Study manual management accounting

1 The management accounting function 2 Financial accounting and management and cost accounting 3 Planning, control and decision-making 4 Information 5 Presentation of information to mana

F o u n d a t i o n l e v e l Management Accounting

2 0 1 2

S T U D Y M A N U A L

ii

Second edition January 2012

First edition 2010

ISBN 9781 4453 8013 1 Previous ISBN 9780 7517 8151 9 British Library Cataloguing-in-Publication Data

A catalogue record for this book

is available from the British Library Published by BPP Learning Media Ltd

All rights reserved No part of this publication may

be reproduced or transmitted in any form or by any means or stored in any retrieval system, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the publisher

We are grateful to CPA Australia for permission to reproduce the Learning Objectives, the copyright of

which is owned by CPA Australia

Printed in Australia

© BPP Learning Media Ltd 2012

Welcome to the next step in your career –

CPA Program

Today’s CPA Program is a globally recognised education program available around the world All candidates

of CPA Australia are required to attain a predetermined level of technical competence before the CPA

designation can be awarded The CPA Program foundation level is designed to provide you with an

opportunity to demonstrate knowledge and skills in the core areas of accounting, business and finance

A pass for each exam is based on a determination of the minimum level of knowledge and skills that

candidates must acquire to have a good chance at success in the professional level of the CPA Program

In 2012 you have more opportunities to sit foundation level exams, allowing you to progress through to the professional level of the CPA Program at your own pace

The material in this study manual has been prepared based upon standards and legislation in effect as at

1 September 2011 Candidates are advised that they should confirm effective dates of standards or

legislation when using additional study resources Exams for 2012 will be based on the content of this study manual

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iv

Chapter

Before you begin ques ions: answer and commentary 3 7

Topic list Tells you what you will be studying in this chapter

Introduction Presents a general idea of what is covered in this chapter

Chapter summary diagram

Summarises the content of the chapter, helping to set the scene so that you can gain the bigger picture

Before you begin This is a small bank of questions to test any pre-existing knowledge that you may

have of the chapter content If you get them all correct then you may be able to

reduce the time you need to spend on the particular chapter There is a

commentary section at the end of the Study Manual called Before you begin: answers

and commentary

Section overview This summarises the key content of the particular section that you are about to

start

Learning objective reference

This box indicates the learning objective covered by the section or paragraph to which it relates

Definition Definitions of important concepts You really need to know and understand these

before the exam

Exam comments These highlight points that are likely to be particularly important or relevant to

the exam (Please note that this feature does not apply in every Foundation Level study manual.)

Worked example This is an illustration of a particular technique or concept with a solution or

explanation provided

Question This is a question that enables you to practise a technique or test your

understanding You will find the solution at the end of the chapter

Key chapter points Review the key areas covered in the chapter

LO 1.2

Introduction vii

Quick revision

questions

A quick test of your knowledge of the main topics in this chapter

The quick revision questions are not a representation of the difficulty of the questions which will be in the examination The quick revision MCQs provide you with an opportunity to revise and assess your knowledge of the key concepts covered in the materials so far Use these questions as a means to reflect on key concepts and not as the sole revision for the examination

Revision

questions

The revision questions are not a representation of the difficulty of the questions which will be in the examination The revision MCQs provide you with an opportunity to revise and assess your knowledge of the key concepts covered in the materials so far Use these questions as a means to reflect on key concepts and not as the sole revision for the examination

Case study This is a practical example or illustration, usually involving a real world scenario

Formula to learn These are formulae or equations that you need to learn as you may need to apply

them in the exam

Bold text Throughout the Study Manual you will see that some of the text is in bold type

This is to add emphasis and to help you to grasp the key elements within a sentence and paragraph

Chapter 1 – The nature and purpose of management ac ounting

This introductory chapter sets the scene for your forthcoming studies of Management Accounting It explains the differences between financial, cost and management accounting and explains the role of the management accountant

It also introduces two key activities of the management accountant: decision making and performance measurement and evaluation

Chapter 2 – Decision making and relev nt cos ing

One of the most important things that a management accountant does is to provide the information that enables a business to make decisions about its activities This involves ascertaining the relevant costs of the business, which are its future costs and cash flows The chapter goes on to consider choice of product (product mix) decisions, make or buy decisions and outsourcing

Chapter 3 – Budgeting

A budget is a quantitative statement, for a defined period of time (often a year) which usually includes planned revenues, expenses, assets, liabilities and cash flows When organisations draw up budgets they have stated objectives and intentions, and the actual results can then be compared with the budget and differences identified and analysed This chapter explains the background of budgeting and then teaches you how to prepare and operations budget and a cash budget

Chapter 4 – Cos behaviour and CVP analysis

This chapter introduces the different types of cost and also discusses cost behaviour It then moves on to cost-volume-profit analysis, which is based on cost behaviour principles; this is necessary so that the appropriate decision-making information can be provided to management

Chapter 5 – Overheads, absorption and marginal cos ing

There are some costs incurred by organisations that have to be allocated out to the various units produced,

so that a cost per unit can be produced This chapter examines the different types of overheads and introduces two methods of accounting for them: absorption and marginal costing It ends with a comparison between the two

Chapter 6 – Overhead cos ing – activity-based cos ing

Activity-based costing (ABC) has been developed relatively recently to suit modern business and accounting practices It provides a modern alternative to traditional methods such as absorption costing, which tend to allocate too great a proportion of overheads to high volume products ABC involves the identification of those factors, known as cost drivers, which cause the costs of an organisation’s major activities

Chapter 7 – Proces and ob cos ing

Costing systems are used to cost goods or services, and the method used depends on the way in which the goods or services are produced Within the context of your syllabus, the two most important are process costing, used when it is not possible to identify separate units of production, and job costing, where work is undertaken to a particular customer’s specific requirements

Introduction ix

Chapter 8 – Standard cos ing

In business, standards are applied to the costs of products and services An organisation will expect the

standards that it sets (for example for the amount of materials to be used in production, or for the amount

of workforce time involved) to be met If they are not, a variance analysis will be carried out, which

identifies where they have not been met

Chapter 9 – Variance analysis

The actual results achieved by an organisation during the reporting period are frequently different from

those expected Variance analysis identifies where these differences from the expected occur It is

important to realise that in some situations a favourable (ie positive) variance on one aspect of production will be cancelled out by an adverse (ie negative) variance on another aspect Hence businesses produce

operating statements, which reconcile the expected and the actual results, by means of all the variances, so management can see the complete picture

Chapter 10 – Capital expenditure

Decisions about capital expenditure require different thought processes from those about revenue

expenditure Capital expenditure often involves the expenditure of larger sums of money, and this usually

happens over a longer period of time Because of this, there are sometimes elements of uncertainty, such as interest rates or the revenue to be gained from a project, and this chapter introduces the different means

of assessing the value of capital expenditure

Chapter 11 – Inventory and pricing decisions

Manufacturing businesses in particular are very concerned to retain the right amount of stock, or inventory They do not want to tie too much cash up in the purchase and holding of stocks of goods or components, but nor do they want to run the risk of not being able to fulfil an order from a customer because they do

not have the stock or cannot get it quickly enough This chapter examines systems for maintaining

inventory and controlling its levels, and also looks at different approaches to pricing

Chapter 12 – Performance measurement and ev luation

This chapter is concerned with performance indicators, i.e the ways of assessing how a business, or a

division, or a particular product within a catalogue, is performing The central theme here is responsibility

accounting, the system of accounting that divides revenue and costs into area of personal responsibility in

order to monitor and assess the performance of each part of an organisation

Management Accounting

x

Answering multiple choice questions

The questions in your exam will each contain four possible answers You have to choose the option that best answers the question The three incorrect options are called distractors There is a skill in

answering MCQs quickly and correctly By practising MCQs you can develop this skill, giving you a better chance of passing the exam

You may wish to follow the approach outlined below, or you may prefer to adapt it

Step 1 Attempt each question – starting with the easier questions which will be those at the start of

the exam Read the question thoroughly You may prefer to work out the answer before looking at the options, or you may prefer to look at the options at the beginning Adopt the method that works best for you

Step 2 Read the four options and see if one matches your own answer Be careful with numerical

questions, as the distractors are designed to match answers that incorporate common errors Check that your calculation is correct Have you followed the requirement exactly? Have you included every stage of the calculation?

Step 3 You may find that none of the options matches your answer

• Re-read the question to ensure that you understand it and are answering the requirement

• Eliminate any obviously wrong answers

• Consider which of the remaining answers is the most likely to be correct and select the option

Step 4 If you are still unsure make a note and continue to the next question Some questions will

take you longer to answer than others Try to reduce the average time per question, to allow yourself to revisit problem questions at the end of the exam

Step 5 Revisit unanswered questions When you come back to a question after a break you often

find you are able to answer it correctly straight away If you are still unsure have a guess You

are not penalised for incorrect answers, so never leave a question unanswered!

LO1.1 Explain the historical development of management accounting 1 LO1.2 Analyse the key differences between financial, cost and management

LO1.3 Analyse the current influences on management accounting 1 LO1.4 Explain the range of theories that underpin management accounting and

LO1.5 Outline the core parts of management accounting systems and how they

LO1.6 Analyse the roles of management accountants in cross-functional teams 1 LO1.7 Identify and explain appropriate internal controls for management and

LO1.8 Explain how organisational behaviour can impact the creation of

LO1.9 Describe the increasing awareness of sustainability and its relationship to

LO2 Decision making

2.1.1 define the problem 2.1.2 identify the decision making criteria 2.1.3 develop alternatives

LO2.4 Analyse the challenges posed by differences between a project and an

LO2.5 Explain the impact of cash flows and risks on project decision making 2, 10

Management Accounting

xii

Chapter where covered LO3 Budgeting

LO3.1 Identify and analyse the human behavioural challenges to the budgeting

LO3.2 Explain the nature of budgets and the reasons that organisations use budgets 3

LO4 Cost behaviour

LO4.1 Apply the techniques to separate costs into their fixed and variable

LO5 Overhead costing – product and service costing

LO5.1 Explain three methods of departmental overhead allocation 5 LO5.2 Explain the concepts underpinning product costing in organisations 5 LO5.3 Develop different product costing statements involving production resource

LO6 Overhead costing – activity-based costing

LO6.1 Identify and apply the principles of activity-based costing to allocate

LO7 Process and job costing

LO7.1 Explain the differences between job and process costing techniques 7 LO7.2 Apply costing principles to job costing and process costing organisations 7

LO8 Standard costing

LO8.1 Explain how standard costing can be used to assist in cost control and

LO9 Variance analysis

LO9.1 Calculate and explain the causes of variances and associated corrective

LO10 Capital expenditure

LO10.1 Analyse capital expenditure decisions in organisations and apply related

LO10.2 Apply capital expenditure analysis to project planning and managing

LO11 Inventory, pricing decisions, and cost-volume-profit analysis

LO11.2 Apply the economic order quantity formula to determine order quantities

LO11.3 Establish and apply the appropriate approach for long-term pricing decisions 11 LO11.4 Apply the principles of cost-volume-profit analysis in organisations 4

Introduction xiii

Chapter where covered LO12 Performance measurement and evaluation

LO12.2 Explain the characteristics and purpose of performance measurement

LO12.3 Analyse the different types of financial performance measures and their

LO12.4 Describe the key characteristics of the Balanced Scorecard and its

advantages over traditional performance measurement systems 12

LO12.5 Outline the characteristics of reward systems and the circumstances in

Topic exam weightings

11 Inventory, pricing decisions, and cost-volume-profit analysis 8%

Management Accounting

xiv

1 The management accounting function

2 Financial accounting and management and cost accounting

3 Planning, control and decision-making

4 Information

5 Presentation of information to management

6 Management accounting systems

7 Design of management accounting systems

8 Developments in management accounting

9 Sustainability and management accounting

Conceptual issues and behavioural implications LO1

Explain the historical development of management accounting LO1.1

Analyse the key differences between financial, cost and management accounting LO1.2

Analyse the current influences on management accounting LO1.3

Explain the range of theories that underpin management accounting and how they

have an influence on practice

LO1.4

Outline the core parts of management accounting systems and how they enable

strategic management

LO1.5 Analyse the roles of management accountants in cross-functional teams LO1.6

Explain how organisational behaviour can impact the creation of organisational

Apply the steps in the decision making process LO2.1

identify the decision making criteria LO 2.1.2

Describe how management accounting creates value LO12.1

Management Accounting

2

This chapter provides an introduction to Management Accounting

We commence this first chapter by looking at the role of the management accounting function

We then examine the differences between management accounting and financial accounting and introducing

This chapter discusses the limitations of some of the traditional methods of management accounting, and

considers how recent developments in management accounting attempt to overcome these

limitations

Finally we examine the management accountant’s role in the creation of organisational value and the relationship between sustainability and management accounting

1: The nature and purpose of management accounting 3

Before you begin

If you have studied these topics before, you may wonder whether you need to study this chapter in full If this is the case, please attempt the questions below, which cover some of the key subjects in the area

If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered

There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual

1 What are the differences between financial accounts and management accounts? (Section 2.2)

2 What are the differences between cost accounting and management accounting? (Section 2.3)

3 Explain the link between an organisation's objectives and its strategy (Section 3.2)

4 Identify steps involved in the decision making process (Section 3.6.1)

5 What are the three types of management activity identified by Anthony (Section 3.7)

(Management Control Systems, 1972)?

6 What are the basic elements of a management control system? (Section 3.8)

7 What is the difference between data and information? (Section 4.1)

10 What are the risks of using traditional management accounting methods? (Section 6.3)

11 What are the components of a management accounting system? (Section 6.2/7.1)

13 Define and explain Total Quality Management (TQM) (Section 8.2)

1.1 Role of the management accounting function

The management accounting function exists to provide information to decision-makers, and to provide advice based on information that is provided The information provided by management accounting covers

all areas of strategy and operations, and includes information to assist with planning, control and other decision-making by management

The role of the management accountant today is more concerned with providing complex analysis and information to support business management than with providing routine reports, since much routine

work is now computerised Developments in technology have also made it easier to provide accounting information to non-financial managers At the same time the areas covered by management accounting have extended and broadened to include strategic information and non-financial information, and information to support risk management Developments in technology have also made it easier to provide accounting information to non-financial managers

1.1.1 The development of management accounting information

In the 1950s Simons identified three attributes of what could by now be called management accounting information:

• It should be useful for scorekeeping – to see how well the organisation is doing overall and to

monitor performance

• It should be attention-directing – to indicate problem areas that need to be investigated

• It should be useful for problem-solving – to provide a means of evaluating alternative responses to

the situations in which the organisation finds itself

Management accounting information is therefore used by managers for a number of purposes:

• To make decisions

• To plan for the future Managers have to plan and they need information to do this Much of this is

provided by management accounting systems

• To monitor the performance of the business Managers need to know what they want the business to achieve (targets or standards) and what the business is actually achieving

• To measure profits and put a value on inventory

• To implement processes and practices that focus on effective and efficient use of organisational resources to support managers to enhance customer and stakeholder value (IFAC 2002)

1.2 Role of the management accountant in cross-functional teams

In some organisations, the cost and management accounting function may be organised as a functional section or department within the organisation However, because management accountants provide information to other managers, it has become fairly common to include management accountants within cross-functional teams, or to assign them to work with non-accounting functions A cross-functional team is

LO

1.6

1: The nature and purpose of management accounting 5

a small group of individuals, with different expertise, taken from many different parts and levels of an organisation, which comes together to work towards a common purpose or goal The size of cross-functional team will vary according to the scale and complexity of the project

Cross-functional teams are typically formed on the assumption that a small group is better able to accomplish a particular task than either individuals acting alone or in a large, permanently structured group Benefits of cross-functional teams include:

• improved coordination and integration of systems or activities

• problem-solving across traditional functional or organisational boundaries

• facilitate innovation and product/ service development

In addition to contributing their technical expertise as accounting and finance experts and their functional expertise as information providers, management accountants have a key role to play in helping maximise the potential of a cross-functional team by:

• providing, collecting and assessing critical team information;

• helping establish goals and set priorities;

• assisting with problem-solving and decision-making, through the application of decision-making models and other techniques

• ensuring the team maintains an organisation-wide perspective

1.3 Defining management objectives of the accounting function

The objectives of the management accounting function within an organisation should depend on the information needs of the ‘internal customers’ – the managers who need information to help them to run the business The overall objective should be the provision of a quality service, but this broad objective can

be analysed into a number of sub-objectives

Sub-objective Detail

The provision of good information

This requires supplying information that fulfils the following criteria Information must

be relevant to the needs of users This involves identifying the users of information

and the reasons why they need it Information can only ever be relevant if it has a purpose and a use

Information should be reliable It should be sufficiently accurate for its purpose For

example it should be free from material error and should not be taken from an unreliable source Unless information is reliable, management will not have sufficient confidence to use it

Information should be timely, which means that it should be provided in time for the

purpose for which it is intended Information has no value if it is provided too late

Some information, such as information provided for control purposes, may lose value with time, so that it is better to provide the information sooner rather than later

Information should be clear, comprehensible and appropriately communicated, since it will lose its value if it is not clearly communicated to the

user in a suitable format and through a suitable medium A large amount of management accounting information should be accessible immediately and on-line to authorised managers

The provision of a value-for-money service

The costs of management accounting should be justified by the benefits that the

function provides to the organisation, and the level of service and the quality of information provided

The availability of informed personnel

Users will expect management accounting staff to be available to answer queries and resolve problems as and when required

Flexibility The management accounting function should be flexible in its response to user

requests for information and reports

Management Accounting

6

1.4 Management accounting function - Establishing activities

Once the objectives have been defined, the activities that the function should carry out to achieve its objectives must be established This is why it is necessary to answer the question:

“What information do we want, or might we want?”

The specific information that a management accounting system is required to provide (and the timing or accessibility of this information) will vary between organisations, according to factors such as the nature of their business and their size The management accounting function should be organised and staffed so that it

is able to provide the information expected from it

A follow-up question is:

“What type and size of function do we need to provide this information, and what will it cost?”

Management, as users of information, should therefore understand what information they are getting, and what it is costing to get it

1.5 Management accounting function - Identifying measures

The performance of the management accounting function should be measured according to its objectives

and its specified activities Suitable specific performance measures might be as follows:

(a) Measures relating to the quality of the information provided Quality measures may be

based on the judgement of users, such as opinions about whether the information provided is useful, whether it is timely or provided too late to be of much use, and whether it is reliable

(b) Measures relating to value for money The cost of the function should be measurable, and it

may be possible to compare the cost with other information provision services within the organisation or in different organisations The benefits are not so easy to assess, but management need to be satisfied that they are getting value for money

(c) Measures relating to the availability of accounting staff to assist management, such as the amount of time the accounting staff spend with managers in other functions, and the speed of their

response to requests for information, advice or assistance

(d) Measures relating to flexibility, such as number of ad-hoc reports issued within pre-set time

limit

(e) Ratings provided from user satisfaction surveys would provide extremely useful measures of

performance ‘Users’ are the ‘internal customers’ for the management information

2 Financial accounting and management and cost

accounting Section overview

• Financial accounting systems ensure that the assets and liabilities of a business are properly accounted for, and provide information about profits and so on to shareholders and to other interested parties

• Management accounting systems provide information specifically for the use of managers within an organisation

• Cost accounting is part of management accounting Cost accounting provides a bank of data for the management accountant to use

1: The nature and purpose of management accounting 7

2.1 Financial accounts and management accounts

Financial accounting systems ensure that the assets and liabilities of a business are properly accounted

for They are used to provide information to shareholders and other interested parties in the form of

(published) financial statements Management accounting systems provide information specifically for

the use of managers within an organisation

Management information provides a common source from which information for two groups of people is drawn

(a) Financial accounts are prepared for individuals external to an organisation: for example

shareholders, customers, suppliers, regulatory authorities, employees

(b) Management accounts are prepared for internal use by managers of the organisation

Much of the data used to prepare financial accounts and management accounts are the same but differences between the financial accounts and the management accounts arise because the data is analysed differently

In addition, management accounting systems draw on a wider range of data, including non-financial data, data from external sources, and data relating to the future

2.2 Financial accounts versus management accounts

Financial accounts Management accounts

Financial accounts detail the performance of an organisation over a defined period and the state of affairs

at the end of that period

Management accounts are used to aid management record, plan and control the organisation's activities and

to help the decision-making process

Limited liability companies must, by law, prepare financial accounts

There is no legal requirement to prepare management accounts

The format of published financial accounts is determined

by local law, by International Accounting Standards and International Financial Reporting Standards In principle the accounts of different organisations can therefore be easily compared

The format of management accounts is entirely at management discretion: no strict rules govern the way they are prepared or presented Each organisation can devise its own management accounting system and format of reports

Financial accounts concentrate on the business as a whole, aggregating revenues and costs from different operations, and are an end in themselves

Management accounts can focus on specific areas of an organisation's activities Information may be produced

to aid a decision rather than as the end product of a decision

Most financial accounting information is of a monetary nature

Management accounts incorporate non-monetary measures Management may need to know, for example, tons of aluminium produced, monthly machine hours,

or miles travelled by sales staff

Financial accounts present an essentially historic picture

of past operations

Management accounts are both an historical record and

a future planning tool

Question 1: Management accounts

Which of the following statements about management accounts is/are true?

I There is a legal requirement to prepare management accounts

II The format of management accounts is largely determined by law III They serve as a future planning tool and are not used as a historical record

A I and II

B II and III

C III only

D none of the statements are correct

(The answer is at the end of the chapter)

LO

1.2

Management Accounting

8

2.3 Cost accounts

The terms ‘cost accounting’ and ‘management accounting’ are often used interchangeably It is not

correct to do so Cost accounting is part of management accounting Cost accounting provides source data for the management accountant to use

Cost accounting is concerned with the following:

• Preparing statements (e.g the construction of budgets and costing statements)

• Cost data collection

• Measuring inventory costs, and the costs and profitability of products and services

Management accounting on the other hand is concerned with the following:

• Interpretation and assessment of financial and accounting data, and communicating it as information

to users, for example as financial targets or performance measurements

2.3.1 Aims of cost accounts

Cost accounting is used to measure:

(a) The cost of goods produced or services provided

(b) The cost of a department or business unit

(c) The revenues earned from a product, service, department or business unit, or the organisation in

total

(d) The profitability of a product, a service, a department, or the organisation in total

(e) Selling prices with some regard for the costs of sale

(f) The value of inventories of goods (raw materials, work in progress, finished goods) that are still

held in store at the end of a period, thereby aiding the preparation of a statement of financial position of the company's assets and liabilities

(g) Future costs of goods and services, based on given assumptions about what will happen in the

future Costing is an integral part of budgeting, because budgets are detailed financial plans

(h) How actual costs compare with budgeted costs If an organisation plans for its revenues and

costs to be a certain amount, but they actually turn out differently, the differences can be measured and reported Management can use these reports as a guide to whether corrective action, or 'control' action, is needed to sort out aproblem revealed by these differences between budgeted and actual results This system of control is often referred to as budgetary control or variance analysis

It would be wrong to suppose that cost accounting systems are restricted to manufacturing operations,

although they are probably more fully developed in this area Service industries, government departments and non-profit making organisations all make use of cost accounting information

Within a manufacturing organisation, the cost accounting system should be applied not only to

manufacturing but also to administration, selling and distribution, research and development

and all other departments and functions

1: The nature and purpose of management accounting 9

3 Planning, control and decision-making

Section overview

• Information for management is likely to be used for planning, control and decision making

• Long-term planning, also known as corporate or strategic planning, involves selecting appropriate

strategies so as to prepare a long-term plan to attain the organisation’s objectives

• Robert N Anthony (Management Control Systems, 1972) has categorised management activities and decision-making into strategic planning, management control and operational control

• A management control system is a system which measures and corrects the performance of

activities of subordinates

• Information within an organisation can be analysed into the three levels of Anthony's hierarchy:

strategic; tactical; and operational information

Planning forces management to think ahead systematically in both the short term and the long term An

organisation should never be surprised by developments that occur gradually over an extended period of

time because the organisation should have implemented a planning process Planning involves the

following:

• Establishing overall objectives

• Selecting appropriate strategies to achieve those objectives

• Setting targets for each strategy

• Formulating detailed plans for achieving those targets

When expected changes are gradual, planning occurs in a fairly stable environment, and routine budget planning procedures may be used

3.2 Objectives of organisations

Definitions

A vision is a succinct statement of an organisation’s future aspirations

A mission statement sets out an organisation’s fundamental purpose

An objective is the aim or goal of an organisation

A strategy is a possible course of action that might enable an organisation to achieve its objectives

Organisations often start by setting out their vision This is a succinct statement of the organisation’s future aspirations e.g Microsoft’s vision is “to help people and businesses throughout the world realise their full potential”

A mission statement is then created, setting out the organisation’s fundamental purpose and including references to its strategy, standards of behaviour and values

The mission sets the overall direction of the organisation and the organisation’s goals and more detailed objectives then follow from this The strategies identified as a result of the planning process are designed to achieve these objectives

Note that in practice, the terms objective, goal and aim are often used interchangeably

LOs

1.7 1.8

It is often assumed that the main objective of profit making organisations is to maximise profits A

secondary objective of profit making organisations might be growth, for example by increasing the output and sales of its goods/services Instead of maximising profit, an organisation may seek to maximise the wealth of its shareholders Unfortunately, the aim of profit maximisation may encourage short-termism and excessive risk-taking by management in order to increase profits ‘now’, regardless of the consequences of their decisions for the longer term

The main objective of non-profit making organisations is usually to provide goods and services A

secondary objective of non-profit making organisations might be to minimise the costs involved in providing the goods/services

In conclusion, the stated objectives of an organisation might include one or more of the following:

• Maximise profits

• Maximise revenue

• Maximise shareholder value

• Increase market share

• Minimise costs

Management accounting techniques are often based on one of these assumptions when recommending a course of action to management Remember however that decisions have consequences for the longer term as well as the short term, and decisions to maximise profit may have high associated risks

3.3 Long-term strategic planning

Management accounting contributes to long-term strategic planning Long-term planning, also known as corporate planning, involves selecting appropriate strategies to attain the organisational objective, and

integrating these strategies into an overall long-term corporate plan or business plan

The time span covered by a long-term plan depends on the organisation, the industry in which it operates and the particular environment involved Typical periods for a strategic business plan are 2, 5, 7

or 10 years although longer planning periods may be used

Long-term strategic planning is a detailed, lengthy process, consisting of four basic elements:

• assess the organisation and its environment

• determine the corporate objectives

• devise strategies for achieving these objectives

• create a corporate plan The diagram below provides an overview of the process and shows the link between short-term and long-term planning

3.4 Short-term tactical planning

The corporate or strategic plan serves as the long-term framework for the organisation as a whole, but for operational purposes it is necessary to convert the corporate (strategic) plan into a series of short- term plans, usually covering one year, which relate to business units, functions or departments

The annual process of short-term planning should be seen as stages in the progressive fulfilment of the corporate plan as each short-term plan steers the organisation towards its long-term objectives It is therefore vital that, to obtain the maximum advantage from short-term planning, some form of long-term plan exists

The management accounting function supports the short-term planning process, for example by providing information for setting targets and standards, and helping to establish the assumptions on which the short-term plan is based, such as growth rates, costs, efficiency savings, cost inflation, and so on

1: The nature and purpose of management accounting 11

As well as providing information for planning, management accounting also provides information to assist

with monitoring and control There are two stages in the control process

(a) The planned performance of the organisation (set out as targets or expectations in the detailed

operational plans) is compared with the actual performance of the organisation on a regular and continuous basis Significant deviations from the plans can then be identified and appropriate corrective action can be taken where possible

(b) The corporate (strategic) plan is reviewed in the light of the comparisons made and any changes

in the parameters on which the plan was based, (such as new competitors, government instructions and so on), to assess whether the objectives of the plan can be achieved The plan is modified as necessary before any serious damage to the organisation's future success occurs

Effective control is not practical without planning, and planning without control is pointless, because targets and objectives will not be achieved without monitoring and control measures when needed

An established organisation should have a system of management reporting that produces control information in a specified format at regular intervals

Smaller organisations may rely on informal information flows or ad-hoc reports being produced as required

A function of management is decision-making Managers at all levels within an organisation make

decisions Decisions may be taken within the routine planning and control processes In addition, there are many other decisions, both long term and short term, and routine and occasional, that managers have to

make at all levels within the management hierarchy Decision making always involves a choice between

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alternative courses of action and it is the role of the management accountant to provide information so

that management can reach an informed decision For example, when comparing actual results against a target when actual results are poor, management needs to decide whether corrective action should be taken or not A decision to take corrective action may involve considering the different ways in which control may be applied, and choosing the preferred course of action from the available alternatives Budgeting decisions often involve making a choice between different ways of using the organisation’s scarce resources (such as cash, equipment and manpower)

Many other decisions arise that face management

It is therefore vital that management accountants understand the decision-making process so that they can supply the appropriate type of information

decision-• Define the problem A decision involves making a choice between two or more courses of

action A decision is made only when a problem is recognised If a manager is unaware that a problem exists, he will not feel the need to make any decision A number of planning problems, control problems and other decision problems have been set out above

• Identify the decision-making criteria Having recognised that there is a problem for which a

decision must be made, the next step is to recognise the decision-making criteria What are we trying to achieve? In the planning process, the criteria may be to maximise profits over the next 12 months, within the limitations of available resources and subject to limitations on the risks that should be taken For a planning decision, the decision-making criterion may be to take control measures if possible to enable the organisation to achieve its planning targets More simply, a decision-making criterion for control decisions may be to reduce excessive spending In management accounting, the decision-making criterion is often to maximise profitability, but as

1: The nature and purpose of management accounting 13

explained earlier, this is not necessarily appropriate, without giving consideration to the longer term and risk

• Develop alternatives Having recognised a problem and recognised what the organisation is

trying to achieve in resolving the problem, the next step is to recognise different ways in which the problem might be resolved in a way that is consistent with the decision-making criteria For a simple decision, there may be just two alternatives – “Do it”, or “Don’t do it.” However there may be a number of different alternatives, and the process of developing alternatives involves:

- recognising the range of possible options and

- from these selecting a small number of alternatives for evaluation

• Analyse the alternatives Each of the alternatives should be analysed and evaluated If the

decision-making criterion is to maximise short-term profit, each alternative should be evaluated financially, to estimate the profit that would result from choosing that alternative Although a management decision is often based on financial considerations, other non-financial factors may also

be considered if they are a part of the decision-making criteria

• Select an alternative A decision involves selecting one alternative from the two or more that

have been analysed The recommended choice should be the course of action that resolves the problem in a way that best satisfies the decision-making criteria

These steps in the decision-making process should be apparent in later chapters, when specific management accounting techniques for analysis are described

3.7 Anthony's (1972) view of management activity

Robert N Anthony (Management Control Systems, 1972) argued that the activities of planning, control and decision making should not be separated since all managers make planning and control decisions

He divided management activities into three levels: strategic planning, management control and operational control

(a) Strategic planning is 'the process of deciding on objectives of the organisation, on changes in

these objectives, on the resources required to attain these objectives, and on the policies that are to govern the acquisition, use and disposition of these resources'

(b) Management control is 'the process by which managers assure that resources are obtained and

used effectively and efficiently in the accomplishment of the organisation's objectives'

(c) Operational control is 'the process of assuring that specific tasks are carried out effectively and

efficiently'

A management accounting system provides information to management for strategic planning and management control, and for some aspects of operational control

3.7.1 Strategic planning

Strategic plans are those which set or change the objectives, or strategic targets, of an

organisation They would include such matters as the selection of products and markets, the required levels

of company profitability, the purchase and disposal of subsidiary companies or major non-current assets and

so on

3.7.2 Management control

While strategic planning is concerned with setting objectives and strategic targets, management control

is concerned with decisions about the efficient and effective use of an organisation's resources to

achieve these objectives or targets

(a) While strategic planning is concerned with setting objectives and strategic targets, management control is concerned with the efficient and effective use of an organisation’s resources (manpower, materials, machines and money)to achieve these objectives or targets

(b) Efficiency in the use of resources to achieve optimum output from the input resources used It

relates to the combinations of labour, land and capital (for example, how much production work should be automated) and to the productivity of labour, or material usage

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(a) Senior management may decide that the company should increase sales by five per cent per annum

for at least five years – a strategic plan

(b) The sales director and senior sales managers will make plans to increase sales by five per cent in the next year, with some provisional planning for future years This involves planning direct sales resources, advertising, sales promotion and so on Sales quotas are assigned to each sales territory –

a tactical plan (management control)

(c) The manager of a sales territory specifies the weekly sales targets for each sales representative This

is operational planning Individuals are given tasks which they are expected to achieve

Although we have used an example of selling to describe operational control, it is important to remember that this level of planning occurs in all aspects of an organisation's activities, even non-standard activities, such as repair work or answering customer complaints

The scheduling of unexpected or ad-hoc work must be done at short notice, which is a feature of much

operational planning In the repairs department, for example, routine preventive maintenance can be

scheduled, but breakdowns occur unexpectedly and unplanned repair work must be done 'on the spot' by a repairs department supervisor

3.8 Management control systems

A management control system is a system which measures and corrects the performance of activities

of subordinates in order to make sure that the objectives of the organisation are being met and the plans devised to attain them are being carried out

The basic elements of a management control system are as follows:

• Planning: deciding what to do and identifying the desired results

• Recording the plan which should incorporate standards of efficiency or targets

• Carrying out the plan and measuring actual results achieved

• Comparing actual results against the plans

• Evaluating the comparison, and deciding whether further action is necessary

• Where corrective action is necessary, this should be implemented

Information to assist with this process is needed for recording the plan, comparing actual results against the plan and evaluating the comparison The information is often financial or partially financial in nature,

although it will include non-financial information too This is why management accounting, by providing information of both a financial and non-financial nature, should be an integral part of a management control system

3.9 Types of information

Information within an organisation can be analysed into the three levels assumed in Anthony's hierarchy:

strategic; tactical; and operational information

3.9.1 Strategic information

Strategic information is used by senior managers to plan the objectives of their organisation, and to

assess whether the objectives are being met in practice Examples of such information include overall

profitability, the profitability of different segments of the business, capital equipment needs and so on

1: The nature and purpose of management accounting 15

Strategic information therefore has the following features:

• It is derived from both internal and external sources

• It is summarised at a high level, and is directed at senior management

• It is relevant to the long term

• It deals with the whole organisation

• It is often prepared on an ad-hoc basis

• It is both quantitative and qualitative

• It cannot provide complete certainty, given that the future cannot be predicted

3.9.2 Tactical information

Tactical information is used by middle management to decide how the resources of the business

should be employed, and to monitor how they are being and have been employed Such information

includes productivity measurements (output per direct labour hour or per machine hour), budgetary control or variance analysis reports, and cash flow forecasts

Tactical information has the following features:

• It is primarily generated internally

• It is summarised at a lower level and is directed at middle management as well as more senior

management

• It is relevant to the short and medium term

• It describes or analyses activities or departments

• It is prepared routinely and regularly

• It is based largely on quantitative measures

3.9.3 Operational information

Operational information is used by 'front-line' managers, such as foremen and supervisors, to

ensure that specific tasks are planned and carried out properly In the payroll office, for example, information at this level will relate to day-rate labour and will include the hours worked each week by each employee, the rate of pay per hour, details of deductions, and for the purpose of wages analysis, details of the time each person spent on individual jobs during the week In this example, the information is required weekly, but more urgent operational information, such as the amount of raw materials being input to a production process, may be required daily, hourly, or in the case of automated production, second by second

Operational information has the following features:

• It is derived almost entirely from internal sources

• It is highly detailed, being the processing of raw data

• It relates to the immediate term, and is prepared constantly, or very frequently

• It is task-specific and largely quantitative

Section overview

• Data is the raw material for data processing Data relates to facts, events and transactions

• Information is data that has been processed so as to be meaningful

• Good information should be relevant, complete, accurate and clear, it should inspire confidence, it should be appropriately communicated, its volume should be manageable, it should be timely to produce and its cost should be less than the benefits it provides

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4.1 Data and information

Definitions Data is the raw material for data processing Data relate to facts, events and transactions

Information is data that has been processed so as to be meaningful to the person who receives it

Information is anything that is communicated

Information is sometimes referred to as processed data The terms 'information' and 'data' are often used

interchangeably It is important to understand the difference between these two terms

For example, researchers who conduct market research surveys might ask members of the public to

complete questionnaires about a product or a service These completed questionnaires are data; they are processed and analysed in order to prepare a report on the survey This resulting report is information

and may be used by management for decision-making purposes

Management accounting systems provide information, and the quality of the management accounting system depends on the quality of the information that it provides

4.2 Qualities of good information

Good information should be relevant, complete, accurate, clear, it should inspire confidence, it should be appropriately communicated, its volume should be manageable, it should be timely and its cost to produce should be less than the benefits it provides

Let us look at those qualities in more detail

(a) Relevance Information should have a purpose; otherwise there is unlikely to be sufficient benefit

from processing data to justify the cost of providing it Information must be relevant to the purpose for which a manager wants to use it In practice, far too many reports fail to 'keep to the point' and contain irrelevant paragraphs which only distract and consume unnecessary time of the managers reading them

(b) Completeness Information users should have all the information they need to do the job properly

If they do not have a complete picture of the situation, they might well make bad decisions

(c) Reliability Information should be reliable This means that it should be sufficiently accurate for

its purpose Using incorrect information could have serious and damaging consequences However, there is no need to go into unnecessary detail Where there is some uncertainty about the accuracy

or reliability, for example when making forecasts about the future, the nature of the uncertainty should be fully understood, so that it is used and treated with caution

(d) Clarity Information must be clear to the user If the user does not understand it properly they will

not be able to use it properly Lack of clarity is one of the causes of a breakdown in communication

It is therefore important to choose the most appropriate presentation medium or channel of communication

(e) Confidence Information must be trusted by the managers who are expected to use it However

not all information is certain Some information has to be certain, especially operating information, for example, related to a production process Strategic information, especially relating to the environment, is uncertain However, if the assumptions underlying it are clearly stated, this might enhance the confidence with which the information is perceived Having confidence in information depends on other qualities of the information – reliability, relevance and clarity

(f) Communication Within any organisation, individuals are given the authority to do certain tasks,

and they must be given the information they need to do them For example, an office manager might

be made responsible for controlling expenditure in his office, and given a budget expenditure limit for the year As the year progresses, they might try to keep expenditure in check but unless they are told throughout the year what current total expenditure is to date, they will find it difficult to judge whether they are keeping within budget or not

1: The nature and purpose of management accounting 17

(g) Volume There are physical and mental limitations to what a person can read, absorb and

understand properly before taking action An inappropriate amount of information, even if it is all

relevant, cannot be handled Reports to management must therefore be clear and concise and in

many systems, control action works basically on the 'exception' principle, with reports only being produced if there is an issue that needs to be brought to management attention or investigated further

(h) Timing Information should be timely, If it is not available until after a decision is made, it will be

useful only for comparisons and longer-term control, and may serve no purpose even then

Information prepared too frequently can be a serious disadvantage If, for example, a decision is taken at a monthly meeting about a certain aspect of a company's operations, information to make the decision is only required once a month, and weekly reports would be a time-consuming waste of effort

(i) Channel of communication Information should be communicated or should be accessible

through appropriate channels of communication There are occasions when using one particular method of communication will be better than others Some internal memoranda may be better sent

by 'electronic mail' Some information is best communicated informally by telephone or word-of-mouth, whereas other information ought to be formally communicated in writing or figures Electronic methods of data transmission, data storage and data access are integral parts of most management accounting systems

(j) Cost Information should have some value, otherwise it would not be worth the cost of collecting

and filing it The benefits obtainable from the information must also exceed the costs of acquiring it, and whenever management is trying to decide whether or not to produce information for a

particular purpose, for example, whether to computerise an operation or to build a financial planning model, a cost/benefit analysis ought to be undertaken

Question 2: Value of information

Managers receive a monthly performance report indicating that costs in the previous month were 15%

more than expected Which one of the following would be the most appropriate response by management

to this information?

A Control action should be taken to deal with the problem and reduce costs by 15%

B The reasons for the overspend may be controllable; therefore they should be investigated with a view to reducing the overspend as much as possible

C The reasons for the overspend may be controllable or uncontrollable; therefore they should be investigated with a view either to reducing the overspend as much as possible or revising forecasts

or targets

D The overspend indicates that planning targets will not be met, and forecasts should be revised

(The answer is at the end of the chapter)

4.3 Why is information important?

Information is important for management because it provides awareness and understanding of an issue By helping management to make better-informed decisions, information should contribute significantly to better-quality decision-making Consider the following problems and what management needs to solve these problems

(a) A company wishes to launch a new product The company's pricing policy is to charge cost plus 20% What should the price of the product be?

(b) An organisation's widget-making machine has a fault The organisation has to decide whether to repair the machine, buy a new machine or hire a machine What does the organisation do if its aim is

to control costs?

(c) A company is considering offering a discount of 2% to those customers who pay an invoice within seven days of the invoice date and a discount of 1% to those customers who pay an invoice within eight to fourteen days of the invoice date How much will this discount offer cost the company?

In solving these and a wide variety of other problems, management needs information

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(a) In problem (a) above, management would need information about the cost of the new product

(b) Faced with problem (b), management would need information on the cost of repairing, buying and hiring the machine

(c) To calculate the cost of the discount offer described in (c), information would be required about

current sales settlement patterns and expected changes to the pattern if discounts were

offered

The successful management of any organisation depends on information: organisations in the public sector,

such as hospitals and local authorities and other non-profit making organisations such as charities and clubs need information for decision making and for reporting the results of their activities just as multi-nationals

do For example, a local government authority needs to know what resources are being used to deliver services to residents A tennis club needs to know the cost of undertaking its various activities so that it can determine the amount of annual subscription it should charge its members

4.4 What type of information is needed?

Managers require a mixture of financial and non-financial information

Worked Example: Financial and non-financial information

Assume that the management of ABC Co have decided to provide a cafeteria for their employees

(a) The financial information required by management might include cafeteria staff costs, costs of

subsidising meals, capital costs, costs of heat and light and so on

(b) The non-financial information might include comment on the effect on employee morale of the

provision of cafeteria facilities, details of the number of meals served each day, meter readings for gas and electricity and attendance records for cafeteria employees

ABC Co could now combine financial and non-financial information to calculate the average cost

to the company of each meal served, thereby enabling them to predict total costs depending on the number

of employees in the work force

4.4.1 Non-financial information

Management accounting is mainly concerned with the provision of financial information to aid planning, control and decision making However, the management accountant cannot ignore non-financial

influences and should qualify the information provided with non-financial matters as appropriate

Non-financial information may relate to matters such as quality, speed, flexibility, creativity, motivation, customer satisfaction and competitive advantage

5 Presentation of information to management

Section overview

• Information may be presented to management in the form of a report Where reports are prepared, they should be presented in a suitable format The main features of a report are: TITLE; TO; FROM; DATE; and SUBJECT

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financial details, and need to have the information presented to them in a structured way Management accountants should therefore be skilled in the writing and presentation of formal reports

5.1.1 Main features of a report

Most reports are usually given a heading to show that it is a report

It is vital that the intended recipients of a report are clearly identified For example, if you are writing

a report for Joe Rafter, it should be clearly stated at the head of the report

If the recipients of the report have any comments or queries, it is important that they know who to contact

We have already mentioned that information should be communicated at the most appropriate time

It is also important to show this timeliness by giving your report a date

What is the report about? Managers are likely to receive a great number of reports that they need

to review It is useful to know what a report is about before you read it! A report should therefore have a clear heading or title

• SUB-HEADINGS

Unless they are very brief, reports should be divided into sections, each with a clear sub-heading

The first heading may be an introduction (explaining the purpose of the report), followed by an executive summary (setting out both the purpose and the findings of the report) The final sub-heading may be for a summary, conclusion or recommendation

6.1 The development of management accounting

Management accounting has developed gradually over time, and has changed in nature Originally, cost accounting systems were used to record costs and report costs to management in manufacturing industries,

so that cost control and profitability could be managed better This was at a time when manufacturing costs were a large proportion of total costs, and a large proportion of total manufacturing costs consisted of direct materials and direct labour costs Manufacturing costs were ‘driven’ by direct labour hours worked

or machine hours operated

Cost and management accounting information was also used for planning, particularly for annual budgeting Budgetary control reports were produced regularly, typically every month, to inform management about actual performance and how this compared against the budget targets

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information to management for decision-making, through the application of concepts and techniques such as relevant costs and discounted cash flow analysis

More recently, management accounting systems have developed quite rapidly, in a variety of different ways Service industries and non-manufacturing activities became more important for many companies, and management accounting systems were developed within service industries, and also for activities such as marketing and distribution

Management accounting techniques have also been developed to analyse costs in different ways, particularly overhead costs, and techniques such as activity based costing and customer profitability analysis have emerged

The importance of information for strategic planning has also been recognised, and management accounting has expanded from the provision of information at the management control level to information provision for strategic planning and control Management accounting systems must now gather non-financial as well as financial information, and information from external as well as internal sources

There have also been changes in manufacturing techniques, such as Total Quality Management and Time (JIT) production As manufacturing management has changed, the information to support management – management accounting – has also had to change so that it remains relevant and useful

Just-in-The expansion and increased sophistication of many management accounting systems would not have been possible without technological change, and enormous improvements in the capabilities of IT systems

6.2 What is a management accounting system (MAS)?

A management accounting system (MAS) can be defined by its tangible components:

(a) People with accounting knowledge (management accountants)

(b) The technology they use

(c) Paper or computer records of financial transactions

(d) The cost accounting system on which it is based

(e) The management accounting techniques that are used to provide information: there are a wide

variety of simple and complex mathematical techniques for analysing data

(f) The reports that are produced by the system, or the nature of the information that is accessible

on-line

(h) The users of the information – the managers for whom the reports are prepared

In summary, a management accounting system is an information system that produces information required by managers to manage resources and create value for customers and shareholders

6.3 Risks in using management accounting systems

In practice, management accounting systems may not provide information of a sufficient quality, and this will affect the quality of decision-making within the organisation Typical weaknesses in some management accounting systems are explained briefly below

6.3.1 Excessive emphasis on financial measures

Management information may be unduly focused on financial costs and short-term profits that can

easily be measured Non-financial information may be overlooked At a strategic level, for example, the objective of a company may be to increase profitability, but in order to grow the business and its profits, it may be necessary to consider factors such as quality, flexibility, customer satisfaction, employee skills and so

on

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6.3.2 Internal orientation

Management accounting systems may use data and information from internal sources, and fail to make use

of external sources A business needs an external orientation It operates in a competitive and regulated

environment, and management cannot ignore what is happening in the business environment There should

be some focus on customers and competitors, suppliers and perhaps other stakeholders

6.3.3 Lack of goal congruence

Management accounting systems may encourage a lack of goal congruence within the organisation, i.e

managers may be encouraged to concentrate on their own part of the company operations, without regard

for other aspects of the business Managers may pursue targets that are in their departmental interests but not in the best interests of the organisation as a whole Often this may reflect poor overall design of the system, with potential conflicts between short and long-term objectives being

ignored and incompatible targets being set for different parts of the organisation

6.3.4 Lack of future perspective

The management accounting systems may highlight historical financial costs and report on past

performance There is a requirement to provide information for management to make decisions about the future Financial information for decision-making should consist of relevant costs (which we will discuss below) However, management accounting systems may fail to provide relevant cost information for management

6.3.5 Failure to adapt performance measures to changing circumstances

A particular problem with management accounting systems is that they may remain ‘stuck’ in traditional methods of reporting and analysis, when new approaches may be much more appropriate and valuable for management

6.4 Risks of traditional management accounting methods

A serious risk with using traditional management accounting methods and reports is that the information they provide may be inappropriate for management’s changing needs Changes in the business environment call for changes in information systems for management Changes in the business environment have included:

• Globalisation and increased competition

• Information technology changes resulting in changes in production methods and information flows

• Changes in organisation structures, such as internal reorganisations and external mergers

• Increasing awareness of sustainability and environmental issues Traditional management accounting systems may be inadequate for advanced manufacturing technology and

a modern business environment that focuses on marketing, customer satisfaction, employee involvement and total quality (‘getting things right first time’)

In trying to improve profitability, management will often look for ways of reducing costs However, as we

will see later, the cost of a new product is substantially determined when it is being designed, not

at the time it goes into production The materials that will be used, the machines and labour required, are largely determined at the design stage In the car industry, 85 per cent of all future product costs are

determined during the design stage and by the end of the testing stage Target costing is a management accounting technique that draws attention to control of product costs at the design stage Traditional management accounting, however, continues to direct its attention to the production stage

Traditionally, management accounting systems have provided more information about direct costs of

operations than about indirect costs (overheads) However even in manufacturing industries, only a small proportion of 'direct costs' are genuinely controllable in the short term Controllable direct costs

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may be about 10% of total costs, whereas controllable overhead costs may be about three times as large There are techniques for analysing overhead costs more closely, such as activity based costing and customer profitability analysis, but traditional management accounting systems do not provide information

of this quality

6.4.3 Non-financial assets

Traditional management accounting measures do not deal with intangible assets, such as knowledge-based

assets Management information systems need to be able to provide information about the resources that drive value, how knowledge-based assets help the organisation to improve its strategic value and develop performance indicators that will help determine resource allocation and strategic

development

6.4.4 Customer costs and profitability

Many costs are driven by customers such as delivery costs, discounts, after-sales service and so on, but traditional cost and management accounting systems do not recognise this Companies may be

trading with certain customers at a loss but not realise it because costs are not analysed in a way that would reveal it

7 Design of management accounting systems

Section overview

• A management accounting system comprises people with accounting knowledge, technology, records, processes, mathematical techniques, reports and the users for whom those reports are prepared The key components of the system are: inputs, processes and outputs It is used for strategic decision making, performance measurement, operational control and costing

In this section we focus on the factors determining the design of management accounting systems, and assessing the adequacy of existing management accounting systems The most important factor is the output they should provide to meet the needs of management, with different output being used for various

decision-making purposes

7.1 Designing a management accounting system

The following factors should be considered when designing a management accounting system:

of detail and accuracy of output must be determined in each case, and also the speed or frequency with which the information should be provided or made available

Sources of input data A management accounting system should be capable of gathering the data that is

needed to provide the information This involves obtaining data from both internal and external sources It also involves specifying the methods that should

be used to obtain and store the data

Processing involved Decisions should be made about how the data will be processed to provide the

information, and how frequently it should be provided (for example, in monthly routine reports, continuously accessible online, or prepared in response to specific requests from management) Decisions should also be made about which methods or techniques of management accounting should be used to process the data

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Factor Detail

Response required A further, vitally important issue is how managers should be expected to respond

to the information provided This will depend to some extent on how the information is presented to them Ultimately the information is meant to result in decision making

A Management will be forced to rely more on external information

B Management will be forced to rely more on financial accounting statements

C None of the information will be used by management

D The quality of decision making will be poor

(The answer is at the end of the chapter)

7.2 Strategic, tactical and operational information

A management accounting system should be capable of providing information at a strategic, tactical (management control) and operational level for management

7.2.1 Strategic information

Definition Strategic Management Accounting is a form of management accounting in which emphasis is placed on

information which relates to factors external to the entity, as well as to non-financial information and

internally-generated information

Some examples of strategic information that may be provided by a management accounting system are

found in the table below

Item Comment

Competitors' costs What are they? How do they compare with ours? Can we beat them? Are competitors vulnerable because of their cost structure?

Financial effect of competitor response

Have sales fallen?

Product profitability

A company should want to know not just what profits or losses are being made by each of its products, but why one product is making good profits whereas another equally good product might be making a loss

Customer profitability

Some customers or groups of customers are worth more than others

Pricing decisions Accounting information can help to analyse how profits and cash flows will vary according

to price and prospective demand

Value of market share

A company ought to be aware of what it is worth to increase the market share of one of its products

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Item Comment

Capacity expansion

Should the company expand its capacity, and if so by how much? Should it diversify into a new area of operations, or a new market?

Brand values How much is it worth investing in a 'brand' which customers will choose over competitors'

brands?

Shareholder wealth

Future profitability determines the value of a business

Cash flow A loss-making company can survive if it has adequate cash resources, but a profitable

company cannot survive unless it has sufficient liquidity

7.2.2 Management control information

The information required for management control embraces the entire organisation It is provided for

budgeting and planning, monitoring and other decision-making purposes at a management control level

within the organisation The information is often quantitative, such as labour hours, quantities of materials consumed, volumes of sales and production, and is commonly expressed in money terms, but (as

indicated previously) tactical information as well as strategic information may include non-financial elements Examples of management control information might include profit forecasts, variance analysis reports, and productivity statistics

Some tactical information is prepared regularly, perhaps weekly, or monthly, in the form of regular

reports

7.2.3 Operational control information

Operational information is information which is needed for the conduct of day-to-day implementation of plans It will include much 'transaction data' such as data about customer orders,

purchase orders, cash receipts and payments

The amount of detail provided in information is likely to vary with the purpose for which it is needed

Operational information is likely to go into much more detail than management control information, which

in turn will be more detailed than strategic information Operational information, although quantitative, is

more often expressed in terms of units, hours, quantities of material and so on The extent to

which management accountants are involved in providing information at the operational level will depend

on the nature of the information and the responsibility structure within the organisation

7.3 Performance measurement in different sectors

An important aspect of management accounting systems is the provision of information about performance The nature of the performance measures used will depend largely on the nature of the organisation’s business and the type of industry in which it operates The information will be both financial and non-financial in nature

7.3.1 Performance measurement in the service sector

Management accounting information is provided for management in service industries, not just manufacturing industries The management accountant must take into account the characteristics of the service businesses, including the fact that (unlike manufacturing) production and consumption of services occur at the same time and there are no finished goods inventories Customer satisfaction may be difficult

to measure in service businesses, and there may also be problems with identifying which parts of the service the customer values most, and providing relevant information about meeting customer needs

In the service sector, performance evaluation (and information about performance) may have several dimensions:

• Flexibility

• Excellence

• Innovation

• Financial performance

1: The nature and purpose of management accounting 25

• Resource utilisation

• Competitiveness

7.3.2 Performance measurement in the not-for-profit sector

In the public sector /government, performance may be judged in terms of inputs and outputs, which tie into the idea of 'value for money', based on:

• Economy – obtaining suitable inputs at the lowest cost

• Efficiency – the process working as expected

• Effectiveness – achieving goals

Management accounting information in the not-for-profit sector may therefore focus on all three of these aspects of performance

8 Developments in management accounting

manufacturing methods are grouped around the concept of World-Class Manufacturing (WCM), which sets

as its objective achieving and sustaining competitive advantage in an environment of strategic cost reduction

We shall revisit these concepts of manufacturing management, and the associated management accounting techniques, in more detail later in the Study Manual

8.1 Just-in-time (JIT)

JIT encompasses a commitment to continuous improvement and the search for excellence in the

design and operation of the production management system Just-in-time manufacturing systems seek to eliminate waste and ‘get things right first time’ in production operations Waste is anything that incurs costs without adding value – holding inventories is one example of waste and JIT systems seek to minimise inventory holding To do this, materials must be supplied at exactly the time they are needed to meet production requirements, and production must be completed exactly at the time that output is needed to meet customer demand

Definitions Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as

they are required by a customer or for use, rather than for stock A JIT system is a 'pull' system, which responds to demand, in contrast to a 'push' system, in which stocks act as buffers between the different elements of the system, such as purchasing, production and sales

Just-in-time production is a system which is driven by demand for finished products whereby each

component on a production line is produced only when needed for the next stage

Just-in-time purchasing is a system in which material purchases are contracted so that the receipt and

usage of material, to the maximum extent possible, coincide

The implications of JIT for the management accounting systems is that they have to be reorganised to

include or highlight items that are seen as costs under JIT but are not included in traditional systems

Systems must highlight excessive inventory levels, machinery set ups and long lead times The

changes in organisation resulting from JIT, such as the regroupings of workings, will also result in changes in accounting systems to adjust to new demands and changed sources of information

JIT is considered in more detail in chapter 11

LOs

1.3

1.4

Management Accounting

26

8.2 Total Quality Management

Definition Total Quality Management (TQM) is a culture of management and operations, rather than a specific

technique The culture is one of achieving continuous improvements, no matter how small each individual improvement may be, so that customer needs and expectations are met with increasing success The approach (like JIT) has a zero defects philosophy

Total Quality Management (TQM) originated in Japanese manufacturing companies, notably Toyota, from

the end of the 1940s The following ‘requirements of quality' could be seen as the characteristics of TQM programs and the TQM philosophy:

(a) Organisation wide there must be acceptance that the only thing that matters is the customer

(b) There should be recognition of the all-pervasive nature of the customer-supplier relationship, including internal customers; passing sub-standard material to another division is not

satisfactory

(c) Instead of relying on inspection to a predefined level of quality, the cause of the defect should be

prevented (Defects should be eliminated and operations should be ‘right first time’.) (d) Each employee or group of employees must be personally responsible for defect-free production

or service in their domain

(e) There should be a move away from 'acceptable' quality levels Any level of defects is unacceptable

(f) All departments should try obsessively to get things right first time; this applies to misdirected

phone calls and typing errors as much as to production

(g) Quality certification programs should be introduced

(h) The cost of poor quality should be emphasised; good quality generates savings

Key costs in a TQM system include:

(a) Conformance costs, those costs incurred to prevent problems and to appraise quality

(b) Non-conformance costs, internal failures such as waste, and external failures selling faulty

goods to customers and as a result suffering claims from customers because products or services supplied have been faulty The emphasis will be on minimising or, preferably, eliminating non-conformance costs as these tend to be much larger than conformance costs

Total quality management and continuous improvement tie in with risk management Constant review of

processes to identify what went wrong, systems to input feedback from within the organisation and from the customer, and procedures to ensure the organisation responds successfully may reduce exposure to certain types of risk

Definition Kaizen is a Japanese term for continuous improvement in all aspects of an entity's performance at every

level Kaizen is a feature of Total Quality Management

The Kaizen method is applied during the production process when it is difficult to make really big changes Kaizen focuses on the key elements of operations: production, purchasing and distribution Kaizen aims to achieve a specified cost reduction, but to do so through continuous improvements

rather than one-off changes