Management Accounting Systems And Costing Approaches Accounting Essay

This document covers two areas within the business; in Part A we examine the advantages and disadvantages of three different management styles which can be applied to the corporation within the Management Accounting Control System. These are

Cost Centre Managers,

Profit Centre Managers

Investment Managers

This will include the impact on the organisation and consider how the individual manager’s performance can be measured for each of their respective portfolios whilst maximising profit for the corporation as a whole.

Part B of the document will contain a comparative and contrast of the following Key Approaches to relevant decision making related to product and service costs : –

Marginal or Variable Costing;

Full or absorption costing

Activity Based Costing (ABC)

This section will include a clear demonstration of each of the approaches with a final conclusive summary of the best suited approach.

Outline your understanding of the essay question and comment on how you’re going to address it.  Ensure that you define the objectives of the essay clearly as they determine the scope of your essay, setting out exactly what you are reaching a conclusion for. You may want to include definitions of certain business terms here for the understanding of the reader.  

Part A

Management Accounting Systems

“The first responsibility of business is to make enough profit to cover the costs for the future. If this social responsibility is not met, no other social responsibility can be met.” Peter Ducker (1955) The Practice of Management

Organisational Structure

As we are looking at ways of maximising profits and measuring individual manager performance then we need to adopt an approach which will allow both goals to be achieved. It would not be in the best interest of the organisation to appoint a single style of manager due to the complexity and size of the organisation

Within the business we have several dissimilar activities, hence it is necessary for the organisation to adopt a divisionalized structure. To ensure that the divisional structure is successful there are a number of things which must be considered.

One of the main limitations of creating and operating a divisional structure over a functional structure is the internal affect on each other this set up may have. As argued by Solomons (1965) Divisions should be more than investments, their contributions are pivotal to the success of the company and to each other. The internal relationships between the divisions need to be regulated; this will ensure that by seeking its own profit, it cannot do so at the expense of the overall company profit. To avoid the conflict between divisions over profits, Solomon does state that any profit which is gained at the expense of another division must offset and be greater than the loss incurred.

To further ensure that performance is managed effectively it is essential that profit or net assets are controllable using the controllability principle. This is implemented by getting rid of any uncontrollable items from the manager’s area for which they are accountable for or by ensuring reports distinguish between what is controlled/uncontrolled.

Three uncontrollable factors were identified by Merchant (1998), they are:

Economic and competitive factors – e.g. changes in customer tastes, business cycles and changing government regulations

Acts of Nature – likely to be one off events beyond the control of the managers, e.g. Recent Icelandic Volcanic Ash affecting British Airspace, impacted on many businesses ability to deliver products and services such as Tour Operators and holidays.

Interdependencies – when a responsibility centre shares a resource, therefore other units can affect the performance of this resource e.g. IT Support Services, call handling can be delayed when the staff are shared with an Operations unit (due to the technical knowledge requirement) and are onsite delivering work.

The above factors make dealing with them one of the most troublesome areas for the implementation of management accounting control systems hence the requirement for the controllability principle.

Responsibility Centres

There are a number of ways an organisation can work to increase its productivity and profitability, however to ensure that they are making the right decisions to make the most profit, a system needs to be in place which is monitored correctly otherwise known as a Management Accounting Control System.

The Management Accounting Control System is split into two core components, the first part deals with the long term planning and budget proposals. Whereas the second deals with the control over the costs, profit, investment funds or revenues. These are known as Responsibility Centres and are classified as Cost Centres, Profit Centres, Investment Centres and Revenue Centres.

Each Responsibility Centre allows the allocation of accountability for its financial outcomes/results to individuals (managers) within the organisation. By doing this the organisation can effectively monitor the performance of the individual managers against their set controls to ensure maximum profitability as they will be required to collect and report revenue and cost information for each of their respective areas. Now let us evaluate the concepts of a Cost Centre, Profit Centre and Investment Centre.

What is a Cost Centre?

Cost or Expense Centres are defined as part of an organisation that does not produce direct profit and adds to the cost of running a company, such as Accounting or Marketing departments.  The cost centre manager has responsibility over all controllable costs for the particular unit. Here the cost can be discretionary cost and committed costs. This management style would be measured by variable analysis, which is the difference between the standard costs (cost of inputs that should have been consumed creating the output) and the actual cost incurred. Possible Appendix e.g.

The Advantages & Disadvantages of Cost Centre Managers?

The benefits are as follows:

Costs can be managed in an effective manner, for e.g. The spend on Research & Development can analysed against the comparison between New Products and Existing Product Development.

Cost Efficiency can be measured – applies more to committed costs as the input/output relationship can easily measured.

Can help quantify costs of particular activity. E.g. In an IT Support Service area, metrics such as level of service, average handling time and cost of call will be used in conjunction with other figures to validate current funding or request to increase budget.

Hence cost centre helps in measuring both efficiency and effectiveness.

The disadvantages are:

It does not measure the benefit and that may act as a hindrance for cost benefit analysis of a particular activity.

Managers are not judged on profits and revenue under this method.

Holistic view of a particular activity may be ignored under this method.

What is a Profit Centre?

This unit of responsibility allows the performance of each division, product line, geographical area or other quantifiable unit to be measured. This is done by using both costs and revenues in the assessment of the profit performance with each division being treated as a separate business entity with responsibility for creating its own profit.

Thus under this the manager is responsible for both revenues and expenses from any of their planning and control activities and this performance is measured by the Profit achieved.

What is an Investment Centre?

An Investment Centre is similar to a Profit Centre in that it is still divisional and the manager is responsible for the profits, but it also includes an added dimension in that the responsible manager must also demonstrate how efficiently they have used any invested capital within their division. Therefore any appraisal of the manager’s performance must be based not only on the profit but also the Return on the Investment residual income (ROI).

Advantages & Disadvantages

Due to both Profit Centre and Investment Centres sharing similar positive and negatives for a divisional set up, they are both listed together below-

The benefits are:

Accountability is far greater than cost centre and helps in identifying the strengths and weaknesses of the organisation.

Uses the Specialist Expertise of the Manager more effectively for decision making and speeds up this process

Market Information is more readily available as these managers have day to day interaction within their respective fields.

This acts as training mechanism to develop the younger managers

This gives greater flexibility in the organisation and makes organisations leaner and efficient.

Motivation of the Manager to achieve goals set; additionally for the Investment Manager they can be linked to bonus system with the investment return, therefore ensuring the Manager achieves greater profitability not only for their division and the whole corporation but also the shareholders investment.

Represents the highest level of managerial autonomy, allowing Central managers to concentrate on the organisations strategic plans.

The limitations can be:

It can lead to conflict between the profits centres on issues of transfer pricing and power sharing.

It may lead to narrow short term focus and the managers may miss the qualitative factors affecting the performance.

It could possibly lead to an adverse affect on inter-department relationships, which could affect the achievement of organisational goals leading to a downturn in overall company profit.

By delegating the decision making to the divisional managers, central management may lose involvement and some control over these areas

Reporting may not be as in-depth as previous reporting

Performance Measures

In order to measure either the managerial or divisional performance there are three main techniques, which are:

Return on Investment (ROI) – calculated on both primary and secondary level and is preferred in Profit Centres where the managers cannot influence or make investment decisions.

Advantages

The return on Investment is represented by a percentage

Used extensively by managers

Disadvantages

Possibility that managers will take less risk with projects in order to ensure ROI and maintain their performance.

Goal congruence is not encouraged

Net Residual Income (NRI or RI) – measures controllable contribution less a cost of capital investment controlled by the manager – used within Investment

Advantages

Method motivates Managers to perform well

Disadvantages

It is an absolute measure

Different Investment Sizes hard to compare

Economic Value Added (EVAâ„¢) – During the 90’s RI was renamed and refined to EVAâ„¢. This was done with the formula of ‘Conventional divisional profit + accounting adjustments – cost of capital charge on divisional assets’. This has been adopted by approx 300 companies worldwide as reported by The Economist (1997). A further UK study carried out by El-Shishni and Drury (2001) also reported EVAâ„¢ is used in 23% of the responding organisations to monitor divisional performance.

Advantages

Encourages Goal Congruence

Reported high success rate in motivating and evaluating corporate and divisional managers

Reduction of harmful side effects from using financial measures as managers do not bear full cost of discretionary expenditure

Do not rely heavily on accounting measures and use non financial methods such as the balanced scorecard approach.

Conclusion

To realise the mix of products, services and investments the organisation should undertake a new company structure and make the key head divisional managers ‘Investment Managers’. We will be able to optimise performance and profitability for the division, organisation as a whole and the shareholders at the same time. However operating underneath these managers will be Cost Centre Managers and Profit Centre Managers where appropriate.

In order to ensure that performance is monitored correctly, the following measures will be used

Cost Centre/Profit Managers – will be measured by the ROI method, this is mainly because they will have no control over the capital investment decisions and only have control over their costs.

Investment Managers – will adopt the EVAâ„¢ method as this in recent years has overtaken the NRI method and is used by some of the world’s most successful organisations such as AT & T, Coca-Cola and Boots. The Economist (1997). The method is not only a financial method but also looks at other factors which can affect the investment performance. It also keeps staff motivated and can provide ownership of the performance encouraging the manager to perform high and reach the goals.

To implement the new structure further action will be needed such as the restructure of staff and specification of targets for the managers. To do this we need to ensure that all of the recognised costs and controls for each responsibility centre are defined and documented with the agreement of the staff to make sure they are happy with what is expected of them.

Part B

Costing Approaches

It is essential with any organisation to know the relevant cost of all products and services they provide, as this will allow ease of all decision making situations.

There are a variety of approaches which can be applied in this area and each approach deals with the situations differently as each one needs to be considered relevant accordingly. In order to define the correct approach we must look at the following: –

Identify all relevant and irrelevant costs & revenues,

Consider any important qualitative factors in the relevant costs

Marginal or Variable Costing

Meaning of variable costing:

Variable costing means the method of costing in which the costs to be inventoried is the variable manufacturing costs. Here, fixed overhead costs are treated as the period cost along with the selling and administrative expenses incurred during the particular period. Variable costing can also be termed as the direct costing and marginal costing.

Definition of variable costing:

Method in which cost of a product or operation is determined by allocating to it an appropriate portion of variable (direct) costs. Direct costing treats fixed costs (overheads such as administrative and selling costs) as period costs (associated with time and not output).It is also called contribution costing.

Variable costing is useful in the following cases:

1. Make or buy decision

2. Accepting the export order

3. Computation of Breakeven point

4. It is used in CVP analysis.

5. Inventory valuation and income determination

6. Determination of product mix

7. Determination of marketing mix.

8. Shut down or continue the operations

9. Optimum allocation of resources when some resources are limiting factor.

Advantages of Variable Costing

a. Corresponds to cost-volume-profit model.

b. Profits fluctuate with sales-volume changes only, and are not affected by inventory level changes

c. More attuned to management thinking.

d. Avoids problem of allocating joint costs.

Disadvantages of Variable Costing

a. Since selling prices must include all costs in the long run, variable costing may lead to under-pricing products in the long-term.

b. Not acceptable for external reporting.

c. Inventories are not shown at their full cost of production.

d. Marginal costing is especially useful in short profit planning and decision-making. For decision of far reaching

Importance, one is interested in special purpose cost rather than variability of costs.

e. It is not acceptable by the Government for the purpose of the income tax.

f.I t is not proper to disregard fixed cost for product for

product cost determination and inventory valuation.

g. Marginal costing technique disregards the use of recovering

fixed cost through product pricing. For long run continuity of business it is not good. Assets have to be recovered of costs.

h. Establishing variability of costs is not an easy. I real life situations, variable costs are rarely completely variable and fixed costs are rarely completely fixed.

I. Exclusion of fixed cost from inventory valuation does not conform to accept accounting practice.

J. The income tax authorities do not recognize the marginal cost for inventory valuation. This necessitates keeping of separate books for separate purposes

Difference between variable costing concept Vs absorption costing concept.

In variable costing only variable manufacturing overhead is considered. However, in absorption costing, all costs including fixed costs are included.

In absorption costing, the product cost of product A is computed as follows:

Therefore, the product cost is more in absorption costing than the variable costing. The difference in product cost will affect the income shown under different types of costing. When production exceeds sales, the absorption costing will show higher net income than the variable costing. When sales exceeds the production, then variable costing show more profit. The profit under both the methods will be same when production is equivalent to sales.

Likewise the presentation of income statement is different in absorption costing and in variable costing

Income statement as per absorption costing – removed if needed put in appendix

Absorption costing vs. normal costing

Normal Costing: Under normal costing actual direct materials and direct labour costs are assigned to the units produced and manufacturing overhead costs are assigned to the units produced using the predetermined overhead rate. Then predetermined overhead will be compared with the Actual overhead. Then variance would arise:

a. If the under/over applied manufacturing overhead is relatively small, it is treated as an adjustment to cost of goods sold

b. If the under/over applied manufacturing overhead is relatively large, it is prorated to the units produced

Normal costing systems estimate the overhead component of product cost:

Normal product cost = actual D/M

+ actual D/L

+ estimated O/H (estimated rate applied to actual quantity of driver)

Absorption costingvs. standard costing.

Standard Costing–Under standard costing standard direct materials and direct labour costs are assigned to the units produced and manufacturing overhead costs are assigned to the units produced using the predetermined overhead rate and the standard is set for each element of cost. Then standard cost is compared with the actual cost. The result is favourable or unfavorable variance.

a. If the direct materials, direct labour, and manufacturing overhead variances are relatively small, they are treated as an adjustment to cost of goods sold

b.If the direct materials, direct labour, and manufacturing overhead variances are relatively large, they are prorated to the units produced

Therefore absorption costing is different from the standard costing. To put simply, standard cost is the technique of controlling costs. However, absorption costing is the method of finding out the cost of the products produced during the particular period.EEC uses standard costing for control of unfavorable variances.

Absorption costing vs. Actual Costing-

Under actual costing, actual direct materials, direct labour, and manufacturing overhead costs are assigned to the units produced. Here, in actual costing , the variable costs and fixed costs are entered in actual terms and there is no question of variance .In variable costing, variable costs are deducted from sales to arrive at the contribution margin. But it is not so in the case of actual costing. In absorption costing all the costs are included in the cost of production. If actual costing is followed, there is no problem of under or over absorption of overhead.

Absorption costing Vs process costing;

Under process costing all the costs (direct material, direct labour, fixed manufacturing overhead and variable overhead) of each process are added and cost of the finished goods will be cost of the product will be the accumulation of costs from the beginning process to the last process. Process costing adds all the costs both the fixed costs and variable costs. Here, absorption costing is applied for each processes of the organisation. If EEC undertakes manufacturing products on process basis, the process costing can be applied.

Job costing:

Job costing is the method of accumulation of cost for each job performed by the organisation and the absorption costing method is followed for each job. If EEC undertakes the job on the basis of job, then job costing can be applied.

Absorption Costing v

Absorption costing (also known as ‘Full Costing’) is one of the traditional approaches which basically mean all the manufacturing costs are absorbed. That is value of finished goods include direct material, direct labour, variable overhead, fixed overhead. Under the absorption costing method full cost i.e., both variable cost and fixed cost are added to the cost of the product and certain percentage of profit is added to the cost and selling price is determined. However, under variable costing, variable cost is deducted from sales to arrive at the contribution and fixed cost is deducted from the contribution to arrive at the profit.

When pricing is made on the basis of full cost will be unsuccessful when the Company has unutilized capacity and the fixed cost is spread over the units produced.

For example, the Company Z has the plant and machinery having the capacity of producing 10000 units of product X.Fixed cost of maintenance of the plant and machinery is $ 100000 per month. Then fixed cost per unit will amount to $ 10 per unit. If the company is unable to utilize the full capacity, it could produced only 8 000 units of product X, then the fixed cost per unit will come to $ 12.5 .Here, the cost per unit is unduly inflated to the extent of $ 2.5.This method of pricing under full costing make the products uncompetitive in the market because it will increase the selling price per unit of the product. At the same time, competitors could sell the same quality of product at a price less than $ 2.5 per unit. This makes the company’s product unsuccessful in the long run.

Therefore, poor decision making arise when the products are priced by adding a fixed percentage of profit to the total cost.

When the absorption costing can be used?

Absorption costing can be applied when there is full utilization of available capacity and the company has high market share and pricing of product on the basis of full cost won’t affect the sales of the products in the market.

Advantages of absorption costing:

This method is accepted by revenue officials as the stock is not undervalued.

It is authorized by the Government to prepare financial accounts.

It recognizes the importance of fixed cost in production.

When sales fluctuate from period to period and the production remains constant, there will be little fluctuation in net profit over the periods.

Marginal costing distorts value of the closing stock which is not so in the case of absorption costing.

Disadvantages of absorption costing:

Since the manger emphasis on total cost, cost volume profit relationship is ignored and the manager needs to use his intuition to take the decision.

Since absorption costing uses full costing, it is not useful for the management to make decisions, planning and control of the activities of the organisation.

Difference between absorption costing and marginal costing:

Identify 2 managerial decisions situ’s where this approach is more appropriate than the other 2 and justify in this decision making situ

This section – which should consists of several paragraphs – should go through all similarities you find in the two topics on which you are writing. There should be at least three comparisons (essentially three short body paragraphs) in which you give an example from both topics of comparisons in each.

This section – which should consist of several paragraphs – should go through all differences you find in the two topics on which you are writing. There should be at least three contrasts (essentially three short body paragraphs) in which you give an example from both topics of comparisons in each

Referring to the sources you’ve collected; perform a detailed analysis of the topic at hand.  Ensure that you critically examine viewpoints from different authors to provide a rational debate and cover reasons for and against the presented argument. Explore similarities and conflicting approaches and demonstrate independence of thought by giving your own opinion. Sequence your ideas correctly and link paragraphs so that the information presented flows seamlessly from one idea to another. Remember to reference your citations throughout this section according to the referencing method recommended in your University guidelines e.g. Harvard or footnotes. Use quotation marks to indicate an exact phrase taken from a source. If you paraphrase, supply the reference at the end of the paraphrased sentence/s.  The number of references to use will depend on the length and nature of your essay although using ten references for every 1,000 words is an effective rule. 

Activity Based Costing (ABC)

Activity Based Costing System: is a modified absorption costing system, where by the indirect costs are traced to their cost pools to reflect resource utilization of indirect resources by the cost object.

Activity-Based Costing (ABC) is a costing method that identifies activities in an organisation and assigns the cost of each activity to products and services according to the actual consumption by each in order to arrive at the actual cost of products and services.

In Activity based costing costs of all organisations’ resources are assigned to the products and services that the organisation manufacture/render. The main intention behind the assignment of resource cost to the product/services is to find out the cost of the product and the resultant profitability.

Following are the steps to be followed in ABC.

1. Identify cause and effect relationships of all the activities to assign costs to the activities.

2. Costs of the activities are to be computed.

3. Then the cost of each activity is assigned to each product/service to the extent that the product/service uses the activity.

4. Then the products with high overhead costs are to be identified and the efforts need to be made to reduce the costs of the costs.

Identify 2 managerial decisions situ’s where this approach is more appropriate than the other 2 and justify in this decision making situ

This section – which should consists of several paragraphs – should go through all similarities you find in the two topics on which you are writing. There should be at least three comparisons (essentially three short body paragraphs) in which you give an example from both topics of comparisons in each.

This section – which should consist of several paragraphs – should go through all differences you find in the two topics on which you are writing. There should be at least three contrasts (essentially three short body paragraphs) in which you give an example from both topics of comparisons in each

Referring to the sources you’ve collected; perform a detailed analysis of the topic at hand.  Ensure that you critically examine viewpoints from different authors to provide a rational debate and cover reasons for and against the presented argument. Explore similarities and conflicting approaches and demonstrate independence of thought by giving your own opinion. Sequence your ideas correctly and link paragraphs so that the information presented flows seamlessly from one idea to another. Remember to reference your citations throughout this section according to the referencing method recommended in your University guidelines e.g. Harvard or footnotes. Use quotation marks to indicate an exact phrase taken from a source. If you paraphrase, supply the reference at the end of the paraphrased sentence/s.  The number of references to use will depend on the length and nature of your essay although using ten references for every 1,000 words is an effective rule. 

Conclusion

You should arrive at your final conclusion by logical reasoning, concisely pulling together the discussions undertaken in the main body of the essay. Explicitly state your viewpoint as the final result, ensuring that you answer the question posed in the introduction as fully as possible.  This final section should also be taken as an opportunity to express any recommendations for further investigation or future action.

Bibliography/List of References

If you’ve used the Harvard method for referencing, display a list of all the references used in your essay in alphabetical order. If you’ve used footnotes on each page, simply include a bibliography here instead.

Drucker, P. (1955). The Practice of Management. London: Heinemann.

Drury, C. (2005). Management Accounting for Business, 3rd Edition. London: Thomson.

Kaplan, R. a. (1998). Cost & Effect: Using Integrated Cost Systems to Drive Profitability. Harvard Business School Press.

Appendices

This section consists of any supportive material (graphs, charts or written text) that is too large to include in the main body as it would hinder the flow of the essay.