I enjoy maturity and evolution models of all kinds, especially for business. Stages of maturity models provide confidence that regardless what stage one is at – low or high – there is a next step further up that can be attained in an evolutionary way.
In biology there is an evolution of humans that has in earlier stages Australopithecus, then Homo erectus, then Neanderthals, and our current stage Homo Sapiens. Examples of important changes are brain size, hand grip, and a larynx for speaking.
This evolution can be used as analogy in the context of financial planning and analysis (FP&A). In the final paragraphs of this article I conclude describing a stages of maturity framework to assess an organization’s management accounting practices and systems that support FP&A.
Just to have some fun I will take the position that some accountants and financial planning and analysis (FP&A) specialists are primitive Homo Accounticus. Just as with humankind there are overlap periods where primitive accountants and FP&A specialists co-exist with more sophisticated ones with more capabilities and skills. This implies they have evolutionary steps in their future. A stereotype of an accountant is as a bean counter. These are the Homo Accounticus. In the evolutionary ladder they can become bean growers. They can add value beyond just reporting to assisting their organization to gain insights and make better decisions.
I mentioned the brain as an important change in this evolutionary ladder. There has been excellent research about the brain by Daniel Kahneman, recipient of the Nobel Prize in Economic Sciences for his seminal work in psychology, that challenged the rational model of judgment and decision making. In his book, Thinking, Fast and Slow, Kahneman explains the two systems that drive the way we think.
- System 1 is fast, intuitive, and emotional. It is largely unconscious. It makes snap judgments based upon our memory of similar events and our emotions.
- System 2 is slower, more deliberative, and more logical. It is painfully slow. It is the process by which we consciously check facts and think carefully and rationally.
An example that Kahneman illustrate System 1 and System 2 thinking is this. Suppose that a bat and ball together cost $1.10 and that the bat costs $1.00 more than the ball. How much does the ball cost? Many people, relying mainly on System 1 thinking, will quickly say $0.10, but the correct answer is five cents. Here are the equations:
Bat + Ball = $1.10
Bat ($1.05) – Ball ($.05) = $1.00
How do accountants and FP&A professionals exhibit System 1 and System 2 thinking?
What caught my attention is that System 1 thinking, which is deliberate and logical, is easily distracted. In our busy day there is little time for solitude and deep thinking. An accountant’s or FP&A specialist’s day may be consumed with the monthly task of “closing the books” for financial reporting or publishing product or standard service-line profitability information. There is little time to consider the validity of the calculated information they are relying on.
For System 2 thinking FP&A analysts delve deep to understand and explain the “why” about reported profits including the causes for changes. For some they measure below the product gross profit margin line to include marketing, selling, distribution channel, and customer service expenses to report a profit and loss income statement for each customer.
Many companies continue to use the long-standing practice of standard cost accounting and allocate the indirect and shared expenses to products and services as a single “cost pool” with a single basis or factor such as sales volume, number of employees, or direct labor input hours. There is no cause-and-effect relationship! In reality some difficult products to make or services to deliver are consuming relatively more of the total indirect expenses. Since cost allocations have a zero-sum error of the total, the easier products services must consume relatively less. The activity-based cost management (ABC/M) accounting method resolves this by disaggregating the single “cost pool” into its component work activity costs, and then traces and assigns each to the products using the quantity of an “activity driver” to resolve this problem.
Might you think that ABC/M should now be a commonly accepted practice by accountants and FP&A specialists? It was frequently written about in the 1970s. However, research by Dr. Martijn Schoute of Vrije Universiteit in Amsterdam published in his 2009 dissertation thesis, Antecedents and Consequences of Cost System Design Choices, cites research that less than 20% of British firms use ABC/M. It is unlikely the percentage is much higher today. Without applying the ABC/M method the consequence is that managers and employees are using flawed and misleading information for analyzing profit margins and operational costs.
Are most accountants Homo Accounticus?
Why would accountants who appear to be genetically born to seek precision, accuracy and detail rely on creating and worse yet using flawed information? My belief is System 1 thinking, which is quickly accepting that their cost information is perfectly correct (because it reconciles with their firm’s total expenditures), is distracting the accountants from the deeper understanding of what they are doing. Higher forms of the accountant and FP&A professional species possess more Systems 2 thinking by being deliberate and logical.
What kind of accountants in your organization are producing reports for users to gain insights and make decisions? To answer this question, consider downloading a paper I authored for the International Federation of Accountants titled “Evaluating the Costing Journey: A Costing Levels Continuum Maturity Framework 2.0.” It presents my stages of maturity model with 8 stages of historical past periods accounting and 5 stages of predictive future periods accounting. It can be downloaded from this link.
How low or high is your organization? Don’t be surprised if your organization is a 5 or lower with the historic view and only a 1 with the predictive view.