MANAGEMENT ACCOUNTING
SHORT TERM
ACCOUNTING DECISION
Introduction:
Decision making is the process of choosing among
alternative courses of action. Decisions
are usually taken through all process of managerial functions.
Decision making is an all round activity taken
place at every level in the organization.
The decision process consists of:
i.
Definition of objective
ii.
Consideration of alternatives
iii.
Evaluation of alternatives in the light of the
objectives
iv.
Selection of the course of action. Decision making is based on both quantitative
and qualitative factors. Management
accounting supplies information for decision making purposes both for long and
short terms.
Short term accounting decision criteria
are usually based on marginal costing, cost-volume-profit analysis,
differential cost and opportunity costs.
Information
for Decision – Making
Management makes decision about the future. When they make decision for economic or
financial reasons, the objective is usually to increase profitability or value
of the business, or to reduce cost and improve productivity.
When managers make a decision, they make a choice
between different possible courses of action (option), and they need relevant
and reliable information about the probable financial consequences of different
options available. A function of management
accounting is to provide information to help managers to make decision, by providing
estimates of the consequences of selecting any option.
Traditionally, cost and management accounting
information was derived from historical cost (a measurement). For example, historical costs are used to
assess the profitability of products, and control reporting typically involves
a comparison of actual historical costs with a budget or standard cost and
revenues.
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Decisions affect the future, but cannot change what
has already happened
-
Decision-making should therefore look at the
future consequences of a decision, and should not be influenced by historical
even and historical costs.
-
Decisions should consider what can be changed in
the future. They should not be
influenced by what will happen in the future that is unavoidable, possibly due
to the commitments that have been made in the past.
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Economic
or financial decisions should be based on future cash flows, not future
accounting measurements of cost or profit.
Accounting conventions, such as the accruals concepts of accounting and
their depreciation of non-current assets, do not reflect economic reality. Cash flow, on the other hand, do reflect the
economic reality of decisions. Managers
should therefore consider the effect that their decisions will have on future
cash flows, not reported accounting profits.
Marginal
Costing and Decision –making
Marginal costing might be used for
decision-making. For example, marginal costing
is used for limiting factor analysis and linear programming.
It is appropriate to use marginal costing for
decision-making when it can be assumed that future fixed costs will be the
same, no matter what decision is taken, and that all variable costs represent future
cash flows that will be incurred as a consequence of any decision that is
taken.
These assumptions about fixed variable costs are
not always valid. When they are not
valid, relevant costs should be used to evaluate the economic/financial consequences
of a decision.
RELEVANT
COSTS AND DECISION-MAKING
Relevant costs should be used for assessing the
economic or financial consequences of a decision.
The key concepts in this definition of relevant
costs are as follows:
Relevant costs are cost that will occur in the
future. They cannot include any cost
that has already occurred in the past.
Relevant costs of a decision are costs that will
occur as a direct consequence of making the decision. Costs that will occur
anyway, no matter what decision is taken, cannot be relevant to the decision
Relevant costs are cash flows. Notional costs, such as depreciation charges,
notional interest costs and absorbed fixed costs, cannot be relevant to a decision.
Terms used
in relevant costing
Several terms are used in relevant costing, to
indicate how certain costs might be relevant or not relevant to a decision.
Incremental
Cost
An incremental cost is an additional cost that will
occur if a particular decision is taken.
Provided that this additional cost is a cash flow, an incremental cost
is a relevant cost.
Differential
Cost
A differential cost is the amount by which future
costs will be different, depending on which course of action is taken. A differential cost is therefore an amount by
which future costs will be higher or lower, if a particular course of action is
chose. Provided that this additional cost
is a cash flow, a differential cost is a relevant cost.
Avoidable
and unavoidable costs
An avoidable cost is a cost that could be saved
(avoided), depending whether or not a particular decision is taken. An
unavoidable cost is a cost that will be incurred anyway.
-
Avoidable costs are relevant costs
-
Unavoidable costs are not relevant to a
decision.
Committed
Cost
Committed costs are a category of unavoidable
costs. A committed cost is a cost that a
company has already committed to or an obligation already made, that it cannot
avoid by any means. Committed costs are
not relevant costs for decision making.
Sunk Cost
Sunk costs are costs that have already been
incurred (historical costs) or costs that have already been committed by an
earlier decision. Sunk costs must be ignored for the purpose of evaluating a
decision, and cannot be relevant costs.
Opportunity
Costs
Relevant costs can also be measured as an opportunity
cost. An opportunity cost is a benefit
that will be lost by taking one course of action instead of the next-most
profitable course of action.
IDENTIFYING
RELEVANT COSTS
There are certain rules or guidelines that might help
to identify the relevant costs for evaluating any management decision.
Relevant
Cost of Materials
The relevant costs of a decision to do some work or
make a product will usually include costs of materials. Relevant costs of materials are the additional
cash flows that will be incurred (or benefits that will be lost) by using the
materials for the purpose that is under consideration. If none of the required materials are
currently held as inventory, the relevant cost is the cash that will have to be
paid to acquire and use the materials.
Note that the historical cost of materials held in inventory cannot be the
relevant cost of the materials, because their historical cost is a sunk
cost. The relevant costs of materials
can be described as their “deprival value”.
The deprival value of materials is the benefit or value that would be
lost if the company were deprived of the materials currently held in inventory.
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If the materials are regularly used, their
deprival value is the cost of having to buy more units of the material to
replace them (their replacement cost)
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If the materials are not in regular use, their
deprival value is either the net benefit that would be lost because they cannot
be disposed of (their net disposal or scrap value) or the benefits obtainable
from any alternative use.
In an examination question, materials in inventory
might not be in regular use, but could be used as a substitute material in some
other work. Their deprival value might
therefore be the purchase cost of another material that could be avoided by
using the materials held in inventory as a substitute.
Relevant
Cost of Labour
The relevant costs of a decision to do some work or
make a product will usually include costs of labour. The relevant cost of labour for any decision
is the additional cash expenditure (or saving) that will arise as a direct
consequence of the decision.
If the cost of labour is a variable cost, and
labour is not in restricted supply, the relevant cost of the labour is its
variable cost.
If labour is a fixed cost and there is spare labour
time available, the relevant cost of using labour is zero. The spare time would otherwise be paid for
idle time, and there is no additional cash cost of using the labour to do extra
work.
Relevant
Cost of Overheads
Relevant costs of expenditure that might be classed
as overhead costs should be identified by applying the normal rules of relevant
costing. Relevant costs are future cash flows that will arise as a direct
consequence of making a particular decision.
Fixed Overhead Absorption Rates are therefore irrelevant,
because fixed overhead absorption is not overhead expenditure and does not
represent cash spending. However, it
might be assumed that the overhead absorption rate for variable overheads is a
measure of actual cash spending on variable overheads. It is therefore often appropriate
to treat a variable overhead hourly rate as a relevant cost, because it is an
estimate of cash spending per hours for each additional hour worked.
The only overhead fixed costs that are relevant
costs for a decision are extra cash spending that will be incurred, or cash
spending that will be saved, as a direct
consequence of making the decision.
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