1.3 Increasing complexity of operations

1.3 Increasing complexity of operations

1.3.1 The vertically integrated firm

At the turn of the 20th century, the US economy was driven by large, mass-producing manu­facturing firms that were capable of achieving unprecedented speeds of throughput by the use of sophisticated, mass-production techniques. These techniques allowed corporate manage­ment substantially to curtail slack in production activities. However, similar benefits could not be captured in the supply of inputs and in the distribution of finished products. Traditional wholesale networks were reaching fewer customers and selling less products, while raw mate­rial suppliers did not realise or pass on sufficient benefits that could be gained by ordering larger input quantities. The gain-sharing contracts that were used at the time to coordinate procurement contracts and sales activities were apparently not capable of motivating agents elsewhere in the value chain to capture and pass on the gains that could be realised by the effective techniques developed in the manufacturing firms. During the merger wave of 1897-1903, large firms integrated backward with suppliers and forward with distributors and thus combined their production activities with new activities such as purchasing, marketing and transportation. The integrated companies now controlled internally many transactions across the value chain that had been mediated in the past by market exchanges (Chandler, 1977).

It is generally believed that inefficient markets may have caused the merger wave of 1897-1903. Some studies show that the UK market system was much more sophisticated and

7

Chapter 1 Foundations of management accounting

8

more efficient than America's. The UK system had low industrial concentration and almost no monopoly positions, competitive pressures were strong and the market was free for interna­tional entrants. UK firms remained much longer (until the 1920s) un-integrated, relying on market prices for exchanges among firms (Hannah, 1980; Johnson & Kaplan, 1987). The more complex US integrated organisations also needed a new organisational structure to control their diverse set of activities. Most organisations changed to the unitary form of organisa­tion, which is comprised of independent units and one central office to manage both the units and the entire firm (Chandler, 1966a).

Traditional management accounting information like product level conversion costs and sales turnover did not suffice in the more complex organisations and were supplemented by budgeting information for the entire enterprise, as well as for each of its constituent units. These budgets expressed the corporate financial objectives and defined each depart­ment's required contribution to the firm's total financial performance. Common denomina­tors to measure and compare the inherently very different department's contributions to the success of the entire company were cash flow (expressed in cash budgets) and return on investment. The E.l. DuPont de Nemours Powder Company (generally abbreviated to DuPont Powder Company) developed this approach in the years between 1903 and 1912. This was shortly after three DuPont cousins (Alfred, Coleman and Pierre) acquired E.l. DuPont de Nemours and Company, an explosives manufacturer in America since 1804. At the time they acquired the company, the explosives industry was organised around sev­eral explosives firms who coordinated output quotas and prices through the Gun Powder Trade Association, a loosely structured black blasting powder cartel. After 1903, the DuPont cousins rescinded almost all trade agreements, incorporated trade activities in the firm and restructured the organisation into three main departments: manufacturing, sales and purchasing.

Pierre S. Dupont, president GM 1920-1923 Source: © Bettman I Corbis

1.3 Increasing complexity of operations

The DuPont accounting system5 supported two central management functions: planning (the allocation of investments, including working capital and financing new capital require­ments) and control (coordination and management of the horizontal flow of operations). The investment decisions were guided by the principle that the expenditures for additions to the earning equipment should be applied to those activities that generate the most additional value to the company(Johnson, 1975). The criterion used to evaluate investment projects was Return on Investment: net earnings (minus depreciation and before deduction of inter­est on long-term debt) divided by net assets (total assets minus goodwill and other intangi­bles, current liabilities, and reserves for depreciation).

Pierre duPont opposed the then widely used measure of profits or earnings as a percentage of sales or costs (as was illustrated by the Carnegie Steel Company) . In his view, the ultimate test is not the percentage of profit on cost, but the rate of return on the money invested in the business. In order to calculate the denominator, DuPont made a complete record of investment in plant and equipment in an 'asset accounting system'. This was a major innovation, sharply contrasting with the conservative accounting practice around 1903, which stimulated charg­ing off capital expenditures to retained earnings as quickly as possible (Johnson, 1972). It took until about 1912 when one of DuPont's financial officers, Donaldson Brown, decomposed the ROI measure further into the product of the sales turnover ratio (sales divided by total invest­ment) and the operating ratio (earnings to sales) and further down into other elementary components. This disaggregation was helpful in detecting the reasons for ROI outcomes to deviate from ROI targets in a given period. The second planning issue was the financing deci­sion. A general rule was not to use debt financing: all investments were financed out of retained earnings and sales of company shares. The projection of future net earnings was, thus, used to

Donaldson Brown (1885-1965) Source: GM Media Archive

5 The accounting system is generally viewed as the most important part of DuPont's revolutionary new manage­ment system. I t was developed by Pierre DuPont, Arthur Moxham, and Russell Dunham. They had all previously worked in several firms in Pennsylvania and Ohio, which used Frederick Taylor's manufacturing cost accounting system following Scientific Management principles.

9

Chapter 1 Foundations of management accounting

10

determine the maximum amount of funds available for future investments. Total net earnings were projected by multiplying the quantity of explosives to be sold by the estimated net profit per unit for each product, added to the non-operating income from land sales and earnings from financial investments. Comparing this number with the investment appropriations led to the projection of the firm's cash position and thus to the estimation of additional financing needed (Chandler & Salsbury, 1971).

The management control function at DuPont was supported by detailed management accounting information systems as they were already fully developed by earlier non-inte­grated firms. The DuPont accounting information system was tailored to each of the three major departments: manufacturing, sales and procurement. Monthly manufacturing cost information about material usage and the dollar costs of all other inputs (except administra­tive overhead) in every production stage of each product in each mill was sent to the mill superintendents of the more than forty geographically dispersed mills. This information was intended to support the superintendents in their primary responsibility of improving production efficiency. The product and process costs were compared with predetermined standards and with cost information from other mills. The corporate management team (the Executive Committee) received a second set of information displaying the financial costs of goods manufactured, net earnings, and return on investment for each product and each mill.

The sales function was managed by a Sales Board, a committee of sales department execu­tives from each of the three product branches (high explosives, smokeless gunpowder, and black blasting powder). They determined minimum sales prices by adding a given return to the costs per output, calculated by the accounting department. Sales managers could not sell at prices below the minimum price level. Additionally, the Sales Board determined a 'base sales' mon­etary amount per salesman, which was calculated by multiplying a 'normal' volume (an average expected volume) with a 'base' price (which was higher than a minimum price). The salesman­ager's salary increased proportionally with the amount he exceeded the base price. He could independently determine the combination of price and volume, as long as he did not set a price below the minimum price level. The branch managers were also monitored on how they con­trolled their inventories and sales costs. The sales department estimated a 'normal' ratio of sales costs to gross sales for each branch office. Sales costs included general office expenses, plus 5% of the average accounts receivable and 5% of the average inventory balance (Johnson, 1975).

Until 1908, most DuPont purchases were done with independent agents who used terms that were easily comparable with market prices. As DuPont started integrating purchas­ing, it also employed its own agents, for instance in Chile to buy nitrates. In 1907, however, the backward integration process almost caused a working capital crisis. The procurement department kept buying large stocks at predetermined prices, while at the same time declin­ing orders for explosives, which severely reduced DuPont's working capital. In order to lower the risk from oversupply, DuPont decided to make the purchasing department responsible for buying at the lowest prices only up to a certain stock level that was determined by each month's end product sales projections. DuPont also recognised the risks of undersupply, and decided to acquire (parts of) the ownership of supply sources, like nitrate and glycerin producers. DuPont's stake in these companies secured uninterrupted supply of quality inputs.

1.3.2 The multi-divisional firm After World War I, some larger companies started to diversify their activities, mostly in an attempt to capture economies of scope and to diversify business risks. However, diversifica­tion also introduced new management problems. Diversifying companies such as DuPont,

1.3 Increasing complexity of operations

Sears Roebuck (a chain of retail stores) and General Motors (GM, an automotive company) discovered that their centralised structures and detailed management accounting informa­tion did not suffice for the management of diverse product lines or sales areas (Chandler, 1966). A good example is GM, which was founded by William Durant in 1912. GM was different, because it consisted of several diversified units, each manufacturing and selling a unique line of autos or parts. Each unit performed all operating functions, from purchas­ing, manufacturing to marketing and sales. Durant managed the entire company, using the same management systems that had been successfully developed by vertically integrated firms since the early 1900s. The detailed management accounting information and central­ised control immersed Durant in the particular activities of each unit. However, the large variety and complexity of the firm did not allow him effectively to manage each unit, and it also made it impossible to generate sufficient economies of scope for the whole company.

When GM encountered a great crisis in 1920 (which was known as the 'inventory crisis') the chairman of the board, Pierre Du Pont6, decided to replace Durant as company president and asked Alfred P. Sloan to work with him in restructuring the firm. They invited Donaldson Brown, the architect of the DuPont management accounting system, to join their team as chief financial officer. The new team installed a new management system that aimed at accomplishing 'centralised control with decentralised responsibility'. This new approach differs greatly from the management systems used in integrated firms in that it decentralised operational decision making and control, while at the same time it centralised corporate strategy making and firm wide coordination of diversified units.

Donaldson Brown, the architect of GM's new system, placed the owners' interest at the forefront. The most important objective of the firm was to earn the highest long-term return on investment 'consistent with a sound growth of the business' (Sloan, 1963). Corporate

Alfred Sloan (1875-1966)

Source:© Everett Collection Historicai/Aiamy

6 During the mid-1910s, the DuPont family was buying shares of GM stock which made them one of the larger shareholders of the company.

1 1

Chapter 1 Foundations of management accounting

12

management implemented this general policy by stating that the firm in the long run should earn an average after-tax profit equal to 20% of investment while operating on average at 80% of 'standard volume' capacity. The standard volume was set at 80% of full capacity (Johnson, 1978). This required rate of return worked as a long-term planning objective against which annual operating plans of the divisions were evaluated.

Each division prepared an annual 'price study' in which division managers proposed sell­ing prices for their products, based on sales estimates for the coming year in units and in dol­lars, costs, profits, capital requirements and return on investment, both at 'standard volume' and at the forecast volume, based on estimations provided by central office. If the proposed price for any model fell below the dollar equivalent of the standard price ratio and, if the gap between these two prices could not be attributed to short-term competitive pressures, then top management requested a division manager to reduce the proposed operating cost (Johnson, 1978, p. 500). During the execution of the plan, GM developed several sophisti­cated ways of controlling operations. Special attention was given to coordination problems between manufacturing and sales functions and to coordination between production divi­sions. Also the evaluation and reward functions of management were significantly improved. We will have a short look at each of these domains.

In coordinating operations, two major issues are of importance: shortening reaction time in production when sales numbers and inventory levels change, and facilitating the exchange of products and services between divisions. The shortening of reaction time was needed as a result of the inventory crisis, during which the division production schedules were not compared with timely sales and inventory data from car dealers. The Ten-day Sales Report was a summary that each dealer was required to send to the division every ten days of cars delivered to customers, the number of new orders taken, the total orders on hand, and the inventory numbers of new and used cars. Division managers compared the sales report to the estimate and, if the estimate was too high, production was immediately reduced. If the estimate was too low, the production programme was increased, within the plant capacity. If the sales reports showed an upward sales trend, also price and production capacity could be adjusted to meet market demands.

Most divisions did not only produce finished products, but also parts to be used in other divisions. GM's management devised a 'transfer pricing' system that allowed parts and prod­ucts to be exchanged at cost-plus transfer prices. The general approach of transfer prices was to set internal prices at such a level as would also be used in transactions with external, independent business partners. This would also guarantee an undisturbed image of value transfers that had taken place within the company.

For the evaluation of production efficiency at different output levels, GM used 'flexible budg­ets' to restate the budget at different output levels. In this way the corporate level was able to distinguish actual income differences caused by unplanned and uncontrollable sales volume variations from controllable operating efficiency variations. 7 The improved forecasts from the Ten-day Sales Reports and the flexible budget variance analysis led to significant improvements in efficiency and in the use of working capital. As a result, the company managed to raise its average annual turnover of total inventories from 1.5 times in 1921 to 6.3 times in 1925.

The reward plan for senior managers of the corporation did not make the reward solely dependent on divisional performance, because GM's management feared that this would lead to behaviour that would optimise divisional performance without taking much care of the impact it might have on the welfare of the whole corporation. Bonuses were based on

7 Other companies at the time also used flexible budgets, like Gillette Safety Razor Company (1927) and the Westinghouse Electric Corporation (late 1930s) (Johnson, 1978, p. 504).

1.3 Increasing complexity of operations

divisional performance records, with possibilities for considering special divisional circum­stances, and they were given in the form of rights to GM common stock. These rights only became vested if the manager stayed with GM for an additional period of time, usually five years. The reward package was intended in such a way that it focused the orientation of sen­ior managers to the welfare of the entire corporation and to the performance of the company in the longer term. The significant growth of GM's common stock in the 1920s was not only an incentive for senior management to comply with the company's performance goals, but also convinced them to stay with the company for a longer time period (Johnson, 1978) .

13