The second means available to
entrepreneurs for overcoming the tyranny of the market – incorporation into
their enterprise of stages in the production process that were previously
carried out by independent supplier firms – constitutes an even more important
theoretical departure from the logic of capitalism and a corresponding movement
toward a precursor of socialist planning. This time, let us use a simple
hypothetical example.
Imagine a firm that has been producing cardboard cartons
in a factory with 80,000 square feet of usable floor space. We may suppose that
the firm buys the cardboard in large sheets from a cardboard producer, and then
stamps, folds, and staples the cardboard into cartons. Cardboard cartons are
the sole product of the firm, and abstracting from a number of issues to which
we shall return, the accounting procedures used to keep track of costs and
determine profit margins are quite elementary and straightforward. The firm’s accountants
have made a few standard assumptions about the depreciation rates of the
machinery, and we may simplify things by assuming that there are no tax
considerations [accelerated depreciation, etc.] to complicate or warp the
bookkeeping. Profit is then the difference between costs and revenues, and the
profit rate is calculated on the value of invested capital, the profit margin
on the difference between cost and sale price of each unit of cartons.
The market for cardboard sheets, we may suppose, is
fluctuating and uncertain, and the carton manufacturing company’s manager
believes that he can stabilize his costs and increase his profits by producing
his own cardboard, rather than buying it on the market. Since there are 25,000 square feet of unused space
on the factory floor, he allocates that space to cardboard production and puts
a young, ambitions supervisor in charge of the new branch of the firm. The question arises: how shall the
profitability of this cardboard manufacturing activity be computed?
There are two reasons why this question needs answering
from the firm manager’s point of view. First, of course, he must decide whether
it is better to produce the cardboard in-house or continue to buy it in the
market. That question, we may suppose,
is relatively easy to answer. Second, as
the manager of a firm with two divisions, each headed by an ambitious
divisional chief, he must evaluate the relative profitability of the two
divisions in order to decide which division chief will be tapped for promotion
when and if a new, higher-level job in the corporation comes open. In large,
modern capitalist firms, this bureaucratic question of internal advancement is
of much greater importance to everyone in management than the older question of
profitability of the firm as a whole. Profitability becomes a key to managerial
advancement, not merely to owner-satisfaction.
The new division manager, eager to make as good a record
for herself as possible, argues as follows to the accountant, whose job it is
to come up with profitability estimates at the monthly meeting of officers of
the firm: “The depreciation on the
factory building is exactly the same whether we run the cardboard-producing
activity or not, as are the general overhead costs for utilities, telephone and
so forth. Save for some small increase
in operating overhead, the cardboard-production experiment imposes no new fixed
costs on the firm at all. What is more,
the bookkeeping, ordering, and shipping departments can absorb the relatively
small flow of work generated by the new division without any increase in
personnel or overtime costs. Hence, in figuring the input costs as against
revenues for cardboard production, the only items that ought to be charged off
against the new division are such direct costs as the new machinery required,
the wages of the extra workers taken on to make the cardboard, and the cost of
the raw materials.”
The manager of the old carton division, who knows a
serious threat to his job when he sees one, flatly refuses to agree to this
self-serving bit of accounting sleight of hand.
What the cardboard-production manager has proposed will, if accepted,
result in a dramatically higher rate of return to her division’s investment
than can possibly be earned in his. How long will it be before the president of
the firm gets it into his head to have them switch places with an appropriate
readjustment of their salaries! He therefore proposes that all of the fixed
costs of the enterprise be allocated to the two divisions in proportion to the
percentage of the floor space they occupy [a method of allocation that happens
to favor him a bit more than the equally plausible proposal to allocate in
proportion to the revenues generated by the two divisions].
The president of the firm, confronted with this
disagreement between his two division managers, turns to the accountant, whom
he asks for an objective, impartial, scientific ruling. And he now gets a distinct shock, for his
accountant, who is as honest as she is competent, informs him that as a matter
of fact [or, more precisely, as a matter of accounting theory] there is no
objective, impartial scientific answer to the question: How shall the fixed
costs of a joint-production enterprise be allocated among the several distinct
productive activities of the enterprise?
This is a rather
startling proposition, on which the entire argument of these remarks
rests. I need therefore to spend some
time explaining it clearly and indicating the grounds on which it rests. My guide here is a pair of monographs written
by a Canadian Professor of Accounting, Arthur L. Thomas, and published by the
American Accounting Association. The
first monograph, “The Allocation Problem in Financial Accounting Theory,” appeared
in 1969; the second, “The Allocation Problem, Part II,” was published five
years later. Thomas seems to be
something of an iconoclastic radical masquerading as a nerdy bean-counting
number-cruncher. In the driest language
imaginable, he argues ploddingly, painstakingly, but devastatingly that a
central activity of financial accountants – the allocation of costs to the
outputs of a firm – has no objective rationale whatsoever, being based rather
on an arbitrary choice of one from among a number of alternative incompatible
patterns of allocation. What this means,
in plain language, is that an accountant, speaking professionally, cannot tell
the management of a firm just what a unit of output costs and hence how much of
the profit of the firm can be attributed to its sale.
Thomas himself draws no larger lesson from this
extraordinary conclusion, but in what follows, I will try to show that it has
the most profound implications for our understanding of the manner in which
something very like socialism evolves in the womb of the capitalist firm. Incidentally, in his correspondence with me,
Thomas seemed to evince a good deal of pleasure at the radical conclusions I drew from his work,
but it goes without saying that when I venture beyond the confines of his
version of financial accounting theory I am entirely on my own.
The accountant is presented by the firm with the raw data
concerning the costs of the firm’s activities – invoices for materials, bills
for rent, electricity, and insurance, hourly wages and managerial salaries,
inventories, and so forth. His job [if
we imagine this to be Thomas himself as the accountant] is then to figure out
how much of each of these factor costs to allocate or impute to each unit of
salable output, and thereby to calculate the contribution to profits being made
by each division of the firm. He is to
do this as objectively and accurately as the data permit, not allowing his
assessments to be influenced either by the hopes and ambitions of the company
management or by the particular aspirations of one division of the firm rather
than another. His conclusions can then
be presented to the investing public as a neutral evaluation the performance of
the firm, and to the management as a sound basis on which to make corporate
decisions.
There are three different features of the activities of
large capitalist firms that defeat the accountant’s effort to find neutral,
objective methods for allocating costs to individual outputs, or to the
subdivisions of the firm responsible for their production. These are the phenomena of fixed capital,
inventories, and joint production. Let
us look at each of them briefly in turn.
Fixed capital is capital that lasts longer than one cycle
of production, which is to say, longer than it takes to produce one unit of
output. The examples are endless – a
robotic riveting machine on an automobile assembly line that can be used in the
assembly of three thousand vehicles before it must be replaced, a power loom
that wears out after being used to make ten thousand yards of cloth, an office
copying machine that must be replaced on average every twenty thousand copies,
an office building good for fifty years.
Some of these items will have a resale value when it is time to replace
them; others will simply have to be scrapped.
Each of these factors of production costs the firm something, and that
cost must in some way be apportioned to the units of output to whose production
it contributes. To put the same point in
other words, the accountant must select a schedule of depreciation for the
productive factor. [I am entirely
abstracting from the enormous complications introduced by the depreciation
schedules stipulated by the Internal Revenue Service, which of course have
nothing whatever to do with the actual wear and tear on the item being
depreciated. These words were written at
my desk in the tiny pied-a-terre that
my wife and I bought in Paris
several years ago, which we rent out to readers of the New York Review of Books.
Our apartment is in a seventeenth century building whose value has been
appreciating steadily for the past four hundred years or so but when it comes
time for me to fill out IRS Schedule E – Rents and Royalties – I am permitted
to adopt the fiction that in twenty two and a half years, its value will have
disappeared.]
Without going into the details of Thomas’ monographs, let
me indicate some of the incompatible alternatives available to the
accountant. He may assume that the fixed
capital yields up equal parts of its purchase price to each unit if output
produced with its aid. This was in fact
the assumption Marx made in Capital. Alternatively, he may assume that the machine
loses equal shares of its value in equal time periods – one tenth during each
year of a ten year life, for example.
This is not at all equivalent to the first alternative, because the
machine may be used in the production of differing numbers of units in
different years, either because of speed-ups and slow-downs in the production
process, or because the machine has a breaking-in period before it reaches
maximum efficiency, followed by a period of optimum functioning, after which as
it wears out it is less and less capable of spewing forth product at the same
rate. Each of these assumptions will
yield a different depreciation schedule, and hence a different quantum of cost
imputed to units of the output.
Alternatively, the accountant may adopt an entirely
different approach, and by appealing to an existing market for second hand
capital goods, impute to each year’s output the difference between what the
machine would have sold for in that market at the beginning of the year, and
what it would have sold for at the end of the year. Or – and this will yield a totally different
set of numbers – he may compare what the company would have to pay for a second
hand machine at the beginning of the year with what it would have to pay at the
end of the year for a second hand machine one year older. But we have not even begun to ring the
changes on this apparently elementary accounting problem, for the accountant
may impute to a year’s output what it would cost the company to rent a machine
for one year, even though the company has already purchased the machine, which
is thus, from its point of view, a sunk cost.
Indeed, Thomas actually considers the suggestion [which has been treated
respectfully in accounting circles, to my surprise] that the company write off
the entire cost of the machine in the year it is purchased, and treat it in all
the subsequent years of its use as a free good, like the air that is required
for the burning of fuel. The accountant
may even, in any given year, choose whichever of these methods of allocation
yields the lowest number, on the theory that he is thereby telling the
management what its most efficient choice would be at any moment.
This litany of options available to the accountant does
not begin to exhaust the logical possibilities.
The problem faced by the firm, as Thomas makes clear, is that accounting
theory offers no way of deciding which of them is objectively right – which accurately reveals to the management of the
firm the true structure of its costs.
Indeed, although the data with which the accountant works are, or can be
made to be, factually accurate, there seems simply to be no answer to the
question, “Just how much does each unit of output cost the firm to produce?” Thus, returning for a moment to our
cardboard and box factory, the accountant cannot resolve the dispute between
the division managers in a neutral and unbiased manner befitting a chartered
accountant. Some of the many options are
likely to favor the head of the box division, others will make the head of the
cardboard division look better.
Similar problems arise when the accountant turns to the
task of deciding how to carry on the books of the firm the cost of the stocks
of material in its inventory. A firm
acquires a stock of some input that it requires for its productive activities –
coal for its furnaces, thread for its power loom, gravel for its cement mixers,
diesel fuel for its trucks. Stocks
characteristically are composed of units acquired at different times and at
different prices. For the most part,
stocks consist of homogeneous units – one gallon of diesel fuel is much like
another, one bag of cement indistinguishable from another. [The homogenization of inputs, and the
corresponding outputs, is, as Marx points out in Capital, one of the signal
features of capitalism, and distinguishes it from the craft production that it
replaces. It is accompanied by a like
homogenization of the labor performed by the workers employed by a capitalist
firm.]
How shall our accountant proceed in allocating the cost
of inputs drawn from stock and then thrown into production [as Marx liked to
put it]? He may assume that the first
unit withdrawn is the first unit that was added to the inventory, and he will
then impute to the output whatever price was paid for it. This is the rule of allocation known in
accounting circles as FIFO – First In, First Out. He will still have to adjust this price for
the opportunity cost incurred by tying up that amount of capital in inventory,
which in turn will require some choice from among the many alternative ways of
computing the relevant rate of interest.
Alternatively, our accountant may opt for LIFO rather
than FIFO – which is to say, Last In, First Out – or some average of the two
ways of computing costs, and so forth.
Since the price of stocks typically varies over the life of an
inventory, it can make a very considerable difference to the profit or loss
imputed to a unit of output which of these accounting conventions is
selected. If I may echo the late
unlamented Richard Nixon, it would be easy, but it would be wrong, to suppose
that choosing one accounting rule and sticking to it will sanitize the
accounting process and obviate these problems.
It only takes a little mathematical imagination and some patience to
construct examples in which, as a consequence of the pattern of variation of
factor prices, the choice of FIFO over LIFO, or any of the other alternatives,
can over time systematically advantage one division of a corporation over
another.
For example, if a factor input has been falling steadily
in price for some years, FIFO will make the division using that factor look
unusually profitable, for the accounting convention will make its costs appear
to fall. LIFO will make it appear that
its profitability is in decline. If two
divisions are in competition within the corporation, one using inputs whose
price is falling and the other using inputs whose price is rising, the choice
between FIFO and LIFO can have an inverse effect on their relative
profitability.
Adverting once again to our cardboard example, when the
manager of the box division draws cardboard from the inventory being
accumulated by the cardboard division, he must for purposes of keeping track of
his profitability choose one convention for imputing the internal cost of the
cardboard to his box output. Just as he
lobbied for an allocation of the cost of space to his division that most
advantaged him vis-à-vis his fellow
division manager, so now he will try to persuade the accountant to select an inventory
convention that has the same beneficial impact on his bottom line.
6 comments:
Why is the suggestion "that the company write off the entire cost of the machine in the year it is purchased, and treat it in all the subsequent years of its use as a free good" not objective and impartial? As for inventory, wouldn't the objective, impartial valuation be the actual price paid for each unit used? Sure, that would be a cumbersome, inefficient method, but it would be objective...wouldn't it?
Hello,
I make my living as a CPA, but also took a significant number of philosophy courses during undergrad. I think I actually stumbled upon your work by way of your "Narrative Time" essay, which I found to wonderfully clear. When I found my way to this essay, however, I was completely intrigued.
I used to say things in class like "adjudication is a problem in accounting too." I'm sure my professors saw me as some sort of novelty item: "a philosophical accountant--look at that!"
Anyway, I thought I should say that your foray into the drab world of financial accounting not only provided you insight into the logic of the modern corporate conglomerate, but also grew your audience of accountants by at least one.
--Brian
welcome! You may be the only one!!
Wouldn't the same issues arise regardless of who owned the factory--shareholders or employees or the state?
Of course. That was one of the points of my argument!
Thanks for this. A couple of points.
The problem you raise seems even greater for service-oriented businesses. How does one account for, say, the sunk costs of the years creating the curriculum for a Taekwondo studio? Or the training of employees in that? Or in the years fostering a reputation in the community that drives business your way instead of to competitors? (A reputation that can certainly be lost, to the detriment of the value of your business).
Further still, the difficulty you raise shows the poverty of a labor theory of value as a way of explicating exploitation. How one accounts for the value of fixed costs, or its depreciation, will seemingly determine whether or the extent to which the employees are being exploited, as they mix their labor with machinery, the building costs, or the business' reputation.
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