The Importance of Principles and the “N=1” Problem

I was recently reading about the “n-1” problem in science.  It’s the problem that constrains scientists in any attempt to answer the question, “What is life?”  The only life scientists are aware of is the life they know here on Earth.  This is the n=1 problem, where n is the number of examples from which anyone can generalize.  Scientists have no idea if life on Earth is average for the cosmos or if it is a freak outlier.  They could fail to notice life elsewhere in the cosmos because it isn’t like anything here on Earth.

Over the past five decades, I’ve found the n=1 problem is also an issue in management accounting.  The perspective from which most practitioners view management accounting issues is restricted by the limited scope of their experience.  For example, most financial accountants I’ve encountered view management accounting as synonymous with cost accounting and believe its purpose is to value an organization’s inventory and cost of goods sold according to generally accepted accounting principles.  I’ve partnered with numerous regional CPA firms over the years and with rare exceptions, the partners and staff couldn’t see beyond that limited perspective.  These were all highly intelligent individuals, but the n=1 problem kept them from a more comprehensive understanding of management accounting.

Similarly, I’ve found that day-to-day operating managers view management accounting as a tool for helping them meet their short-term performance goals based on traditional accounting definitions and rules.  That appears to be the reason so many of them become enamored with concepts like “lean accounting” and “throughput costing.”  For these managers, many costs are either fixed or beyond their control during the periods for which their performance is being evaluated.  Not only that, but their understanding of costs and expenses is constrained by financial accounting’s definitions.  Again, these are all highly intelligent individuals, but the n=1 problem limits their understanding.

In recent decades, many solutions have been developed and heavily promoted to remedy the management accounting problems perceived by individuals whose experience is limited by the n=1 problem.  Grenzplankostenrechnung (GPK) has been developed by individuals whose perspective is to control day-to-day business operations through flexible analytic cost planning and accounting.  Activity-Based Costing (ABC) has been developed by individuals whose perspective is to better measure the cost of products and services.  Throughput costing and lean accounting have been developed by individuals whose perspective is to optimize the short-term performance of the organization.  The list goes on.  Solutions to problems perceived by individuals limited by the n=1 problem.

What management accounting needs to emphasize is more than methods to solve its problems.  It needs to emphasize its fundamental underlying principles.  Fundamentals not only solve an individual’s immediate management accounting problems; they frame the problem in a way that allows the individual to understand that there are perspectives beyond the scope of their own experience.  They help overcome the n=1 problem.

The Profitability Analytics Framework is a structure designed to provide a framework for a comprehensive view of management accounting’s principles.  It highlights the importance of causality in developing models for the three primary concerns of the field: revenues, investment, and costs.  It modifies financial accounting’s definitions of investment and expense to more accurately reflect economic reality.  It points out the shortcomings of traditional depreciation methods and the need to measure the ongoing accumulation of funds required to preserve the organization’s base of both tangible and intangible assets. It calls attention to the fact that cost of capital is legitimate business cost.  It emphasizes the need to link revenues, investments, and costs with the organization’s strategy.  It encourages decision makers to understand that there are different measurements of cost for different purposes.  In short, it incorporates all of the critical principles of management accounting in one package. 

To succeed in an ever more competitive, world-wide business environment, management accountants must develop a comprehensive understanding of management accounting’s principles. Understanding methodologies that are limited by the n=1 problem is not enough.  Methods help us address the problems that we know.  Principles change how we understand things and help us address problems outside of our immediate experience.  In both the way academia teaches management accounting and the way practitioners put it to use, principles should be paramount.  The Profitability Analytics Framework has been provided as a tool to help reach that goal.