Tuesday October 14th 2003
Accounting 1: session 1, second part
The operations of a firm create a quantity of information
Examples of information of a non monetary nature
What do managers do?
What kinds of decisions managers are faced with?
Driving a firm is like driving a car
What have we learned so far?
What is money?
The operations of a firm create a quantity of information
We saw that the operations of a firm create a large quantity of information, some of it of a monetary nature and some of it of a non monetary nature. This information must be organized, treated and summarized.
All firms all over the world produce on a regularly basis, usually weekly or monthly, an internal document presenting all the important information for the managers in their work. It may have many names: "operations report", "weekly overview", "business outlook", "le tableau de bord" etc. For instance every Monday morning there will be the "managers meeting". For this meeting the "operations report" is prepared and an agenda is decided upon. Usually it has a regular structure: review of what happened that is noteworthy in production, in selling, in human resources etc. over the past week. Review of the productivity parameters that are OK, and of those that show a worrisome evolution. Review of the current situation with prospects and with clients. Discussion of problems and what to do. Decision by the boss of who will do what. Discussion of the bigger problems of a strategic nature, discussion of options. End of the Monday morning "managers meeting". This is a simplified version of the real life in firms. Larger firms will have different meetings for discussion of operations, for discussion of strategy etc.
The "operations report" will also contain information of a monetary nature. This is "accounting information". It is prepared by the accounting department.
Accounting data are part of the information that managers need to monitor all the time.
In the Chinese toy manufacturer example we saw information of a monetary nature and information of a non monetary nature (example : percentage of waste in the usage of wood).
Examples of information of a non monetary nature:
In a bakery:
There are bakeries where you wait a long time in line and bakeries where you do not.
Well run shops spent a lot of thinking about their layout in order to serve their clients as efficiently as possible. Supermarkets are fantastically efficient at treating clients in the checkout lines. Laser readers, plus moving counters, enable the clerks to calculate the price of a whole shopping cart in less than two minutes where in the old days it took more than five minutes.
Note the following calculation at McDonald's: in their shops usually you don't wait long in line, and, when it's your turn to order, the sandwich you want is often already prepared. This production policy leads to some waste in sandwiches, because they cannot wait more than say ten minutes. McDonald's made the calculation that doing so they serve more clients and make more profit.
If you are in charge of production in a firm there are plenty of parameters that you have to keep track of in order to have an efficient production, and these parameters are not of a monetary nature. For example the downtime, the idle time, and the working time of machines is something that must be monitored.
In a car assembly line there are say 200 workers along a long line. Cars in construction pass in front of each worker about one minute. During this one minute one worker performs a job (puts on the hood, or the windshield, or the rearview mirror...). His job takes less than one minute - of course! Usually it takes between 40 and 50 seconds. Take your calculator and see that such a plant "loses almost one hour of work every minute". This is a small illustration of the problem of "balancing a line" in production engineering. In well run firms this leads to adaptations not only in the production process but also in the conception of the products.
Of course the optimization of these parameters in the end translates into profits.
Managers don't actually "do" anything. The only thing they do is take decisions. That is why they're also called decision makers. Of course for that they obtain and study information. A manager does not manufacture any product. A sales manager in a large firm does not sell anything, he or she only manages a team.
Managers study information in order to take decisions. This information comes from accounting (the monetary information) and from other reports ("production review", "weekly sales report" etc.)
What kinds of decisions managers are faced with?
For example
All these are decisions. Some of them long-term decisions. Difficult to take decisions. Some other decisions are very easy to take. Top managers, top executives, are only in charge of the most important decisions.
If the price of a supplier goes up you may consider changing supplier. But changing supplier is always a difficult decision to take. It has all sorts of consequences in production. Even commodity products like polypropylene are never exactly the same from one supplier to the other. You have to reset your machines. You may have to adapt a part of your production process. We may also discover new problems with delivery. A new supplier may turn out not to be as reliable as the old one.
Managers keep receiving information from various parts of the firm, accounting information and other information.
Driving a firm is like driving a car.
In your car, behind the steering wheel you have plenty of dials showing the speed, the temperature of the engine, the level of oil, how much gasoline remains, your have a rearview mirror, etc. When you drive your firm and things run well, the accounting reports are very good, the other reports too, money is flowing in the till etc. it is exhilarating. You feel very smart! (And when things go bad you feel very unlucky :-) )
Accounting is nothing more than the collecting of monetary information on the operations of the firm and the creation of a dashboard to pilot the firm. It collects information, organizes it into accounts, then synthesizes it to produce useful documents for the managers.
This information is used by managers to take decisions. For instance when the cash goes down you may delay some expenditures. You will have to choose which ones. Apple Computer in the '90s reduced its R&D expenditures from about 20 percent of its turnover to about 5 percent. Great savings! Good decision? What were the options?
When the orders go up you may hire temporary people or hire them permanently. Temporary people are more costly... but less risky... It's what we call a trade-off.
Example of a press shop in a car manufacturing company. (Listen to the lecture part b, 12 minutes after the beginning.)
The next topic is money.
In all societies on Earth money appeared in the same way.
Societies, in the common acception of the word (the members of which constantly give and take, exchange) date from neolithic times. They appeared with the sedentarization of man about 8 000 b.c. (b.c. stands for "before Christ"). This process took place in the Middle East, in northern India, and in other locations in the world I'm less familiar with. The Lascaux cave settlement, dating from about 20 000 years ago, most probably was not a society based on exchange.
Sedentarization appeared when man in certain tribes discovered how to grow crops and raise herds. It required to stay at the same place for one year. This led some populations to stabilize in the same location.
This in turn led to specialization (way before Taylor!) because it increased productivity.
And this in turn led to exchange.
The process is summarized like this:
Grow crops and raise herds > sedentarization > specialization > society based on exchange.
This also led to political organizations, and to the codification of laws. The most famous early law code is Hammurabi's code dating from 1750 b.c.
Schematized specialization :
A will be in charge of growing the wheat
B will be in charge of raising cattle
C will be in charge of making pottery
D will be in charge of producing textiles
Of course there were also warriors W (in charge of war), and priests P (in charge of worship). But here I'm only talking about the working class :-)
At first the exchanges were what we call "barter", that is simple exchange as follows: if B wanted many pieces of cloth, he would have to convince D to accept a cow or a goat... D wanting pottery could convince C to accept textiles or perhaps a cow... Etc.
This may sound fun, but, mind you, barter is still practiced by some countries "lacking liquidities".
The problem with barter is that it is very inconvenient. The exchanges are difficult, because each party must need or at least accept what the other one has to offer, even if it does not need it and will therefore have to find somebody else who wants it.
Barter is a complicated system.
Another illustration can be given with languages: in this classroom we use a common language English, which is neither your mother tongue nor mine. If we didn't use the common language English, I would have to learn Chinese, Norwegian, Arabic, the language spoken in Congo etc. or you would have to learn French (which you will actually do). But then traveling you would also have to learn Spanish, German, Japanese, Russian, Hindi, Farsi etc. It is much simpler that all of us keep our mother tongue and also learn one foreign language: English.
We may learn other foreign languages too because it opens onto great cultural riches. But that's another matter.
So barter is not an efficient way to exchange.
The emergence of "commodity money":
In societies based on exchange and practicing barter almost always appears very quickly the following phenomenon: one commodity emerges to play the role of an intermediary in exchanges.
This commodity always has the following features:
This phenomenon can also be observed in "laboratory conditions" in jails and in various other confined environments. In prisons there is almost always a commodity that plays the role of money. Usually it is cigarettes. You can observe that it has the five characteristics Iisted above.
In all societies based on exchange appears fairly soon one commodity that plays the role of money.
In history what are the various commodities that played the role of money?
In Latin "capita" means "head". Etymologically, your "capital" is the number of "cattle heads" you own. All over history owning cattle was a sign of great wealth. Some of my great-grandparents were modest people living in the north of France but for a period they owned a horse... In the family we mean by that that they reached some wealth.
"Commodity money" is a great improvement upon barter .
It makes exchanges much more easy and fluid. When you want to sell one of your cows in order to buy pottery, it is no longer necessary that the potter want a cow. You will exchange your cow for money, from whomever wants a cow (and has money...) and this doesn't have to be the potter. And then, later on maybe, you will go to the potter and offer money for pottery. A fantastic system! And - even more fantastic - it appears spontaneously!
Except for small and closed societies, studied by anthropologists, where we saw all sorts of commodity money appear, in ancient times gold and silver were the most common commodity money used. (Gold was easy to get from the Pactole river in Phrygia, later conquered by Lydia, making Croesus, who lived in the sixth century b.c., faboulously rich.)
For any other goods produced and exchanged on the market of the society under consideration there emerges a ratio of equivalence with gold: for instance one goat is worth 10 ounces of gold, one cow is worth 20 ounces of gold, etc. As everybody knows, this is called the price.
As you can see those members of the society that have access to plenty of gold, perhaps because they own a mine, or for any other reason, readily become very rich without having to produce anything else. This explains the "Gold Rush" in California in 1849. (One of my ancestors, left the family farm in the Pyrenees to travel to America and to join the gold rush in San Francisco, but there rather than being a gold miner he became a cattle head merchant... "Jean Cabannes : né le 14.9.1823 à Bernadets, mort, célibataire, le 3 juillet 1865 à San Francisco, où il était marchand de boeufs".)
Prices are set by the "desirability" of gold, not by the difficulty or easiness to produce it. This topic pertains to the field covered by the law of supply and demand, that you will study in economics.
I have met dreamers who wanted "money to be based on the value of work as opposed to the value of gold". But aside from its moral attractiveness they never indicated how to implement the principle. And they overlooked the spontaneous character of the appearance of commodity money, and of prices.
Prices are not decided by someone - another beauty of the system - they are set by the law of supply and demand.
When governments want to impose prices on markets where other prices would be reached by natural equilibrium, this leads to all sorts of severe economic problems. One of the most conspicuous one is the emergence of a black market, but there are many other. (Read for instance Ludwig Von Mises works.)
We saw that gold was (with silver) the main commodity money used in developed societies of ancient civilizations. It has all the characteristics listed for a commodity money: it is not easy to produce for everyone, it is not perishable, it is easy to exchange, to transport and to store, and it is desirable. It is nice looking, people like gold. (There is more to say about metal money in ancient times - roman emperors "coined" their money for instance... - but this is outside the scope of the course and is a refinement not necessary to study to understand money, and its central rôle in accounting of modern firms.)
"Commodity money" is only, historically, the first of three types of money.
A tremendous innovation appeared in Western Europe around the XIIIth century. It is called scriptural money. There must have been innovations of the same kind elsewhere, in Asia, but I'm less familiar with that. Let's see what it is.
Until the late Middle Ages (that is the centuries after the year 1000 a.d.) gold was the commodity of choice for commerce and for payment. Merchants would travel with their goods for sale and with their gold for their purchases. The Romans would ship their gold all over their empire to pay their soldiers. Conversely gold from taxes would go to Rome etc.
Even though it is a great improvement upon barter commodity money is still somewhat inconvenient: gold is rather heavy, and when you transport it on long journeys you risk attacks by robbers. (This money carries its value embodied in it.)
As is often the case in ancient times the next improvement came from merchants.
Technical and social improvements in traditional societies almost always came either from merchants or from the military. The military have always come up with plenty of technological innovations to try to gain an advantage at war (but the enemy would soon copy it, or even come up with a superior innovation...). To this day most of the technological innovations we see appear around us have a military origin.
Merchants have always been a vector of innovation too for another reason: they travel a lot and meet many people from other cultures, and they meet the most inventive people of these other cultures. So they bring back new ideas, new arts, extraordinary stories etc. We shall meet Marco Polo in a little while. Commerce, requiring competition too, also pushes naturally for innovations.
And it is one of those that we shall presently study.
Download the sound file put on the Net to listen to the remainder of the lecture
XIIIth century Champagne fairs
scriptural money
endorsement
banking
modern accounting
Marco Polo
Ottoman's land lock
"Great discoveries"
gold and silver swamp Europe
inflation
change in social structure of revenues and equilibrium of power
downfall of the Ancient Regime
fiduciary money
bank of England