At this meeting,
Chapter It) Behavioral Aspects of Accumulating and Controlling Costs ”9
lverson hoped to receive the agreed upon cost standards and the various chosen
allocation bases for corporate indirect cosm so that she could start constructing
the system.
Everything proceeded according to schedule. lverson presented her
report to the president and his management team and asked them to study
the new system carefully and report any omissions or ambiguities to her
within a weelt. She also insisted that all employees affected by the new
cost accoanting and reporting system were to be carefully educated on its
objectives and structure and that training sessions were to be held to ensure
proper use and maintenance. She offered lter services in the education
process and promised to be available at the budgeting time if any unforeseen
implementation problems should surface.
Back in her office at PW, lverson reflected on her completed assignment.
She was convinced that she had performed well and that she had solved the
problems that had caused such animosity within the top management team. By
working together in the standard cost system design stage. they had learned to
understand each other's needs. They realized that they all shared one goal—
the growth and Well-being of the organization that provided their livelihood.

SUhflWARY
In this chapter, we demonstrated the behavioral aspects of accumulating and
controlling costs. We showed that traditional (historical) cost systems are
behaviorally unsound and may induce unwanted and destructive responses
when used in controlling and evaluating individual perfonnance. Although
standard cost systems have the potential to increase motivation and goal
congruence, they may also be used to achieve high levels of autocratic
and coercive control. The behaviorally superior method is direct (variable)
costing. which. by isolating product cost and period cost. provides the most
relevant information for controlling the various types of costs and in leading
management to more profitable decisions. We also analyzed the behavioral
aspects of cost accounting steps and suggested approaches that could induce
desirable employee behavior.

REFERENCES
lEdwin H. Caplan. Management Accounting & Behavioral Science (Reading.
Mass: Addison-Wesley Publishing Co, l97l ). 60.
2John A. Bekett. "An Appraisal of Direct Costing," NACA Bulletin Sect.l (Dc-
cember l95l): 407—415.
3
David Hawkins. “Behavioral Implications of Generally Accepted Accounting
Principles." California Manage-meal Renew (Winter 1969). l3-2l.