Management Accounting Research, 1998, 9, 2 1-30

Management accounting and the economics of internal organization: a review essay*

Martin Walkerf

This article reviews two books by leading management accounting researchers which rely on advances in the economics of internal organization for their theorectical foundation. The review relates the theoretical content of the two books to the broader research agendas of information economics and transaction costs economics. In addition the review attempts to identify areas where alternative theoretical perspec- tives might be used to address the main weaknesses of models based on conventional notions of economic rationality. 0 1998 Academic Press Limited

Key words: information economics, internal organization; rationality; transaction costs.

The first task I was given, on being newly appointed to an academic post 20 years ago, was to design and teach an intermediate level course in management account- ing. Being a somewhat over-confident young economist at the time, this seemed to me to be a pretty simple task (and one for which I was grateful given the need to finish my Ph.D. and associated research papers). Six months later, after reading numerous textbooks and articles, and with only 10 days to go before the first lecture, I discovered that my colleagues had launched me on a fools mission! Having departed from the nice, ordered world of microeconomics, I found myself on a totally bizarre planet: the world of academic Management Accounting. The principal problem I encountered was that none of the textbooks available at the time contained an adequate explanation of the nature of management, although all of them made claims that the role of management accounting was to serve the decision making and control needs of managers.

The last 20 years or so, has seen the establishment and growth of new bodies of literature which have considerably improved our understanding of the organizational

tSchool of Accounting & Finance, University of Manchester, Manchester M60 9PL. * Editors Note: although Management Accounting Research does not normally publish book reviews, from time to time there are some books which have particular importance in the area of management accounting and merit attention. The recent books by Demski (1994) and Zimmerman (1997) are two such books. The Editors invited Professor Martin Walker to write a review essay covering the general areas addressed by these two books.

Received June 1997; accepted 20 October 1997

1044-5005/98/010021 + 10 $25.00/0/mg970062 0 1998 Academic Press Limited

22 M.Walker

context of management accounting. At the risk of gross over-simplification one can view this literature as falling into two main traditions: sociological perspectives on the organizational context of management accounting and economic theories of internal organization. The purpose of this essay is to review the books of Demski (1994) and Zimmerman (1997) which, taken together) provide a useful summary of the current state of economics-based approaches to Management Accounting. The essay begins with a brief review of developments in the economic theory of the firm and the implications of these developments for management accounting. There then follows a review of the books of Zimmerman and Demski. Finally the essay considers the limitations of economics as a foundation for management accounting and considers alternative) but potentially complementary) theoretical approaches.

1. The economics of the firm

The neo-classical theory of the firm seeks to represent the choice behaviour of the firm as the rational solution to a single person decision problem. The simplest versions of the theory assume a single period choice situation in which the firm faces a given demand function) a given production function and a given set of factor prices. The firm is assumed to choose a vector of factor inputs and a level of output so as to maximize net profit. Sufficient conditions on the form of the production function are imposed to ensure existence and uniqueness of the optimum solution.

This basic model has proved extremely useful for the economic analysis of particular industries or markets. For example, it has been used to study the implica- tions of economies of scale and/or scope for industrial structure and also to predict the qualitative effects of changes in demand conditions or factor supply conditions on particular firms or industries.

The neo-classical model was not designed for understanding the set of complex issues that arise in choosing an optimal organizational form. Viewed from the perspective of industrial analysis) such matters are of second order importance. However, viewed from the perspective of management accounting) which is inti- mately associated with the design of optimal organizational structures) the neo-classi- cal theory of the firm provides an inadequate theoretical framework. In particular the standard theory of the firm is based on an assumption of perfect certainty. This assumption is problematic) in the context of attempts to explain organizational structures) because it is not possible to produce a rationale for the existence of firms in a world of perfect certainty. In other words the conventional theory of the firm is internally inconsistent. Economic uncertainty must form an essential part of any attempt to explain why the organizational structures of a firm are what they are.

In recent years economists have begun to think about issues relating to the internal organization of the firm from a variety of theoretical perspectives. Three main issues have been addressed in literature:

1. Conflicts of interests. This issue has been thoroughly explored in the principal-agency literature. Typically the models studied in this area assume that there is a conflict of interest between the owner of the firm (the principal) and his employees (the agents). In addition) the principal is assumed to be limited in his ability to observe the decisions made by the agents on his behalf.

Economics of Internal Organization 23

The early principal agency literature focused on the design of reward functions that are Pareto-optimal, subject only to the observability constraints faced by the principal. Demski (1994)) which is reviewed below, provides an accessible introduction to this literature. More recently mathematical economists have attempted to extend the principal agency paradigm to reflect the fact that complex contingent claims contracts are costly to write and enforce. Because of this contracts in practice tend to be less than complete. Hart (1995) has shown how formal models of costly contracting help to explain how the boundaries of firms are determined. Dispersal of information. There is a vast literature which explores the implica- tions of information dispersal for the design of economic organizations. In the early part of this century there was a major debate about whether and how, centrally-planned economies might achieve economically efficient resource allocations in the presence of dispersed information (see Hayek, 1935 for the highlights of this debate). With the recent demise of communism this literature may seem somewhat redundant, but in fact many of the issues covered in the debate are also relevant to the problems of managing capitalist organizations. The managers of large multinational firms, for example, encounter problems similar to those encountered by the managers of planned economies (Hunvicz, 197 1). An important contribution to the literature on organizational decision making in the presence of dispersed information is Marschak and Radner’s Economic Theory of Teams (1972). This work explores the decision problem of a set of individuals who are working together towards some common objective. Each member of the team has to choose one of the decision variables and each member of the team has information that other members of the team do not have. Marschak and Radner show that, in such circumstances, a necessary condition for a set of optimum decision rules, is for the decision rule of each individual to be person-by-person optimal. In other words the decision rule of each individual should maximize the expected utility of the team, holding the decision rules of the other members constant. Unfortunately the authors also show that there may be more than one set of decision rules which are person-by-person optimal, i.e. there may be more than one equilibrium solution to the team game. This is not the place to explore all the details of their model, but three points should be noted about their contribution. The first is that co-ordination problems can arise even if the members of the team are motivated to pursue a common objective. Second their work shows that, even in the absence of incentive problems, the general problem of optimum team design is immensely more complicated than standard single person decision problems. Third, in dealing with problems of organizational design, the possibility of the existence of multiple equilibria needs to be taken very seriously indeed. Multiple equilibria are endemic in this area. Bounded rationality. The mathematics of agency relationships and teams are both complex. In general the organizational design problem requires the simultaneous solution of a multi-person optimum reward structure problem and a multi-person team problem (see Chapter 9 of Ichiishi, 1997 for further details). The sheer complexity of such problems, coupled with the likelihood of there being multiple equilibrium solutions leads one to question the applicabil-

2.

3.

24 M.Walker

ity of such models as a basis for explaining how real world firms are designed. In practice the design of an organization is likely to be tempered by factors that reflect the extreme difficulty of solving the organizational design problem. Most economists would now agree that further progress on the theory of the firm will require the explicit modelling of some form of bounded rationality (see Radner, 1996 for an authoritative statement of this position). The big question that faces economists working in this area is how to represent bounded rationality in a mathematically tractable way.

2. Transaction costs, markets and hierarchies

One possible approach to modelling the firm in a world of bounded rationality is to attempt to explain the existence of different organizational forms as choices from a limited menu of ‘workable’ contracting structures. As a basic modelling strategy, we focus first of all on the organizational arrangements of real world firms and then attempt to explain the cross-sectional variation in organizational structures and why such structures change over time. This is essentially the approach that underlies the transactions cost approach towards the theory of the firm.

The founding father of the transactions costs approach was Ronald Coase who, in his 1937 paper, posed a fundamental question which goes to the heart of manage- ment accounting and the theory of the firm:-

‘What is a firm and what determines its boundaries’?

The importance of Coase’s contribution was the recognition that conventional neo-classical economics cannot explain why firms exist. He hypothesized that firms exist because they are able to conduct the organization of certain aspects of economic activity more cheaply than the market. This important insight has been developed by a number of economists under the general heading of transactions costs economics. Two particularly influential contributions to this literature were Williamson (1 975) and Klein et al. (1978). More recently Hart (1995) has introduced what he calls ‘A Property Rights Approach’ to the theory of the firm which represents a significant extension of the transactions costs approach. For present purposes the important general point that distinguishes these transactions costs approaches is that they assume that contracts are costly to write and enforce and that the existence of many organizational and institutional forms, such as hierarchical firms, can be explained by the need to economize on contracting and enforcement costs. Buckley and Michie (1996) present a useful collection of articles from this literature.

3. Accounting for decision management and control

Zimmerman (1997) approaches the subject of management accounting from a transactions costs perspective. Indeed it represents the first authoritative accounting text to treat the subject in this way.

Zimmerman argues, correctly in my view, that management accounting cannot be properly understood without a prior theory of the nature of organizations. He is aware that the transactions costs perspective he adopts is not the only possible choice,

Economics of Internal Organization 25

but he does not enter into any discussion of the alternative approaches or their respective strengths and weaknesses.

Zimmerman’s essential contribution is to show how the transactions costs a p proach provides a simple general framework to which all the standard and not so standard) techniques and procedures of management accounting can be related. This approach has enormous advantages from the student’s viewpoint. By mastering the general theoretical framework they will find that they can more easily relate the various, apparently disjointed) topics of management accounting) to each other. They should also find that they are in a better position to think about the potential strengths and weaknesses of any ‘new’ management accounting methods that come along.

As a student-centered textbook) I recommend this book without reservation. It sets out the essential theoretical framework in two core chapters (Chapter 2, on the Nature of Costs and Chapter 4 on Organizational Architecture). Zimmerman sees management accounting as being located within a general organizational design problem. The design of an organization typically involves three key interrelated issues: (1) the optimum partitioning of decision rights; (2) the establishment of systems for measuring and evaluating the performance of decision centres; and (3) the choice of a system for linking rewards/promotions to measured performance. Zimmerman highlights an important general type of constraint that affects almost all organizations: the dispersal of information combined with the potential for conflicts of interest between the organization and its employees. The general problem that arises here is that individuals who have private access to information may have to be motivated to reveal it truthfully. In particular individuals may be reluctant to reveal information if they believe it could be used to assess their performance. Thus organizations will typically face a trade-off between designing the accounting system for decision making purposes and designing it for control purposes. Zimmerman sees the optimization of this trade-off as a central feature of the organizational design problem.

Around 70% of the book is devoted to illustrating how the information-for-control versus information for decision making trade-off arises in relation to different parts of the accounting system. Responsibility Accounting and Transfer Pricing, Budgeting) Cost Allocation, Absorption Costing (including full coverage of Activity-Based Cost- ing)) Standard Costs and Managing Accounting in a Changing Environment (pro- ductivity measures) TQM and JIT) are all subjected to the Zimmerman ‘spin’. The early part of the book (Chapters 1-3) introduce notions of opportunity costs and their application to capital budgeting.

The book is well written and easy to follow. All the main ideas are illustrated by simple numerical examples and several are illustrated by extended cases. Both the author and the publishers have obviously gone to considerable lengths to achieve a very high standard of presentation which makes the book easy on the eye and a real pleasure to read. If I needed to achieve high teaching scores on an MBA course, this text would provide an excellent start.

As well as contributing a useful new addition to the list of adoptable textbooks) I believe Zimmerman has also performed an important service to the academic accounting community) by providing a no frills exposition of the transactions costs approach. If management accounting is ever to establish a genuine debate between the sociological and economic branches of the discipline) we need more books and

26 M.Walker

articles like this. Zimmerman makes clear what he sees as being the key first order factors in the design of management accounting systems. He also goes to consider- able pains to cite and discuss relevant empirical evidence relating to his views. These contributions are important because they will make it easier for scholars in the area to identify those areas where the rival schools differ and also to design research studies capable of comparing one theory against another on the basis of empirical evidence. It is to be hoped that other (e.g. sociological) schools will now feel able to provide similar no-nonsense statements and illustrations of their core beliefs.

Having extolled the considerable virtues of this text, I now move on to consider its main potential weakness as an adoptable book. The main problem I have with the book, is its single-minded adherence to one particular theorization of management accounting. There are pedagogic advantages in this ‘one club’ approach, but the better MBA students and Ph.D. students who read this text will need to know what alternative theoretical positions underpin management accounting research and what are the strengths and weaknesses of these alternative theoretical positions.

Zimmerman chooses to ignore the entire sociology based literature on Manage- ment Accounting. For example, the book includes almost no reference to the main international journal in this area: Accounting, Organizations and Society. It is difficult to reconcile the lack of references to A.O.S. with the view that management accounting needs to be underpinned by a theory of the organization.

The book is also limited in its coverage of economic perspectives on organizations. It contains no coverage of the formal agency literature, no consideration of formal models of decentralized decision making and important themes from the Markets and Hierarchies literature (e.g. asset specificity, bounded rationality and the employ- ment relation) are not addressed. The first of these gaps in coverage could be remedied by referring students to the Demski (1994) book, reviewed below, the second by reference to Hess (1983) and the last by reference to Pitelis (1993).

4. Managerial uses of accounting information

Demski (1994) is targeted primarily at the MBA market. Advanced Accounting undergraduates might also benefit from the book, but I suspect most would find it too demanding. It could also form the core text for an economically oriented first year doctoral course in management accounting.

Unlike Zimmerman, Demski makes no attempt to ground his book on any particular theory of organization. In this respect Demski follows a line closer to the traditional ‘management accounting as a collection of techniques’ form of textbook. T o differentiate his product from these traditional textbooks Demski attempts to draw an analogy between the management accounting system and a library. A library which contains a variety of different representations of the transactions and operating history of the firm, along with other information of potential value for forecasting the consequences of future managerial decisions. The central purpose of the book is to explain to a professional manager, how to make intelligent use of the firm’s account- ing library. Roughly two-thirds of the book are devoted to developing the accounting library concept, but I believe further elaboration of the organizational context in which the accounting library is located may be needed to really establish the concept as a significant contribution to accounting thought. The final third of the book does

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consider some of the implications of conflicts of interest and dispersed information for management accounting practice. Such issues are discussed and illuminated, using the mathematics of principal agency theory. Unfortunately, as has been noted by Hart (1995)) this approach is rather limited in its ability to explain either how the boundaries of the firm come to be drawn or the way the firm is organized internally. The failure of the author to supply a theory of the business organization, to which the practices and procedures of management accounting can be related, limits the usefulness and relevance of the book.

Having voiced my principal concern, I hasten to add that I still believe that this is a book that any serious student of management accounting should read. Demski is a master technician who is able to make difficult concepts and theories accessible and even enjoyable. This is especially so of the final third of the book which deals with performance evaluation and agency theory. In addition every chapter of the book contains an impressive collection of problems and exercises that will tax even the most conscientious student.

A second valuable feature of the book is the pains the author takes to explain the key conceptual differences between the notion of cost as embodied in the neo-classi- cal theory of the firm and notions of cost in accounting. The neo-classical theory of costs makes extreme simplifying assumptions about the rationality of individuals and the availability of relevant technological and price information. What cost accounting does is to maintain a database of cost statistics, mostly based on the production history of the company. From this basic database, accountants produce a variety of simplified representations of cost which serve a variety of purposes. Demski shows that most of these representations involve a mixture of three main types of simplifi- cation: aggregation, local linear approximations and cost allocation. The various forms of approximation and the usefulness and limitations of the representations of costs to which they give rise are explored in chapters 1-9 which cover all the usual Cost Accounting topics (basic product costing, standard costs, joint costs and cost allocation, job order costing and process costing). Chapter 9 also contains an introduction to activity based costing which neatly debunks some of the more fanciful claims to originality that surround this particular costing technique.

Finally, special mention should be made of chapters 1 1 - 16 which deal with the use of management accounting information for decision purposes. The key chapters for this section of the book are chapters 11 and 12 which deal with the art of decision framing. Decision framing is concerned with the way that decision makers represent their decision problems. Problem representation is something of an art. Often the fastest path towards the solution of an apparently complicated problem will be to produce an alternative representation of the problem that is more manageable. Moreover good decision framing aids the decision maker in the selection of simplify- ing assumptions designed to produce an imperfect representation of the original problem which is much easier to solve and which yields a tolerable approximation to the optimum solution of the original decision problem.' Demski stresses three important aspects of decision framing (transformation of the objective function, the ability to engage in local searches and the possibility of reducing the dimensionality of the problem). These ideas are neatly explained by reference to simple optimization

'An example of excellent decision framing was Markowitz's (1 952) mean-variance representation and simplification of the general portfolio choice problem.

28 M.Walker

problems, including linear programming. Further illustrations of the framing princi- ples are provided in chapters 13- 16 which cover, respectively, cost function estima- tion, short-term decision problems (e.g. make or buy), long-term decision problems (capital budgeting) and decision analysis in strategic situations (e.g. duopoly).

5. Weaknesses of the economics of internal organization

Economics based approaches to theory of organizations assume self-seeking rational optimization on behalf of all economic agents. In the specific context of management accounting there are at least two major potential problems with this approach. The first is that by ruling out bounded rationality on the part of decision makers one automatically rules out any explanation of a demand for accounting reports which help decision makers to understand their decision situation. If all individuals are super-rational then they have no need for decision aids of any kind. The second problem with super-rationality is that it implicitly imposes the assumption that all individuals share a common understanding of the world in which they operate: an understanding with which they are all somehow exogenously endowed. The central problem with this approach is that it rules out any notion such as a socially constructed reality. Issues such as the influence of social and cultural factors on organizational structures cannot be easily captured by models which assume economic agents are bloodless super-calculators.

Economic models of organizations have also tended to abstract away from any form of learning process, either individual or social. Thus there is no allowance for the possibility of an accounting system emerging from an historical process of joint productive activity involving groups of individuals endowed with multiple imperfect rationalities, who interact with and learn from each other and who benefit over time from increased experience. In a nutshell the information economics approach is explicitly a-historical.

Criticisms of the unrealistic and a-historical nature of the economics approach to accounting have mostly emerged from academic accountants on the ‘soft’/‘critical perspectives’ parts of the discipline. Many of the articles published in journals such as Accounting, Organizations and Society and Critical Perspectives in Accounting, for examples, reject the ‘abstract formalism’ of mainstream economics. As an economist, I have read much that I disagree with in journals such as these, but I do think that some of the ideas in these journals have potential for adding value to the economics based approach. Some of the better articles in these journals show how ordinary people make some sort of sense out of complex economic circumstances, whilst others provide promising ideas on how the indeterminacy of economic equilibria might be resolved by considering the influence of political, social and cultural processes (Hopwood and Miller (1994) provide a useful collection of articles in this area).

6. Labour process theory

There isn’t space here, to fully discuss the potential for fruitful discourse between the economic and critical wings of the management accounting discipline, but it may be helpful to consider one article that nicely illustrates the scope for collaboration.

Economics of Internal Organization 29

Hopper and Armstrong (1991) point to fundamental problems in the theoretical framework of transaction costs economics:

1. 2.

3.

4.

The term ‘transaction costs’ has never been precisely defined. A failure of the theory to consider the links between product market power and organizational form. A failure to take into account the influence of social and political processes on the development of firms. A failure of the theory to consider the potentially exploitative nature of the relation between capitalist firms and their employees.

Of these four forms of criticism I find the first three less than convincing,’ but I do believe that there is something to be said for the fourth. No one with any knowledge about the development of the U.K. economy over the last century could fail to be aware of the ebb and flow of the balance of power between workers and their bosses. In a world of costless decision making, perfect labour markets and perfect risk sharing markets, there would be no scope for any individual firm to exploit individual workers. In reality individual workers need the countervailing power of trade unions to protect their position in bargaining conditions where the firm has all the bases stacked in its favour. Moreover, in understanding the development of accounting systems, it simply will not do to assume that such structures represent the outcome of some sort of even handed negotiation between individual workers and employees.

Current transaction cost models of the employment relation run the risk of being dismissed as little more than apologetics for unbridled capitalism. But this is not an inevitable feature of such models. It should be possible to produce transaction costs models which more faithfully represent employee-employer relations by taking into account the limited access of the worker to calculating power, the ownership and control of the organizational information system (and organizational memory) by the firm and imperfections in labour and risk sharing market^.^

7. Summary

Both Demski (1994) and Zimmerman (1997) represent important additions to the set of adoptable textbooks. They are also, in my view, strongly complementary. Zimmerman provides a neat general framework which is illustrated by numerous examples and references to relevant empirical evidence on accounting practice. Demski fills in much of the technical detail which is missing from Zimmerman, especially on the nature of accounting costs and the mathematics of agency. An ideal graduate course would supplement these two texts with a selection of articles, from journals such as A.O.S., which advocate alternative theoretical perspectives.

’Labour process theory also relies on terms that are difficult to define precisely, e.g. ‘Class’ and ‘Power’. It is difficult to see why product market conditions should influence organizational form (at least as a first order effect). The problem with the ‘need to consider political and social forces’ form of criticism, is the implication that one cannot study any economic phenomena in isolation from everything else. 3For specific illustrations of the links between management accounting and the control of labour see the articles by Bougen and Armstrong in Hopwood and Miller (1994).

30 M.Walker

References

Buckley, P. J. and Michie, J. (eds), 1996. Finns, Organizations, and Contracts: A Reader in

Coase, R. H., 1937. The Nature of the Firm. Economica, 4, 386-405. Demski, J., 1994. Managerial Uses of Accounting Information. Norwell, Mass., Kluwer

Hart, O., 1995. Firms, Contracts, and Financial Structure. Oxford, Clarenden Press. Hess, J. D., 1983. The Economics of Organization, New York, North-Holland. Hopper, T. and Armstrong, P., 199 1. Cost accounting, controlling labour, and the rise of the

conglomerates. Accounting Organizations and Society, 16, 405-438. Hopwood, A. G. and Miller, P. (eds.), 1994. Accounting as Social and Institutional Practice.

Cambridge, Cambridge University Press. Hurwicz, L., 197 1. Centralization and Decentralization in Economic Processes. Chapter 3 in

A. Eckstein (ed.), Comparison of Economic Systems, Berkeley, University of California Press. Ichiishi, T., 1997. Microeconomic Theory, Cambridge Mass, Blackwell Publishers. Klein, B., Crawford, R. and Alchian, A., 1978. Vertical Integration, Appropriable Rents, and

the Competitive Contracting Process. Journal of Law and Economics. October, 297-326. Markowitz, H., 1952. Portfolio selection. Journal of Finance, 7, 77-9 1. Marschak, J. and Radner, R., 1972. Economic Theory of Teams, New Haven, Yale University

Press. Pitelis, C., 1993. Transaction Costs, Markets and Hierarchies. Oxford, Blackwell. Radner, R., 1996. Bounded Rationality, Indeterminacy, and the Theory of the Firm. The

Williamson, 0. E., 1975. Markets and Hierarchies.: Analysis and Antitrust Implications. New

Zimmerman, J. L., 1997. Accounting for Decision Management and Control, 2nd edition,

Industrial Organization, Oxford, Oxford University Press.

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