(1) Kaplan and Norton; The Balanced Scorecard; Harvard Business School Press, 1996

In the world of air travel this relationship works quite well, because the navigator has ever-adapting technology and is responsible solely to the pilot. In the business world however, the accountant is responsible to a diverse range of stakeholders including, but not limited to, the management team, shareholders, regulators, vendors, customers and employees. Furthermore, the "technology" that the accountant uses to generate his or her information has not evolved significantly from the early days of the industrial revolution.

The information generated by today's financial accounting systems is primarily focused on the needs of external users of financial information. External users have a vital need for timely, accurate, and relevant information, and it is important that there be a common framework, such as generally accepted accounting principals (GAAP) within which to evaluate the information. However the information generated to meet external needs is not sufficient or appropriate for internal management.

Management accounting addresses some of these internal needs. However, management accounting principles are largely an extension of financial accounting concepts, and are premised on an industrial production environment.

Historically, the financial reporting system has served as the key measurement system. Although managers developed measures to manage their own domain, those measures have always been intrinsically linked to the financial system, which served as the final measure of success. As managers became aware of their need for better information, they naturally looked for a single answer to replace the financial reporting measures.

This can be an increasingly frustrating quest, as managers try to balance the diverse needs of different stakeholders, and trade-off between long-term benefits and short-term costs. There are a number of approaches to solving these measurement issues and a few leading methodologies have gained widespread acceptance. In spite of the desire for a single, elegant solution to an organization's performance measurement needs, there does not appear to be any single, best answer. Managers must understand the core elements of the leading approaches, and apply them intelligently to their unique business situations. There is no holy grail that will provide managers with all the answers to every question through the magic of technology or otherwise.

This series will explore the evolution of performance measurement, and examine the strengths and weaknesses of today's leading methods, specifically Economic Value Added (EVA®), Balanced Scorecard (BSC), Activity Based Cost Management (ABC) and Theory of Constraints (TOC). Furthermore, the series will look at the situations that lend themselves to application of these tools. This first installment will examine the evolution of current accounting and measurement practices in order to understand where that evolution has stalled and fails to support management decisions.

Traditional Financial Information

Financial Accounting

The objective of financial statements is to communicate information that is useful to investors, members, contributors, creditors and other users in making their resource allocation decisions and/or assessing management stewardship. Consequently, financial statements provide information about:

a) an entity's economic resources, obligations and equity/ net assets;
b) changes in an entity's economic resources, obligations and equity / net assets; and
c) the economic performance of the entity.


Qualitative characteristics define and describe the attributes of information provided in financial statements that make that information useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability.(2)

(2) CICA Handbook, Canadian Institute of Chartered Accountants, Section 1000.15 and 1000.18

The first published description of double entry bookkeeping was written by Luca Pacioli, in Venice, Italy, in 1494. The nature of accounting has remained essentially unchanged since that time, although it has evolved in response to the massive changes in the business environment.

The focus of financial accounting continues to be the external user of financial information to support investment decisions. Any usefulness of the information for management purposes is purely coincidental. In fact, in North America, the United States Securities and Exchange Commission (SEC) continues to be a leader in influencing the development of accounting standards. The recommendations published by the Federal Accounting Standards Board (FASB) are often in response to queries raised by the SEC.

Management Accounting

Management accounting can be described as the process of identifying, measuring, accumulating, analyzing, and communicating financial information, which is used by management to plan, evaluate and control an organization. Management accounting is also responsible for the appropriate use of, and accountability for the resources of the firm.(3)

(3) Srikanth, M., and Umble, M., Synchronous Management Profit-based Manufacturing for the 21st Century

Management accounting seeks to interpret the actions and decisions of an organization in financial terms. Many critics have argued that the financial focus of traditional management information leads to decision making with exceptionally short time horizons. In order to maximize current profits and return on investment, companies have over-invested in short-term assets and under-invested in long-term assets and technologies. These decisions have impaired the long-term viability of the firm.

Traditional management accounting focuses on cost management. Using a framework that was established during the early industrial age, the emphasis is placed on the management of "direct costs", which is defined as materials and direct labour. Indirect costs that relate to production or delivery of goods and services are applied on an arbitrary basis to all products, in ways that assigns each product its "fair" portion of cost. Usually this means applying the overhead as a percentage of direct labour or some other algorithm. The logic behind this approach is premised on two critical assumptions:
1. All cost must be attributed to products
2. Overhead costs are not material

As we move away from a production driven economy that relied heavily on direct labour towards a service driven economy (Exhibit 1), both of these assumptions begin to collapse.

EXHIBIT 1

Economic Value Added® (EVA®)
Activity Based Management (ABM)
Theory of Constraints (TOC)
Balanced Scorecard (BSC)

Some of these initiatives not only tout their own benefits, but also exploit the shortcomings of other systems. Each system has its own inherent shortcomings, and in certain circumstances will lead to poor decisions if used in the wrong context, for example:

• TOC or ABC alone can lead to sub-optimal product mix or capital investment decisions
  
• A balanced scorecard may have unforeseen consequences if people do not understand the context of the measures or if performance controls are not in place.
  
• EVA® Also referred to as Economic Profit) may be difficult to communicate to divisional managers as they may only have control of certain element of the equation.

In spite of their individual limitations, used together, these four initiatives can provide a comprehensive view of the company. There is a no performance measurement "holy grail", and no one measure against which an organization can monitor the implementation of strategy and the relative success or failure of that strategy. These are in fact all linked and complementary systems with interdependence between each system.

The inclusion of TOC in this group may be surprising to some. Many consider TOC be an operational management approach. However, TOC is implicitly important to a discussion of performance measurement due to the fact that it encourages organizations to focus on maximizing throughput. In so doing it focuses measurement systems on throughput and constraints.

As we will discover in future installments of this series, all of these methodologies are intrinsically linked. The goal of most organizations is to make money. This money is ultimately returned to the investors in the form of debt payments, dividends or share redemption. In order to attract capital, the company must execute a strategy to generate the greatest cash returns to these investors. Therefore economic profit is the ultimate measure of the organization's success or failure. Economic profit is, however, a result of managing the activities of the organization in different "balanced" dimensions.

Therefore, there is a requirement to understand and align the activities of the organization with the strategic direction. These activities must be managed to maximize the economic profit of the enterprise, while addressing the needs of diverse stakeholders and ensuring long-term returns in addition to short-term performance.

While each of these approaches has strengths and followers who will attest to the wonders that the application of these tools can reap for an organization, each has limitations, and in fact must be integrated with elements of other methodologies to succeed. Furthermore, if any of these methodologies is implemented in isolation, or implemented poorly, there can be unexpected and potentially damaging results for the enterprise.

In the next issue, we will examine the trade-offs between Activity Based Cost Management and Theory of Constraints. We will examine the impact on long-term planning and product mix decisions in particular.

In the third installment, EVA® and Balanced Scorecard will be compared as ways of monitoring, measuring and influencing organizational performance.