As stated by the Chartered Institute of Management Accountants (CIMA), management accounting is referred to as ＆the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources＊. It has been widely applied in modern organisations to provide managers with valuable accounting information, and highly suggested to be adapted in our company as well. It is the aim of this report to explain in detail the strategic benefits a management accountant could bring to our company, what kinds of costs are relevant to strategic decision making and which cost method should be applied to accurately measure these costs. The structure of the report is as follows. Primarily, five main roles of strategic management accountants will be introduced. Next section will use several small numerical examples to differentiate relevant costs and revenues from irrelevant ones. Finally, the advantages and disadvantages of activity based costing (ABC) will be included.
The first role a management accountant can undertake is planning, which is defined by Atril and McLancey (2005) as ＆establishing objectives and developing corresponding strategic plans to fulfil these objectives＊. This is one of the core responsibilities of managers in any organisation. Therefore, the management accounting information can be essentially valuable in terms of providing managers with projections of the likely financial outcomes from the chosen courses of action. Then managers are able to use these projections to assess each of the proposals and select the most proper one as the final strategic decision (ibid).
Planning is closely linked with controlling, which is the second role a management accountant could play, involving the steps taken by managers to make sure that these objectives made in the planning stage can be attained and lead to favourable outcomes (CIMA, 2005). In order to quantify the controlling process, budgeting is commonly applied to help managers turn the plans into action (Atril and McLancey, 2005). It is normally a one-year business plan whose control process for most businesses is shown in Figure 1. Budgeting is valuable because it provides the yardstick to monitor whether things are going on as planned, and the difference between the actual and budgeted performance is termed as variances (ibid). According to Dugdale and Lyne (2009), budgeting is rather popularly adapted in UK companies. Among their research all the 40 respondents confirmed that their companies set budgets and as many as 95% financial managers regarded budgets as very or extremely important.
Thirdly, the accounting information provided by management accountant can be used to evaluate organisational performances by comparing the planned and actual results. As long as the variance is significant, some investigation should be carried out together with corresponding actions. This is known as ＆management by exception＊ (ibid). Traditionally performance evaluation was mainly focusing on financial performance via ARR (Accounting Rate of Return) or ROI (Return on Investment), complemented by budgeting and other core financial ratios such as profit margins, return on capital employed (ROCE) and earnings per share (EPS). However, they had only limited usage because of solely focusing on historical data, lack of comparability across organisations, being short-termist, and one dimensional (O＊Hanlon & Peasnell, 1998; Mouritsen, 1998). Today, many companies are increasing using new approaches such as Economic Value Added (EVA) and Cash Flow Return on Investment (CFROI). Some even apply more than one method for different purposes. For instance, the U.S. based multinational agricultural biotechnology corporation Monsanto is using CFROI at group level and EVA at divisional level (ibid). These new approaches are still imperfect yet since they ignore non purchased intangible assets like employee skills and customer satisfaction, which also create great value for the company and shareholders (Ittner & Larcher, 1998; Riceman, Cahan & Lal, 2002). Kaplan and Norton (1992) thus developed ＆balanced scorecard＊ (see Figure 2) to evaluate non-financial performance. Unlike the traditional one-dimensional methods, balanced scorecard successfully covers multi perspectives including financial, customer, internal processes and organisational learning. Its aim is to achieve a balance between short term and long term objectives, inside and outside measures, and objective and subjective measures (ibid).
Furthermore, management accountants are also responsible for ensuring the accountability of organisational resources. Resources especially rare and valuable ones are rather limited to an organisation and thereby it is the responsibilities of managers to ensure that these resources are used effectively and efficiently. In consequence, management accounting knowledge is essential to decisions regarding to matters like the optimum level of production, the range of product and/or service lines and the appropriate amount of investment in new equipment (Atril and McLancey, 2005). As the demand for better usage of resource becomes increasingly important, a new accounting approach 每 Resource Consumption Accounting (RCA) has been developed recently in order to provide managers with supporting information of such decisions, and its core idea is a different view of resources (Clinton and Anton, 2008a & 2008b). Under this approach, the cost and revenues of an organisation are all a function of the resources that produce them. Cost behaviour thereby is determined by the behaviour of resources as they are applied to organisational value added activities (ibid).
Finally, it has been an increasing essential role of management accountants to report externally. In the past the information offered to managers was largely restricted within the organisation. However, due to the growing significance of external factors such as the attitudes and behaviours of customers and rival businesses, the focus of management accounting today has become much more outward-looking (Atril and McLancey, 2005). On one hand, management accountants are suggested to conduct competitor profitable analysis in order to gain valuable information of competitors. On the other hand, customer profitability analysis (CPA) has been widely applied to access the profitability of the business regarding to each customer (ibid). Drury and Tayles conducted a survey among 176 large UK businesses in 1999, indicating that 76% of respondents did analyse the profitability of trading with customers. The reason behind this is that companies＊ resources are limited and not all the customers are profitable to businesses. As seen in Figure 3, only 20% of customers are actually profitable. Therefore, companies must tailor their products or services to meet the specific requirements of the most profitable customers.
After describing the five major roles a management accountant can undertake in Jessup, the following section of report will focus on differentiating relevant cost from irrelevant cost. As defined by Investopedia (2010), relevant costs are those specific to management＊s decisions. It eliminates unnecessary data that could complicate the managerial decision-making process. The report will firstly explain which costs belong to relevant costs and then use several numerical examples to better illustrate.
First of all, suck costs such as initial research and development, or market surveys are costs that have been incurred and cannot be reversed (ibid). The past cannot be changed by the decision being taken today and costs incurred in the past are no longer an input factor in our decision. Therefore, suck costs are irrelevant costs. Secondly, financing costs such as the interest payable should also be ignored since they will be accounted for in the cost of capital rather than treated as cash flows. In addition, the opportunity cost which is alternative cost that must be forgone in order to pursue a certain action is one kind of relevant costs and thereby should be included. For instance, the opportunity cost of going to college is the money you would have earned if you take a job. Hence, revenues caused by opportunity cost should be taken into consideration. Finally, in terms of organisation＊s non-tangible assets like machines and factories, their value decrease over time. This is termed as depreciation in accounting and because it is an expense not a cost, it is irrelevant.
Price offered for a job =㏒2,500.
l 30 hours of 1 staff
邦 Each staff is paid ㏒20 per hour
邦 Charge out rate ㏒45 per hour
邦 No other member of staff can do this job
l 5 hours of mainfarme computer time
邦 Mainframe is used 24 每 7
邦 Normal charge out rate ㏒50 per hour
l Supplies and incidentals of ㏒200
Question: What is the opportunity cost of the job?
The opportunity costs here include the labour cost, computer times and supplies and incidentals. Therefore, the total opportunity costs equal ㏒1,800.
Labour (30 hrs @ ㏒45) = ㏒1,350
Computer time (5 hrs @ ㏒50) = ㏒250
Supplies and expenses = ㏒200
Total = ㏒1,800
It is important to notice that not all the variable costs are relevant and not all the fixed costs are irrelevant. Example 2 can be used to illustrate this point.
Wensum manufactures bath towels.
l Production capacity = 44,000 towels per month.
l Current monthly production = 30,000 towels.
Direct materials: ㏒6.50all variable
Direct labour: ㏒2.0025% variable
Factory overheads:㏒5.00㏒1.50 variable
Marketing costs: ㏒7.00㏒2 fixed
TOTAL cost: ㏒20.50
l Total fixed direct labour = ㏒45,000.
l Total fixed overhead = ㏒105,000.
Question: special order 每 A hotel in Puerto Rico has offered to buy 5,000 towels from Wensum at ㏒11.50 per towel for a total of ㏒57,500. No marketing costs will be incurred for this order. Should we accept it?
Solution: in accounting a special order is a one-time order that is not considered part of the company＊s normal ongoing business, and it is profitable as long as the incremental revenue from the special order exceeds the incremental cost of the order.
The incremental cost for this special order is the sum of direct material cost, direct labour cost and overheads. The unit direct material cost is ㏒6.50 and is 100% variable. Hence, the relevant direct material cost for one unit of bath towel is ㏒6.50. Conversely, the direct labour cost and overheads are not 100% variable. Therefore, the relevant unit costs are ㏒0.50 and ㏒1.50 respectively. The detailed calculation is shown below. Because the special order leads to a net profit of ㏒15,000, we should accept this offer.
Unit incremental costs:
Direct Material = ㏒6.50
Direct Labour = ㏒0.50
Overhead = ㏒1.50
Total incremental cost = ㏒8.50 * 5,000 =㏒42,500
Total incremental income =㏒57,500
Net benefit =㏒15,000
Magyar International is considering an investment opportunity to expand their leisure clothing market share. They have identified a new building which they can lease on favourable terms of ㏒15,000 a year and have estimated that machinery requirements for the project can be bought from their current capital budget for ㏒400,000. The project will last for five years.
The company＊s accountants have produced the following estimate of financial performance for each year of the project＊s life:
Lease of premises
Interest on borrowings
The following information is relevant:
1) The provision for overheads includes an allocation of ㏒10,000 of existing costs, the remaining overheads being directly related to the project.
2) Market research, completed six months previously, cost ㏒50,000 in total and is being written off through the life of the project.
3) Interest on borrowings refers to a loan at 12% the company raised for half the capital cost of the project. The loan will be repaid in full on completion.
Question: Identify the relevant costs and revenues.
1) Market Research 每 non-relevant because it is a sunk cost
2) Interest on Borrowings 每 non-relevant because it is a financing cost which has been included in the calculation of Cost of Capital and its inclusion in the calculation would be double accounting.
3) Overheads 每 only partially relevant since only additional Overheads incurred as a direct consequence of the project should be included, which is ㏒15,000 in this case.
4) Depreciation 每 non-relevant because it is not a cash cost
Then the table may now be re-constructed to include only relevant cash flows:
Less: Labour costs ㏒60,000
Lease of premises 15,000
Overheads 15,000 125,000
Net relevant Cash Flows ㏒115,000
The final part of the report is going to critically discuss the advantages and disadvantages of introducing an activity based accounting (ABC) system to Jessup. Before that a brief introduction of the traditional costing system will be provided.
According to Seal, Garrison and Noreen (2009), the traditional cost allocation process can be classified into three steps. Primarily, costs are accumulated within a production or non-production unit in an organisation. Then costs from non-production units are allocated to production units. Finally, these production costs are further allocated to different products, services or customers (see Figure 4). In the third step it deals with the allocation of overhead costs. The traditional costing system are almost exclusively applied and developed in manufacturing industries where the products are standard. In addition, these products are largely manufactured or assembled manually and consuming similar amounts of supporting activities. Consequently, a relatively high proportion of both direct material costs and direct labour costs s is incurred as a proportion of total cost, which also mistakenly results in an especially low level of overhead cost (Coulthurst, 1999).
Today however, the manufacturing processes have become more complex with a wider and more complicated product range and diverse individual customer specifications. Furthermore, modern technology has allowed mass automation to replace manual work (ibid). Hence, the cost structures have changed dramatically. Direct labour costs have declined sharply and been replaced by an increased proportion of overhead costs in many business areas. Thus, the traditional cost accounting methods have become less suitable, and a new cost accounting approach is developed named Activity Based Costing (ABC).
As stated by CIMA (2005), ABC is an approach that involves measuring the consumption of organisational resources and costing final production levels. Resources are allocated to each activity and the activity cost objects are based on estimated consumption. Then cost drivers are utilised to attach activity cost objects to real outputs. In order words, it focuses on what causes overhead costs and how these relate to products. ABC assigns costs to a product or service based on its consumption of an activity. Figure 5 shows the process of ABC.
Under the ABC framework, all the costs are indentified by activities and can be connected in processes across departments. In addition, all the activities are directly linked with products. This is totally different from traditional costing approaches where first costs are indentified by cost centres and second, overheads from non-production cost centres are transmitted to production ones before they are absorbed into product costs (Coulthurst, 1999; Seal, Garrison & Noreen, 2009). ABC is more favourable since it does not treat overheads as a homogeneous cost item and reject the idea that volume of output drives all cost items. Actually quite a few companies have adopted it in real businesses. Innes, Mitchell and Sinclair (2000) investigated the ABC adoption status among large UK-based enterprises and found out that 17.5% of respondents were currently using ABC and 20.3% of them were considering using ABC. The percentage was much higher in the financial sector where the adoption rate was 40.7%.
On the other hand, Activity-based costing also has its shortages. First of all, it is very costly and time-consuming to design, implement and maintain the ABC system in organisations. The selection of cost drivers and activities can be rather complicated. That is the reason why there are some indications of dissatisfaction among current users (Beaulieu and Lakra, 2002). Moreover, ABC cannot be adopted universally since it is not appropriate for firms that do not have complex and diverse product offerings (ibid). Finally, in theory ABC requires direct proportionality and the absence of common costs (Noreen, 1991), which are difficult conditions to meet.
In conclusion, this report has successfully introduced the five major roles a management accountant can undertake in our company, which can be identified as planning, controlling, evaluating performance, ensuring accountability of resources and external reporting. Moreover, by using three numerical examples, relevant costs and revenues such as opportunity cost, direct labour cost, direct material cost and overheads are being differentiated from irrelevant ones like sunk cost and depreciation. Finally, activity based costing avoids the disadvantages of traditional costing like over-emphasizing the importance of direct labor, and assigns costs to a product or service based on its consumption of an activity. Although it seems costly and time-consuming to design and conduct, it is still worthwhile if our company starts adapting it.
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