Wednesday, November 07, 2012

On Business Architecture and Management Accounting

Someone asked on Linked-In Should EA be knowledgeable about accounting and its pitfalls? Here is a rewritten version of my reply.

Management accounting provides a view of the distribution of costs, benefits and risks. Costs include labour costs, materials and other purchases, and so-called overheads. So if we want to know the total production cost of a particular product, or the total cost of a particular activity, we need to work out what share of the total expenditure should be allocated to this product or this activity. These calculations are important for many reasons, including deciding whether to invest in improved systems and technology, deciding whether to keep some capability inhouse or outsource, determining how profitable a given product or service is at a given price and volume.

In One Strategy One PL (January 2013), John R Moran argues that a company can only have a unified strategy if it has a single unified accounting view, and suggests that "the entire logic of profit centers rests on the assumption that maximizing the pieces will maximize the whole". Clearly the relationship between the performance of the pieces and the performance of the whole is an important topic for architects.

Accountants use various simple methods for cost allocation, including so-called Activity-Based Costing. These methods all make some structural assumptions about the dependencies between activities, capabilities, resources and other things. They also involve rules about handling expenditure spanning more than one accounting period. These assumptions also affect project evaluation (e.g. return on investment).

If these structural assumptions are simplistic or incorrect, the management accounting view may lead management to make poor decisions - for example, about investment or cost-cutting or outsourcing. (See my post on Architecture as Jenga.) So business architects need to appreciate what structural assumptions are implicit in the management accounts, and be prepared to challenge these assumptions when necessary.

This is not just because business architects should understand the structure of the business, but also because architecturally-led initiatives may depend on producing a business case that relies on a correct allocation of costs and benefits. For example, architects often wish to advocate long-term investment in shared services and platforms, but such investment may sometimes appear unattractive or unfundable when viewed from a conventional accounting viewpoint, and may be hard to get through the conventional budgeting process. If architects don't understand the potential distortion of the conventional accounting viewpoint, and allow management to take the accounting viewpoint at face value, then they are effectively ceding control of the business structure to the accountants.

Business architects need to pay attention to the structure of cost. Accountants allocate costs according to implicit (and often simplistic) architectural assumptions. For example, accountants use activity-based costing, based on a very simple activity architecture. If left unchallenged, these cost allocation rules can create difficulties for architects in establlshing the business case for shared services and shared infrastructure platforms, and other architecturally-led initiatives. This is one reason why architects need to take on the accountants rather than accept the accountancy view at face value.

See also my post on the Calculus of Cost. This is one of a series of posts on The Purpose of Business Architecture.

See also Tom Graves, Financial-architecture and enterprise-architecture (30 September 2013)

Updated 2 September 2013


Gabriel Morgan said...

Great points, Richard. I agree that Financial Accounting be a core skill set for Business Architects. I've recently published a set of Business Architect Skills on my blog to help describe these.

Richard Veryard said...

Thanks Gabriel. My blogpost talks about Management Accounting rather than Financial Accounting. I'm guessing you intend your skills spreadsheet to include both.

Elizabeth J. Neal said...

These methods all make some structural assumptions about the dependencies between activities, capabilities, resources and other things. formazione fad roma