Chapter 15. Evils of Traditional Cost Accounting

Loss of Relevance

The issue of loss of the relevance in traditional cost accounting was raised during the 1980s (Goldratt, , 1990; Johnson and Kaplan, ). Traditional cost accounting methods were developed in the 1920s in leading U.S. firms and were suitable for the production environment of those days: mass production of a limited number of products, utilizing economies of scale, and learning curves. Direct labor wages were a major component in costs and were considered true variable costs, taking into consideration the labor relations at that time. The indirect costs were low and assigning them to products based on direct wages (or another volume‐based variable like machine hours) was a reasonable approximation for making business decisions, such as continuation or discontinuation of the production of a product, investment decisions, make or buy decisions, and so on.

For example, the cost structure of one unit of product A was:

Materials

$10

Direct labor

4

Overhead allocation

2

Total product cost

$16

In the business environment of the past, traditional cost accounting allowed the breakdown of business outcomes at profit centers by individual product and preparation of a separate balance sheet for each product. Managers could make decisions about one product (e.g., increasing/decreasing production, using subcontractors) without concurrently checking the impact of the decisions on other products. This is the separation principle that created ...

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