The idea for this article was born at Easter, during a cycling tour in Greece, when my friend Drago and I exchanged a few thoughts on the topic of accounting. Back then he was working for an accounting software company with established clientèle in the US aerospace industry. Airliners and rockets belong to the most complex products of our economy and accounting for their development and production can be quite daunting. Indeed, it’s not hard to imagine that a godzillean manufacturing process that involves the punching of several million rivets and the laying of hundreds of kilometres of cable can be difficult to grasp in its various financial facets. Unsurprisingly, spectacular cost overruns happen too.

Accounting relies on the ability to portray the business in terms of money, and do this accurately. Here I want to write about the role of the market in the monetary measurement of assets, internal processes and their input/output. It’s a fundamental role, for without it we wouldn’t be able to express value in terms of money, the standard unit of account.

I found the initial version of this article superficial in its conclusions so I left my thoughts to simmer for a while. Now you should have a much more definitive text in your hands. Management accountants who seek to gain a better system understanding in their work should find this reading useful.

Where do things obtain their monetary dimension?

The purpose of accounting is to measure aspects of a business in terms of money. In business, money is the universal and the ultimate measure, for important things like capital, sales and profit. Therefore, money is the standard unit of account.

The monetary dimension of things, however, cannot be taken with a ruler or derived from a formula. Neither it is given arbitrarily. Instead, it is a result of a dynamic exchange process - the market.

Fig. 1. In the market traded goods and services obtain a monetary dimension

The market value of traded goods and services derives from the interaction between supply and demand, and can change with time, hence is dynamic. You’ll never know how much money something is worth until it’s transacted in the market and because of this market dynamics you can never predict future monetary value with absolute certainty.

The magic of market proximity

This economic connection between monetary value and the market is crucial for the functioning of accounting. Interestingly, financial accountants do not really need to be aware of this to do their job. I call this phenomenon “the magic of market proximity”. According to it, the ease and the accuracy of monetary measurement depends on how close the accounting events are to the market:

In situations when we have to account for transactions that cross the company/market boundary (e.g. purchases or sales, where market distance = 0), there really is no concern with the monetary measurement of the transactions - we simply record the amount that was paid. The market plays its role so well here that we don’t even notice it. It’s almost like magic.

However, as soon as we step away from the company/market boundary (market distance > 0) and enter the domain of management accountants, that is, the internals of the business, things change. When we try to measure the internal business processes and their intermediate inputs/outputs, we notice that they no longer have an immediate monetary dimension. Accounting in this context suddenly becomes much harder.

Fig. 2: Accounting at the company/market boundary is comparatively easier and more accurate. Inside the business, as the distance between accounting objects/events and the market grows, monetary measurement becomes more difficult.

Recreating the lost connection

You can now see how critical the transactional connection to the market becomes as the distance between accounting object/event and the market increases. This is of particulate concern to larger enterprises, with deep and complex processes, which in effect produce a lot of intermediate goods and services for internal consumption. How do you measure the monetary value of things that never reach the market (in a direct form)?

The market connection that financial accountants take for granted, management accountants have to establish themselves.

When we look at the various existing strategies to measure the internal aspects of a business in monetary terms we’ll notice that they all aim to establish an economic link between the object/event to be accounted for and the market. Some approaches provide more accurate linking, others less, but the underlying principle is the same:

The methods to measure cost (direct/indirect costing, Activity-Based Costing, etc.) are based on a simple premise: everything that a business produces (output) is some composition of materials, labour and knowledge (collectively called inputs) obtained from the market. This premise applies whether the output is the final product shipped to the customers or some intermediate stage in the production line. To calculate its cost you add up the costs of the respective composing inputs, which should be traceable back to the market and their price well known. Complications arise when inputs have to be traced over several production steps, or when they spread out over many areas of the business (overheads).

Fig. 3: a) Measuring cost using input decomposition. Complications arise with b) deep production lines and c) extensive cost fan-out as with overheads

The ability to measure how much (customer) value each part of the enterprise creates can be of much use to managers, yet is still underdeveloped. Here you cannot apply simple decomposition as with costs, because the market value of the product is normally different (and hopefully more!) than the sum of its parts. We will discuss this issue, along with a possible solution, at the end of this article.

The measurement of asset depreciation (for management purposes and not necessarily for tax reporting) also relies on establishing an economic link to the market, so that the current market value of the asset is well reflected.

Shortening the distance

The following graph gives an idea of how the accuracy of monetary measurement (cost) develops as business processes become more complex and the accounting objects/events more distant from the market. This curve, of course, is a rough guess. More definite curves can be obtained from empirical data or from simulations based on network theory.

Fig. 4. Accuracy of monetary measurement vs. distance from the market

Now that we know the importance of market distance, how can we improve measurement accuracy?

There are two possible approaches:

1. Improve the technical ability of the accounting system to trace costs
2. Restructure the economic connection between the accounting objects/events and the market in order to shorten distance

The first approach has a shallower reach than the second and its potential for improvement is more limited. It is usually pursued by adopting sophisticated accounting technology (e.g. through ERP software) and implementing some organisational changes in order to accommodate the technology. But ultimately, the ability to account for a business is constrained by its structure and functioning. If our business is in a state of mess, expensive accounting systems won’t bring much.

The second approach comes from a different side. In it we realise that improved accountability results from restructuring the underlying business so that it is better connected to the market. If the various parts of your business have a strong, streamlined and economically sound connection to the market, we shorten the distance between accounting objects/events and the market, thus improving measurement accuracy. This, by the way, is the approach of The Transaction Company.

Some of you may be surprised to discover this effect of market-connectedness and orientation on the accuracy of monetary measurement. I love such system insights because they show us how deeply interconnected things can be and reveal new “hidden” options that we have for bringing about improvement.

Seamlessly interconnected

Let’s now examine how The Transaction Company affects monetary measurement within the enterprise.

As the name of the concept implies, it gives employees the ability to conduct monetary transactions among themselves, replacing many of the traditional organisational constructs. Management, allocation of resources, control, remuneration as well as accounting are done through transactions. This essentially leads to an integrated system of transactions to encompass the enterprise from end to end on two related planes:

• All employees across the company in all their work-related interactions
• All processes across the business that make up the value chain

The resulting network of transactions within the enterprise connects seamlessly to the market as the company’s interactions with the market are traditionally also transactional. At the same time, every transaction within the enterprise has a defined monetary value and therefore, whatever becomes subject of a transaction (any activity across the value chain or any intermediate process inputs/output) can be directly measured and accounted for in monetary terms. This in effect restores the lost “magic of market proximity” which I described in the beginning of this article. Wonderful, isn’t it!

Fig. 5. A system of transactions that encompasses the whole enterprise and connects seamlessly to the market. Every subject of a transaction has a clear monetary connection to the market

The magic of transactions works so well, that it brings monetary measurement to a whole new level. It practically does away with the traditional problems of overheads accounting - of how to allocate or apportion costs on an equitable basis. In fact, there is no explicit distinction between variable and overhead costs, because the supporting enterprise activities (according to M. Porter’s value chain representation, i.e. firm infrastructure, HR, development and procurement) are so tightly integrated into the primary ones. If we want to classify a transaction as variable-cost-related or overhead-related, we may have to do that separately by determining the case for it.

Here is a small example showing the engineer Jack and the three production lines of the company he works for. Occasionally the production lines experience technical problems and their respective managers call for his support. When such a case occurs, the manager and Jack agree on a price for his service. Regardless of the range of problems that Jack services and how his work divides among the three production lines, to calculate the cost of his support for a given line you just add up the money that was paid to him by the corresponding manager.

Fig. 6. Example of transactional accounting for overhead support services

Notice that the price for every rendered service is agreed between Jack and the line manager. It is not imposed by some third party within the company. Greater economic independence and self-responsibility of people is central to the philosophy of The Transaction Company. Every employee has the freedom to evaluate of the contributions related to his own job, either received or given, and then negotiate the price to be paid for them.

Measuring how value is generated

This higher degree of economic agency of people in The Transaction Company, which also brings us functionally closer to the market, has many benefits over traditional organisations where employees have more restrictions put upon them. In terms of accounting and monetary measurement, besides the improved cost accounting discussed above, it also makes it possible to measure how much value is added at each stage of the enterprise.

Value is always subjective and is determined on a personal basis. As I mentioned above, it is not the same as the sum of its parts, and cannot be allocated or apportioned the same way costs can. The Transaction Company enables the monetary measurement of value within the enterprise by allowing employees to evaluate directly each other’s work contributions.

The following example shows a simplified value chain of a firm consisting of three employees. Notice how the chain of internal transactions connects to the market on the supplier and customer side. The value added by each person can be calculated by subtracting the values of the inbound from the outbound transactions. It’s then distributed as personal wage (90%) and dividend to the shareholders (10%). The actual percentages can be chosen differently.

Fig. 7. Example of a simplified transactional value chain showing how the added value is measured

Also notice that despite the subjective nature of added value, it is not arbitrary given but regulated economically. On one hand, employees would presumably try to add more value in order to maximise their gain, while on the other hand, they would have to make sure that they fit into the value chain.

Traditionally organised businesses can never truly measure the creation of value to the same extent because their employees have a lower degree of economic interaction and independence. While we can relatively easily determine the margin of the whole enterprise or of a well distinguished value chain, we cannot come to more structured information by simple measurement.

I hope you enjoyed this tour of accounting and the role of the market in monetary measurement. I certainly did!

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