Cost Analysis

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Cost analysis for pricing: Exploring the gap between theory and practice

Michael Lucas � , James Rafferty

School of Business, University of Buckingham, Buckingham MK18 1EG, UK

Received 2 July 2007; received in revised form 12 October 2007; accepted 8 November 2007

Abstract

There has been much discussion over many years of the alleged gap between management accounting theory and

practice. Whereas researchers sympathetic to neoclassical economics have sought to rationalise the gap in terms of

information economics and have proposed constrained optimisation as the norm, Scapens [Scapens, R.W., 1994. Never

mind the gap: towards an institutional perspective of management accounting practices. Management Accounting

Research 5, 302–321.] and Ahmed and Scapens [Ahmed, M.N., Scapens, R.W., 2000. Cost allocation in Britain: towards

an institutional analysis. European Accounting Review 9(2), 159–204.] have suggested that the old institutional economics

framework might better explain management accounting practice.

Old institutional economics originated at about the same time as neoclassical economics and in opposition to it. It

largely rejects rational optimisation as the basis for much of human behaviour and stresses instead, adherence to custom

and rule following.

This paper reports on the findings of two cases studies undertaken as part of a programme of case studies, intended to

examine the power of the old institutional economics framework to explain the gap between management accounting theory

and practice, in the realm of costing for pricing. The paper concludes that much observed management accounting practice is

difficult to reconcile with ex ante constrained optimisation, but is explicable in terms of conditioning by various institutions.

r 2007 Elsevier Ltd. All rights reserved.

Keywords: Cost accounting; Pricing decisions; Institutional economics; Case study

1. Introduction: the history of the reality gap

Much has been written, over a prolonged period of time, about the alleged gap between the conventional wisdom of the management accounting textbooks, academic/professional journals and management accounting practice. Nowhere has the ‘reality gap’ attracted more attention than in the area of cost analysis for pricing and product mix decisions.

The textbooks recommend a decision relevant approach to cost analysis for pricing decisions. Empirical research, on the other hand, has consistently suggested that such an approach is not widely used in practice. The ‘reality gap’ became apparent as soon as accounting researchers began to systematically conduct empirical

e front matter r 2007 Elsevier Ltd. All rights reserved.

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ess: [email protected] (M. Lucas).

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studies of management accounting practice. Examples of such studies in the UK include Coates et al. (1983) and in the US Gordon et al. (1981). Such studies have been regularly replicated up to the present day, for example, Drury and Tayles (2005). (Full) cost plus pricing appears to be common. Most studies also suggest that demand and competition are often taken into account. However, ‘cost’ as defined by accountants (typically full cost as measured for external financial reporting purposes) was shown to be a very important benchmark in pricing—adjustments in response to demand and competition certainly did not constitute equivalence to the full application of marginalist/incrementalist principles.

From the 1980s onwards, the conventional wisdom has also advocated the use of target costing as a way of dealing with increased competition. Survey evidence, however, suggests this approach is not widely used in practice (Drury et al., 1993; Garg, 2003).

As recently as 2005, Drury and Tayles attempted to explain management accounting practice in terms of cost-benefit contingencies (i.e., in terms of information economics). Their approach was consistent with the arguments of Demski (1972), Feltham (1972), Demski and Feltham (1976)—drawing on the earlier work of Arrow (1963)—and Horngren (1990), that sophisticated techniques are often costly to implement and the benefits may not justify the costs. They concluded, however, that the contingent variables suggested by theory (e.g., Cooper, 1988) could not satisfactorily explain divergences between theory and practice. The cost-benefit contingency (i.e., constrained optimisation) approach assumes a degree of rationality and consensus that is often not present in group decision-making contexts—in which pricing decisions are often made. Consequently, these authors called for further research, using case studies, to provide insights into why accounting practice differs from accounting theory.

2. Alternative research frameworks

Other researchers have suggested that the ‘reality gap’ results from the fact that the world in which management accounting is practised, is different from that of neoclassical economics, on which the conventional wisdom of accounting is based (Scapens, 1994; Ahmed and Scapens, 2000).

In this view, either the competitive conditions differ from those assumed by the conventional theory, or the decision-making context differs (or both). The former would include tacit collusion among oligopolistic firms rather than price competition (Tool, 1991). The latter would include group decision-making under conditions of uncertainty and ambiguity, rather than the ‘rational mode’ of decision-making assumed by neoclassical theory (Stacey, 1996). Group decision-making is different from individual decision-making. In addition to scope for different interpretations of the decision problem, there is likely to be a lack of goal congruence among the group members—each of whom has their own functional responsibilities. Also, there is likely to be an unresolved agency problem between group members collectively as agents and the shareholders as principal.

Under such circumstances, the techniques prescribed by the management accounting textbooks may be irrelevant to the needs of managers in practice.

2.1. The institutionalisation of cost accounting

Scapens (1994) and Ahmed and Scapens (2000) have suggested that the reason for the reality gap is that the world in which management accounting is practised is better explained by the old institutional economics framework of Veblen (1899), Commons (1931, 1934) than by the neoclassical economics framework on which the conventional wisdom of the textbooks is based.

‘Institutions’ are important for economic life and have been defined by North (1990) as the rules of the game with organisations as the players. They are credited with establishing patterns of human action by excluding some types of behaviour and encouraging others. Institutions facilitate and maintain patterns of habitual behaviour (Hodgson, 1988), as opposed to rational behaviour. They can be considered a response to the high information and computation costs that so-called rational behaviour would have and a coordinating device for human actions (Loasby, 1999). Hodgson (2006, p. 2) has defined institutions as:

the systems of established and prevalent social rules that structure social interaction.

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An important aspect of institutions is, according to Hodgson (2006, p. 2), that they are useful to create stable expectations:

Generally, institutions enable ordered thought, expectation and action by imposing form and consistency on human activities.

The institutions we share with each other make social life easier, more predictable and therefore more efficient.

In the institutional world view, human behaviour is not typically the result of rational optimisation as postulated by neoclassical theory. People do not have the information, the cognitive capacity, or the inclination to optimise; rather, behaviour is guided by custom and rule following. In a given decision-making situation, the problem is identified as being a particular type and then the appropriate custom or rule of thumb is invoked.

The particular custom or rule followed will be the result of specific historical episodes or events. Ahmed and Scapens (2000) argue that much of contemporary costing and pricing practice has its origins in the developments in cost accounting which occurred in the first two decades of the 20th Century. These developments comprised two historical episodes: first, the evolution of industry uniform costing systems, to avoid damaging price competition which failed to take account of the full cost of production; and second, Government contracting in WW1 which made it necessary to avoid profiteering by private contractors.

Cost accounting was not intended to be concerned with determining ‘relevant costs’, i.e., incremental future cash flows attributable to a particular product. Rather, it was concerned with ensuring the systematic recovery of all historical monetary outlays on production resources (based on a functional classification) and the earning of a fair or normal return on investment.

Institutionalised accounting methods proved to be appealing to firms in a number of industries, because they seemed to offer a way of ensuring the systematic recovery of all production costs in the prices charged to customers; also, if all firms in the industry adopted the same (full cost plus) approach, this would drastically reduce price competition. Where firms have similar cost structures, similar prices will result. Even where there are significant differences in cost structure, however, cost plus pricing will tend to result in stable prices rather than prices constantly changing in response to short-run demand fluctuations.

As Blyth (1923, p. 124), a prominent contributor to the early literature on cost accounting, puts it:

uninformed price cutting would be gradually eliminated and by this means, one of the greatest menaces to successful business would be removed. This would tend to create greater stability not only in each industry, but in industry generally.

Costing practice thus provided a means of subliminal tacit collusion. Institutional writers have also observed that cost plus pricing may be considered more socially acceptable than the seemingly opportunistic demand driven pricing (Tool, 1991).

Given the Scapens/Ahmed and Scapens explanation regarding the divergence between competitive conditions assumed by theory and those in which management accounting is practised, management accounting practices are customs or institutionalised rules to facilitate conformity across organisations in a field (DiMaggio and Powell, 1983), to provide order and stability in the industry. In this context, institutional economics, unlike neoclassical economics, is not mechanistic or deterministic; it postulates that there will be a wide variety of approaches to costing and pricing—reflecting different historical trajectories—i.e., ‘path dependency’ rather than universal optimisation (Scapens, 1994).

A general proposition of old institutional economics, however, is that there are large sectors of the modern industrial economy where tacit collusion rather than price competition prevails. The foregoing discussion of the institutionalisation of cost accounting suggests that costing practices may be instrumental in maintaining such collusion.

2.2. Alternative decision-making modes

Given Stacey’s explanation regarding group decision-making under conditions of uncertainty and ambiguity (for example, decision-making as a political process), management accounting information is not

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used to facilitate ‘rational optimisation’, but to provide ex post rationalisation of decisions taken on other grounds. This theme—i.e., of accounting being used to justify ex post rather than inform ex ante pervades the early literature on ‘behavioural explanations’ of cost plus pricing—see, for example, Earl and Hopwood (1979), Weick (1979) and Cooper et al. (1981).

2.3. The validity of neoclassical theory

It must be emphasised that the issue here is not the validity of the neoclassical economic theory of the firm. Indeed it is probably impossible to test that question by reference to observed costing and pricing practices at the level of the individual firm. Friedman (1953) in his famous Essay in Positive Economics argues that the competitive process results in firms having to act optimally (or at least in a way consistent with constrained optimisation)—only firms doing so will survive. Where a rule of thumb (such as full cost pricing) is employed rather than explicit application of the marginalist calculus, the firm may have found over time by trial and error that this approach produces the maximum profit.

Thus, the firm’s behaviour is ‘as if’ it were acting according to neoclassical assumptions: using a ‘rule of thumb’ results in the same outcome as would explicit application of the marginalist calculus. Any observed behaviour (as Friedman himself suggests even simply picking a figure at random) could, therefore, in principle be consistent with profit maximisation—thus vindicating neoclassical economic theory.

Thus, potentially, whatever a firm’s costing and pricing approach, it could achieve the same (profit maximising) outcome as if the marginalist calculus had been explicitly applied. The question being explored in this paper then, is not whether neoclassical theory is valid in predicting the outcome of pricing decisions (with respect to achieving profit maximisation). The purpose here is to explore the behavioural dimension in management accounting practice in order to understand why the neoclassical approach is not applied in practice and, in particular, to evaluate whether behaviour is explicable in terms of the old institutional economics framework. In this respect, management accounting could be said to be a practice in search of a theory.

3. The need for case studies at the level of the individual firm

Although there is no logically necessary association of neoclassical economics and positivist research methodology, such as that employed by Drury and Tayles (2005) the latter approach has tended to be the dominant one in the economics-based management accounting research literature. This approach is based on the discovery of general laws of behaviour, which can be represented by statistical correlations. Given this approach, if existing theory cannot explain observed behaviour, then a new theory is required: case studies are simply exploratory devices for generating hypotheses for subsequent testing, using quantitative methods in the search for general covering laws of behaviour (Ryan et al., 2002).

3.1. The institutional view: behaviour as rule following

Old institutional economics, however, like other ‘interpretivist’ approaches (i.e., approaches that believe ‘reality’ is socially constructed/negotiated) is based on the assumption that as Outhwaite (1987, p. 13) puts it:

human beings are not only propelled by causal influences, but also act for reasons which are not causes and must be understood in terms of rule following or some other mode of analysis radically distinct from the identification of law like regularities.

‘Rules’ have been defined by Hodgson (2006, p. 3) as:

a socially transmitted and customary normative injunction or immanently normative disposition, that in circumstances X do Y.

Institutional economics also recognises that the rules being followed reflect ‘dispositional power’ (Ribeiro and Scapens, 2006). These authors suggest that the ‘reality gap’ results from the fact that the ‘reductionist’ approach of the conventional wisdom ignores the social and organisational context of management

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accounting. They argue that ‘dispositional power’ is a major component of organisational context and that this can provide a framework for the study of management accounting practice in organisations.

Dispositional power is contrasted with the overt exercise of power in conflict situations and is defined as the ability to take advantage of others’ acceptance of one’s authority and the legitimacy of one’s interests. Accounting researchers adopting the old institutional economics perspective (e.g., Burns and Scapens, 2000; Burns, 2000) have explicitly considered this aspect of power. They suggest that institutionalised rules constitute an important dimension of power. The power of social actors is enhanced or constrained by prevailing rules framing social situations; the power of an actor to achieve desired outcomes over time will derive from the appropriateness of institutionalised rules in allowing for those outcomes. The view of these institutional economics contributors is that rules and routines become institutionalised as ‘the way things are done’ in people’s minds; thus, such rules and routines constitute an important dimension of power.

3.2. The institutional research approach

The purpose of research within the institutional approach, then, is to draw on the theoretical framework to understand/explain specific behaviour—not to identify general covering laws. Regarding the adoption of the institutional economics framework to understand/explain management accounting practices, it is necessary to identify the institutions’ (i.e., settled patterns of thought) conditioning behaviour in particular organisations. This involves identifying the rules being followed, the power bases reflected in such rules and their meaning/ significance to managers, which account for their perpetuation.

To explain the accounting practices of individual organisations, therefore, it is necessary to study the processes of accounting practice in the context of the internal dynamics of the firm.

In order to evaluate the explanatory power of the institutional economics framework, a number of case studies were undertaken, using a semi-structured questionnaire. The following section discusses two of the case studies undertaken as part of the research programme.

4. Case 1: Hatfield Distributors Ltd.

Hatfield Ltd. is a distributor of computer accessories, based in Hertfordshire, employing about 300 people and with a turnover of about £250m. Its net profit, however, is only about 1.5% of sales turnover. Hatfield purchases equipment from original equipment manufacturers (OEMs). It stores, packs and delivers to a range of corporate, retail and wholesale customers—also performing various ‘value added activities’ such as providing special packaging and security tagging. Different customers place very differing demands on the firm’s operating resources, yet no cost allocations are made to different customers to reflect these differing resource consumption levels: pricing and customer profitability analysis are based solely on the buy in price of the equipment from the manufacturer. Senior managers believe that overall profitability could be improved by a better understanding of customer profitability—renegotiating terms or even dropping unprofitable customers.

Conventional wisdom would recommend the allocation of attributable operating costs (inbound/outbound logistics and so on) to particular customers, using appropriate cost drivers, but this is not done. This is particularly surprising, given that the firm operates in highly price competitive markets with wafer thin profit margins. Operating costs total about £9 m—small in relation to sales turnover, but large in relation to net profit (£4.5 m).

The non-allocation of such costs in assessing customer profitability, effectively assumes equal consumption per £1 of sales value. Yet, managers recognise wide differences in consumption of operating costs relative to sales value. Thus, significant distortions in profitability measurement are likely to occur. Cost apportionment problems might be expected to arise where a truck delivers to several customers in the same district—such problems mitigating against the introduction of a more sophisticated approach to customer costing. However, delivery to customers is subcontracted out to several freight operators—who charge Hatfield on the basis of tonne/miles. To Hatfield, therefore, delivery is a direct cost and such an apportionment problem does not arise—although even this cost is not actually allocated to customers in assessing their profitability!

This non-conformity to the conventional wisdom appears explicable in the following terms.

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4.1. Origins of the approach

According to several members of the current senior management team, the founding fathers of the industry were lorry drivers with a less than sophisticated, ‘macho’ attitude that emphasised sales and market share growth rather than profitability. They appear to have valued these things per se—for kudos among peers/rivals. In addition, they believed (wrongly) that increased sales would automatically increase profitability. The firm has survived in a very price competitive field because all its competitors act similarly—reflecting similar origins—and thus also lack the information necessary for optimal decision- making.

4.2. Reasons for persistence of the approach

The approach seems to have persisted because decisions are made by a group of managers, rather than the individual ‘entrepreneur’ of basic neoclassical economics (and by implication management accounting’s conventional wisdom.) The management team has its own functional responsibilities and problems, which often take precedence over corporate objectives. Given the day-to-day pressures, managers wish to ensure first that their individual functional responsibilities are fulfilled. Certain members of the team (the Group Supply Chain Director and the Operations Director) recognise the need to introduce activity-based costing to improve their understanding of customer profitability, but the issue does not have a powerful champion. As far as it was possible to determine, this did not appear to be a priority for Sales and Marketing Management.

There seems to be a lack of congruence between the organisation’s goals and those of each functional manager. This is probably inevitable where growth and increased complexity, make it necessary for groups of managers with roughly equal power to make decisions, rather than a single individual who is unlikely to have the knowledge or information processing capacity necessary to make effective decisions (Stacey, 1996). Thus, there is a conflict between the need for decentralisation and integration/goal congruence.

Interestingly also, the way Sales and Marketing personnel are rewarded may provide them with a disincentive to seek allocations of operating costs to customers. The Marketing function stipulates a minimum price (adding a margin to the bought in cost of the equipment) and is rewarded on this margin. The Sales personnel are rewarded on the basis of the contribution achieved in excess of this budgeted margin. Thus, together, the two functions are rewarded on the basis of sales minus cost of bought in goods. If the customers producing the highest gross profit also consume disproportionate amounts of operating costs, certain product group managers (marketing function) and or customer account managers (sales function) would have a strong incentive to resist the introduction of a formal cost accounting system.

However, Hatfield’s behaviour may be due, in greater part, to the ‘dispositional power’ of the Sales and Marketing function resulting in a general lack of financial orientation in the organisational culture—as evidenced, for example, by the exclusion of the finance function from the pricing/customer selection decision- making process. Thus, in this firm, the dispositional power underlying the rules of pricing appears to lie with the Sales and Marketing functions, as a result of the historical development path of the firm. The Accounting and Finance function is geographically remote from ‘the action’ and its role seems restricted to a ‘score keeping’ rather than a decision support one.

The organisation’s culture does not have a financial orientation—financial controls and performance measures are not prominent in people’s minds. Size—turnover, market share and number of employees do seem to be. The firm operates a Balanced Scorecard approach to performance evaluation and non-financial performance measures seem to be given more attention than financial indicators—seemingly consistent with the firm’s non-financial cultural orientation.

Hatfield also provides an example of what Stacey (1996) describes as ambiguity in decision-making—i.e., where managers have different interpretations of the decision problem. There was a lack of agreement among the management team on the importance of price in the firm’s marketing mix. This, of course, is significant because it would seem likely to influence the perceived need for accurate cost information. With a cost leadership strategy, accurate cost information is likely to be more important than with a differentiation strategy, which is normally synonymous with premium pricing.

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There is general agreement that the firm’s profitability is poor (at only 1.5% Return on Sales). However, there is disagreement over the cause and by implication the appropriate remedial action. Some managers believe it is inherent, due to the nature of competition in the industry (i.e., price competition):

price is everything—we compete solely on the basis of price! (Sales Director)

Given this view, accurate cost information is vital since margins are inevitably wafer thin. It must be pointed out, however, that despite his diagnosis, the Sales Director has not been a powerful champion of the introduction of activity-based costing for customer profitability analysis. This may be the result of the way the sales force is rewarded, as discussed above.

The Group Supply Chain Director, on the other hand, believes that there is scope for differentiation in pricing, based on service quality differentiation. In this view, the low profitability must be due to inadequate exploitation of this potential differentiation, which the firm fails to reflect in a value added pricing policy. The different interpretations of the problem imply different remedies (and differing importance of accurate cost information).

Where there is such a lack of consensus concerning the nature of the problem, it is not surprising that the implementation of potential remedies continually drifts—and in effect reinforces the preoccupation of managers with their own individual functional responsibilities.

In addition, the firm’s main objective seems to be long-run market share rather than short-run profit maximisation—the assumption of management accounting’s conventional wisdom. This may be a good thing, as Simmonds (1981) argues that market share has intrinsic value: it reduces unit costs through economies of scale. Indeed, a large market share often represents a formidable barrier to entry and thus restricts competition. It also makes people tend to automatically make the firm their supplier of first choice. Thus, market share may be a good leading indicator of long-run profitability.

This also makes accurate cost information less critical, as limited action would follow as a result of a better understanding of customer profitability—there is less likelihood that customers would be dropped or have their terms of trading renegotiated as turnover/market share takes precedence over short-run profitability. Moreover, certain large customers (most of whom the firm already knows are unprofitable) must be retained anyway for kudos—thus restricting further the scope for acting upon more accurate customer profitability information; although this really only relates to a handful of customers and does not seem sufficient justification for the failure to introduce a customer costing system.

4.3. Case summary

In summary, therefore, Hatfield’s behaviour fails to conform to management accounting’s conventional wisdom for four reasons:

(1)

Ple

Ac

Its founders were largely unaware of the dangers of pursuing growth at the expense of profitability. Thus, the firm’s behaviour is explicable in terms of a specific historical episode, rather than in terms of rational optimisation—a fundamental premise of institutional economics.

(2)

There may still be an element of kudos among peers being the objective function, rather than profit maximisation—such kudos coming from sales/market share growth. Such a ‘settled pattern of thought’ would indeed constitute an ‘institution’.

(3)

Decisions are made by a group of managers rather than an individual, each with his own more pressing issues. The introduction of activity-based costing to improve knowledge of customer profitability does not have a powerful champion and so it continues to drift. Moreover, there is ambiguity concerning the nature and causes of the decision problem, which seems likely to impact on the implementation (or otherwise) of a possible remedy; such a decision context is postulated as typical by institutional economists.

(4)

Short-run profit maximisation is not the objective, perhaps rightly so, as it might conflict with long-run profitability. Thus, the firm operates a Balanced Scorecard approach to performance management, with an emphasis on long-run market share and a range of critical success factors/key performance indicators to achieve this goal. Again, institutional economists contend that sales/market share growth rather than short-run profit maximisation are typically a firm’s objectives.

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5. Case 2: Chemar Ltd.

Chemar manufactures a range of industrial ducting products. The firm has a turnover of about £20 m and employs about 100 people. It uses (in contravention of conventional wisdom) a rigid ‘cost plus’ approach to pricing and product mix decisions—based on a hybrid ‘cost’ figure somewhere between conventional full cost and marginal cost.

5.1. Non-conformity to conventional wisdom

The conventional wisdom recommends the use of Shillinglaw’s (1963) ‘attributable cost’ for regular pricing and product mix decisions—activity-based costing, for example, is intended to capture attributable cost (Shank and Govindarajan, 1993). In terms of the cost hierarchy discussed in the activity-based costing literature, this normally includes all unit level, batch level and product sustaining costs, allocated using appropriate cost drivers, while excluding non-avoidable (with respect to particular products) facility sustaining costs. The hybrid cost figure used by this firm includes some of each type (all allocated using direct labour hours) whilst excluding others, based on a functional classification of costs as ‘production’ versus ‘non- production’ costs. Thus, for example, materials handling and production scheduling batch level costs are excluded from unit product costs, as they originate in ‘non-production’ departments. This cost is clearly not the attributable cost, failing as it does to reflect cost cause–effect relationships.

To this hybrid cost figure is added a mark up to give a 40% gross margin. This cost plus policy is rigidly enforced by senior management monitoring sales reports (indicating margins achieved)—seemingly independently of varying market demand conditions.

5.2. Origin and persistence of the approach to costing and pricing

It appears that the reason the firm does not apply the incremental costs and revenues analysis recommended by the conventional wisdom (see Drury et al., 1993) is that it is not engaged in price competition in a competitive market. Rather, it is probably engaged in tacit collusion where the approach to costing and pricing is intended to maintain an orderly and stable market—i.e., avoid ‘rocking the boat’. This seems a reasonable inference, as the firm has been able to apply rigid cost plus pricing (independent of demand conditions and not reflecting attributable product cost) for many years. In such circumstances, it would not wish to change prices as a result of applying an incremental cost/revenue analysis (as prescribed by the conventional wisdom) through fear of competitor reaction.

This situation seems consistent with Ahmed and Scapens’s ‘institutionalisation of cost accounting’ hypothesis outlined earlier in this paper. The firm takes ‘production cost’, based on a functional classification and adds a ‘normal’ profit mark up. This is the approach to pricing new products, based on accepted practice within the industry. It seems to have become the accepted norm of right and proper behaviour, which maintains such ‘institutions’ (Scapens, 1994; Ahmed and Scapens, 2000). The accountants’ approach to costing and pricing in this firm seems to be accepted as legitimate by other functional managers—e.g., Sales. When asked if, in a tight market situation, he would seek to argue the case for an incrementalist approach to pricing, the response was as follows:

possibly, but you’re really in last resort territory here; it is, after all, necessary to cover all these costs.(UK Sales Manager)

Thus, other managers seem to accept as legitimate, the approach of the accountants which is based on the fear that an incrementalist approach would result in the under recovery of overheads. Thus, in this firm, the dispositional power (underlying pricing rules) appears to lie in the presumed expertise of the accounting and finance function. The costing and pricing practices advocated by the accountants seem to have become ‘institutions’—settled patterns of thought or behaviour.

For existing products, there is a firmly established market expectation of a particular price; the costing methodology described is then used for product profitability analysis and product mix decisions. The market price must cover ‘production cost’ and earn the normal profit mark up—this being considered to represent the

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opportunity cost (in terms of contribution displacement) of using ‘non-production’ resources in making this product rather than another. This approach clearly does not capture attributable cost and hence reveal true product profitability—spreading as it does ‘non-production’ overheads evenly over different products (via the application of the uniform 40% margin), which actually consume these resources very unevenly.

The approach to cost analysis has come to be rationalised (i.e., institutionalised) on other grounds too— thus contributing to its persistence. Production departments are treated as profit centres—each with its own product range—and it is necessary to measure controllable profit for each profit centre. Production department managers are assumed to be able to control their own department’s costs, but not the costs of the various service and support departments (e.g., Materials Handling, Production Scheduling). If only controllable costs are included in unit product costs, then these alone will be reflected in profit centre performance measurement. The department manager will thus have an incentive to control those costs that he/she can control.

5.3. Case summary

So, the approach to cost analysis has come to assume meaning and significance to managers as facilitating cost control and performance measurement. The system of costing and pricing has been in operation for many years and none of the current management team knows its origins. Actually, the firm’s approach was once the conventional wisdom. As discussed earlier in this paper, the cost accounting methods advocated by those involved in the uniform costing and government contracting episodes, employed exactly this approach, i.e., full ‘production cost’ (based on a functional classification) plus a fair/normal profit mark up.

In the second half of the 20th Century, Cost Accounting evolved into Management Accounting with its advocacy of ‘relevant costs’ for decision-making—today’s conventional wisdom. The latter, however, is based on the assumption of short-run profit maximisation as the firm’s objective. The former was intended to facilitate long-run order and stability in the industry and it appears to have become institutionalised practice in some organisations.

It seems that this firm’s approach to costing and pricing is attributable to the fact that the competitive conditions in which it operates (i.e., tacit collusion in oligopolistic markets rather than price competition, such collusion facilitated by cost accounting practices as described above) are at variance with those assumed by the conventional wisdom of today’s management accounting textbooks. This situation is consistent with the way in which real market economies are assumed to operate by old institutional economics writers (Tool, 1991).

6. The practice of management accounting

The above case studies present us with an ‘institutional’ perspective which reflects the interconnectedness between management accounting practice and other phenomena. Management accounting practice in the hands of one group may be performed differently in the hands of another. When we think of assets, technology and innovations in a physical sense such as plant and buildings, processes and devices, we often overlook the fact that these are enmeshed in a network of people. People in their role in the economic organisation of the firm do not limit their advice to technical expertise. Instead, they use their position as manager/adviser to advocate particular programmes of action. In this sense, managers do not just discuss the ends and means efficiency of this or that policy independent of their own value assessment of the policy; rather they infuse their contribution with their own values. Management accounting is a powerful way of analysing, interpreting and formulating action plans, and it may well be value neutral; but managers are not value neutral (Rafferty, 2007).

6.1. Accounting as social and institutional practice

Institutional economists view the economic system in a less mechanistic and deterministic way than do neoclassical economists. In the absence of a complete resolution of the agency problem, whereby managers as agents would act solely in the best interests of shareholders as principals, managers have considerable discretion in decision-making; into this space fall various ‘institutions’. Both case studies reveal group

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decision-making, with different group members possessing dispositional power; these group members bring to the table their values and views about how things should be done. These values and views, in turn, reflect the ‘institutions’ generated by their environment.

Why do different members/functional departments possess power in imposing their values/views in the management practices employed? This may be partly attributable to the personalities and the internal dynamics of the particular organisation concerned. However, it may also be necessary to look beyond the boundaries of the particular organisation to the wider society, to explain the origins and dissemination of various ‘institutions’ and the dispositional power reflected in them. In the Hatfield case, the dispositional power (of the Sales and Marketing personnel) reflected in the approach to costing and pricing, seems explicable in terms of the industry’s origins—the ‘macho’ culture of the founding fathers. In the Chemar case, rigid ‘cost’ plus pricing has clearly become institutionalised—seemingly reflecting the dispositional power of the accountants.

Institutional theorists (for example, Meyer and Rowan, 1977) have argued that it may be necessary to look beyond the organisations boundaries, to the wider social role of accounting, in order to understand particular accounting or management practices—and the status of accountants. Hoskin and Macve (1994) have argued that the development of the modern forms of accounting and accountability made possible the emergence of our familiar modern economic discourses on productivity, profitability and performance. Miller (1994) has argued that by reducing diverse activities and processes to the end point of a single figure (ROI, NPV, EPS, labour efficiency variance, etc.) accounting makes comparable the entities of which it produces calculations. In the process, accounting makes possible a particular way of governing individuals and activities which reflect wider social and economic agendas.

Miller and O’Leary (1987) and Loft (1986a, b) discuss how cost accounting practices provided a bridge between national efficiency objectives and economic governance of individual enterprises in the post-WW1 reconstruction. According to Loft (1986a, p. 133), Britain was to be recreated as an efficient manufacturing nation:

One of the members of the corps of experts who were to provide efficiency data was the costing expert y Within the enterprise, accounting was to provide a ‘truth’ about production which would enable its efficient management; and the sum of efficient enterprises would be an efficient nation.

The accountancy profession was thus brought prominently forward; this elevation in status contributed to the financial (rather than production) orientation of British management.

Thus, the ‘discourse on national efficiency’ resulted in a change in the ‘rules of the game’, enabling various experts, including cost accountants, to gain positions of power and influence. The form of power achieved could be understood in terms of Ribeiro and Scapens’s (2006) concept of dispositional power.

6.2. Different institutional environments and different accounting practices

It may be instructive to study the ways in which different environments determine the amount of accounting done in a particular organisation, rather than tacitly accepting that this derives from intrinsically necessary technical work processes (Meyer, 1986). Importantly, Meyer and Rowan (1977) observe that organisations are driven to incorporate the practices and procedures defined by prevailing concepts of what is rational. These can obviously change over time.

Chemar was established in 1952, but was subsequently acquired by Aerospace-are-Us. The approach to costing and pricing is widely used across the Group’s manufacturing subsidiaries and the Group FD believes it was imposed by the Group on its subsidiaries. Aerospace-are-Us was a major manufacturing firm during WW1 in the Automotive and Aerospace industries. It seems likely, therefore, that it would have been influenced by the socioeconomic and environmental factors discussed by Ahmed and Scapens (2000) and Loft (1986a, b), etc.

On the other hand, a comparatively recently established—late 1980s—service firm (Hatfield) would not be subject to the same environmental institutional pressures and is quite likely, therefore, not to adopt the financial orientation of traditional manufacturers. These pressures within the environment which shape the institution’s response in its historical context, also have their ‘institutional twin’ in the activities within

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individual firms. The generalised theory put forward here, supporting the specific organisation’s institutionalised activities, can perhaps be explained in terms of the interconnectedness of networks of people and functions.

Networks of people are also networks of concepts and ideas that interact with the inputs from other sources with similar networks. More complex networks lead to more complex links between people, ideas and actions. These integrated networks are the organisations ‘connectedness’, if we think of connectedness in the wider sense as the resources, capabilities and competencies required to achieve organisational goals/objectives. In this sense, management accounting practice is part of the ‘connectedness’ profile of the firm. It is a networking activity that attempts to bridge the different organisational worlds within the same firm, with those of the operational imperatives imposed by the historical environments of the individual industry contexts.

In the cases outlined above, the role of management accounting practice is to utilise existing knowledge (costs and prices) and adapt it to the settings of the connected networks—the wider environment on the one hand and the sales and marketing, operations, finance and general management on the other. Within this role, the practice of management accounting also acts as a source of inventive recombination.

While aspects of management accounting are new in some respects (zero-based budgeting, balanced scorecard, activity-based costing, etc.) they are rooted in historical routines, methodologies and even rituals. In its role in the connectedness profile of firms, management accounting practice finds its distinctive feature in the constructive assimilation of these pre-existing methods with a new synthesis, which is often shaped by the general circumstances and configurations of the organisation’s behaviour.

Like many inventions, the practice of management accounting comes from the influences of other ideas that emanate from the network arrangements that evolve in the organisation. In this sense, management accounting practice recombines existing processes and systems with new ideas, methods and orientations that emerge from the networks of people and functions with which it engages on an ongoing basis. In its most effective form, this practice of inventive recombination accommodates change and redirection where necessary and provides the bridging process whereby the historical practices are married with the routines and rituals of the existing contexts and conditions.

Thus, in our cases we observe the practice of management accounting as one where the disciplines of costing are adapted to the social and operational imperatives of the organisation, which stem from the orientations of the different network arrangements, ideas and concepts that form the connectedness profiles of firms.

7. Conclusion

Much of the previous research into cost analysis for pricing and product mix decisions has tended to adopt the positivist view of the world (Ryan et al., 2002). The purpose of such research is to uncover general laws and ideally express them in the form of quantified relationships between variables (Drury and Tayles, 2005 is a good example of this approach).

Within this research approach, the only role for case studies is as a source of hypothesis generation (where theory is relatively underdeveloped) for subsequent testing using quantitative methods on large-scale data.

Axiomatic to the approach of old institutional economics, is that we are unlikely to be able to explain particular management accounting practices by invoking general covering laws (of the form if X, then Y): particular behaviour cannot be understood or explained outside its specific context—its relation to the social system of which it is a part.

In old institutional economics, as in other ‘interpretivist’ approaches, the intention is not to produce statistical generalisations representing general covering laws. Rather, it is to understand or explain behaviour in a particular set of circumstances. The type of generalisation sought is what Ryan et al. (2002) call ‘theoretical generalisation’. With such an approach, case studies are viewed as a method by which theories are used to explain observations. The theories that provide convincing explanations are retained and used in other case studies. Case studies in new or different contexts are used to generalise (i.e., extend) the theory to a wider set of contexts (Ryan et al., 2002). This has been the purpose of the present research programme, with respect to the old institutional economics framework. The approach to costing and pricing in both the cases discussed in this paper is best understood with reference to old institutional economics.

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This agenda implies the need for further case studies, identifying the rules of the game being followed, the dispositional power reflected in such rules and their origins in terms of environmental ‘institutions’. For institutional theorists, the research objective is to identify those pressures within the environment that lead organisations to incorporate institutionalised activities. To understand accounting practices from this perspective, it is necessary to trace the processes that link accounting with its institutional environment (Miller, 1994). Such research may demonstrate the explanatory power of the old institutional economics framework regarding the practice of management accounting and the ‘reality gap’.

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