In Part I of this series, we reported on SAI’s Fall 2011 survey of CFOs regarding the format and the utilization of their company’s particular Income Statement in relation to the NAHB Chart of Accounts Income Statement.
According to the survey, 50% of respondents said their company’s Income Statement did not comply with the NAHB Income Statement, 40% said they had to produce multiple versions of their Income Statement, 20% used a Contribution Income format, and 40% said they performed some level of breakeven analysis. Between 40% and 60% reported compliance with NAHB-recommended placement of the following equivalent line items: Indirect Construction Cost, Selling Expenses (including Commissions), and Financing Costs.
Hardly a ringing endorsement and picture of conformity.
We noted that the NAHB Income Statement was acceptable as a traditional, GAAP-compliant, externally-focused, functionally-oriented classification of costs, but the effect of its functional cost allocation was to indiscriminately blend costs that are either variable or non-variable, in terms of how they behave in relationship to changes in Revenue volume. We said that this practice obscured cost behavior, and prevented the use of important management accounting tools.
Generally-speaking, we said, in order to use Cost-Volume-Profit (CVP) – which includes breakeven analysis – you must have a Contribution Income Statement; to have a Contribution Income Statement, you must use variable costing.
But, don’t take our word for it.
As part of the survey, we asked CFOs for more than answers to survey questions; we asked for insight related to the structure of the NAHB Income Statement (i.e., line item accounts in series 300-900), as it relates to cost allocation (variable v. absorption) and management tools (breakeven, CVP, etc.).
This was from one of the CFOs, who is also a CPA:
“Homebuilding is often compared to manufacturing, but there are differences that need to be taken into account when developing an accurate costing method for management decision-making.
“In the manufacturing world, variable/direct costing allocates all costs directly associated with an activity, including variable manufacturing overhead, to inventory and cost of goods sold and treats fixed manufacturing overhead as an operating expense along with selling, general and administrative expenses. Absorption costing allocates all costs directly associated with an activity and all manufacturing overhead (variable and fixed) to inventory and cost of goods sold and treats selling, general and administrative expenses as an operating expense. Both approaches to costing have their drawbacks when applied to homebuilding.
“While absorption costing is necessary for GAAP basis external reporting, its usefulness in providing management information in making pricing decisions is limited, because it allocates fixed manufacturing overhead to inventory and cost of goods sold (costs that should not be considered when making a pricing decision), and does not allocate other variable costs such as selling expense, financing costs. Also, variable/direct costing is limited in its ability to provide useful pricing information to management, as it only allocates variable overhead to inventory and does not allocate other variable costs.
“A costing system that allocates all variable expenses to an activity would provide management with the most accurate information for making the proper pricing decision.”
“The NAHB Chart of Accounts is designed for historical financial reporting. It is not a managerial accounting tool. NAHB would do its members a great service by developing guidance on cost and managerial accounting.
“Most manufacturers have two sets of accountants and two sets of statements – financial accountants and financial statements for historical financial reporting, and cost/managerial accountants and financial statements designed for internal management and individual pricing decisions.
“In my roles as both a CFO and a President of a homebuilding company, I am intimately familiar with both the strengths and weaknesses of the NAHB Chart of Accounts. It was a great tool for benchmarking our performance with other builders and to industry standards. It was interesting to benchmark our company, but the statements produced utilizing the NAHB Chart of Accounts were of no use when it came to making pricing decisions.
“In order to make informed pricing decisions, I created my own operating statements by community that allocated all variable costs that could be specifically identified with the individual unit that generated them and removed all fixed costs. In an environment of declining sales prices, rising costs, and a market that required substantial sales incentives, these operating statements were not only helpful, they were the key to our company’s survival.”
The thoughtful examination of any managerial accounting or cost accounting textbook validates this CFO’s statements.
To quote one:
“Financial accounting is mainly concerned with the historical aspects of external reporting . . . governed by generally-accepted accounting principles (GAAP). Management accounting, on the other hand, is concerned primarily with providing information to internal managers . . . charged with planning and controlling the operations of the firm . . . not subject to GAAP . . . one thing is clear from the NAA definition of management accounting: The major function of cost accounting is cost accumulation for inventory valuation and income determination. Management accounting, however, emphasizes the use of the cost data for planning, control, and decision-making purposes.” – Accounting Handbook, Barron’s, J. Siegel and J. Shim, 1990.
To quote another:
“Although an Income Statement prepared in the functional format may be useful for external reporting purposes, it has serious limitations when used for internal purposes . . . the Contribution Income Statement emphasizes the behavior of costs, and therefore, is extremely helpful to a manager in judging the impact on profits, of changes in price, cost, or volume.” – Managerial Accounting, 10th Ed., McGraw-Hill Irwin, R. Garrison and E. Noreen, 2003.
To quote yet another, directed towards resolving the need for a company to prepare multiple sets of financial information:
“For companies committed to maintaining variable contribution information, there are two choices available . . . 1. maintain their accounting system on a full-absorption GAAP basis, with separate calculations and analysis of variable contribution information [or] 2. maintain their accounting systems on a variable contribution basis with a monthly reconciliation to GAAP . . . if the only real reason for maintaining full-absorption accounting is to satisfy external requirements, doesn’t it make more sense to use option 2 and perform simple month-end reconciliation to GAAP?” – The Measurement Nightmare: How the Theory of Constraints Can Resolve Conflicting Strategies, Policies, and Measures, APICS series, The St. Lucie Press, D. Smith, 2000.
The last preceding excerpt is consistent with the others; however, in fairness, it comes from Throughput Accounting (the emergent cost accounting methodology supporting Theory of Constraints), which places it outside the mainstream. Throughput Accounting uses a profit and loss statement to the right of even a Contribution Margin profit and loss statement, refusing to assign costs to inventory, and expensing product costs immediately; it literally has no internal use for GAAP compliance.
In the similarly nascent and outlying world of cost accounting methods that aim to support Lean, in its broadest sense, as a management system – as a business strategy, as an operating philosophy – the advice is more obtuse; Lean Accounting sees no conflict with GAAP, uses an operating statement that clearly mixes variable and non-variable costs, but nevertheless states these among its Lean Accounting Concepts and Principles: “2. Do not confuse a fixed cost for a variable cost” and “3. Eliminate absorption accounting for manufacturing transactions.” – The Real Numbers: Management Accounting in a Lean Organization, Managing Times Press, J. E. Cunningham, O. J. Fiume, E. Adams, 2003.
At best, comparison with “industry best practices” promotes a satisfaction with some sort of competitive equality, a settling for the expediency of the ideas of someone else. The real problem with best practices is that it stifles creativity and innovation, works against creating competitive advantage, and creates the illusion of continuous improvement.
GAAP-for-the-sake-of-GAAP? Compliance-for-the-sake-of-compliance? You manage every day; you only report periodically. You are not in the business of complying with generally-accepted accounting principles; you are in the business of making money. You need to do both, but compliance is a case of the tail wagging the dog.
Bottom-line: The two arguable attributes of the NAHB Chart of Accounts Income Statement – comparativeness-driven conformity and reporting-driven compliance – might be desirable, and to a degree necessary, but they are not a justification to sacrifice sound managerial accounting. You cannot properly and effectively manage a homebuilding operation using the cost allocations recommended in the NAHB Chart of Accounts Income Statement.