MANAGEMENT ACCOUNTING (Theory)

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NATURE AND PURPOSE OF MANAGEMENT ACCOUNT

Management Accounting is the application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies in planning and control of the undertaking.

Management accounting is concerned with identifying, presenting and interpreting information used for planning and control of an enterprise operation.

Management accounting involves data gathering, analyzing, processing, interpreting and communicating the reporting information for effective planning decision marking and operations.

Management accounting uses data from the financial and cost accounting systems and Statistics.  Management accounting also uses statistics and operations research for analysis.

Management accounting produces information: which is relevant for the intended purpose.  Management accounting is concerned with helping management to run a business efficiently.

Purpose of Management Accounting

The main Purpose of management accounting is the provision of information used for:

a.       Formulating strategy

b.      Planning and controlling activities

c.       Decision making

d.      Optimization use of resources

e.      Disclosure to shareholders and employees

f.        Safeguarding the assets

Management accounting compared with financial accounting and cost account.  Financial accounting is concerned with stewardship function.  The emphasis is on financial record-keeping and preparation of financial accounts whereas management accounting provides information that is useful to the manager of an organization in taking decisions within the scope of their managerial responsibility.  Therefore, the main difference between management accounting and financial accounting lies in their purpose; financial accounting is for stewardship purpose while management accounting is essentially for internal purpose.  Management accounting and cost accounting are closely related.

There is no realistic guideline between cost accounting, management accounting with regard to the provisions of information for planning and control.  Cost accounting is concerned with the provision of information about costs while management accounting uses this information to plan, control or provide problem-solving analyzes.  Therefore cost accounting is the essential foundation for the development of management accounting system.

In general, management accounting is wider in scope and uses more advanced techniques than cost accounting.  A fundamental requirement for management accounting is the existence of a sound costing system to provide basic data.

 

Management accounting is activity base and is concerned mainly with the present, the future and sometimes the past.  Cost and management accounting provide an internal information system to assist the planning and control decisions by managers.

Financial, cost and management accounting from past of the financial information system of an organization and in many enterprises, the various facets are totally integrated with no artificial divisions between them.

MANAGEMENT ACCOUNTING AS A TOOL OF MANAGEMENT

Managers must be properly informed in order to carry out their responsibility for planning and controlling the resources of a business.  Thus management accounting as a tool of management is management information system which analyzes past, present and future data to fit the variety of different problems confronting managers.

Management accounting ensures that there is effective:

a.       Formulation of plans to meet objectives

b.      Formulation of short term operational plans

c.       Acquisition and the finance

d.      Communication of financial and operating information

e.      Corrective action to bring plans and results into line

f.        Reviewing and reporting on systems and operations.

Evolution of Management Accounting

Management accounting evolved out of industrial revolution and the challenges of modern business to meet the dynamic nature of environmental and industrial conditions.  Management accounting starts from where cost accounting stopped.

DIFFERENCES BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING

a.       Financial Accounting is regulated by law while management accounting is not e.g. CAMA 1990

b.      Financial Accounting is for external and internal use while management Accounting is for management internal use.

c.       Management Accounting is future oriented while financial accounting is past oriented

d.      Management accounting reports are generated when the need arises while financial accounting reports is prepared periodically e.g. yearly.

e.      Financial accounting report follow a prescribed format while that of management accounting do not

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.

-          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.

-           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.

-          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)

-          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.