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Management Accounting: M. Mongiello
Management Accounting: M. Mongiello
M. Mongiello
AC3097
2015
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr M. Mongiello, Programme Director (Executive MBA), Principal Teaching Fellow in
Accounting, Imperial College Business School.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
Contents
Introduction............................................................................................................. 1
About this edition........................................................................................................... 1
Aims.............................................................................................................................. 1
Learning outcomes......................................................................................................... 2
Why study management accounting?.............................................................................. 3
Organising your studies.................................................................................................. 3
Essential reading............................................................................................................ 5
Further reading............................................................................................................... 5
Online study resources.................................................................................................... 8
Examination advice........................................................................................................ 9
Changes to the syllabus................................................................................................ 10
Abbreviations............................................................................................................... 10
Chapter 1: Management accounting and its strategic context............................. 11
Aim.............................................................................................................................. 11
Learning outcomes....................................................................................................... 11
Essential reading.......................................................................................................... 11
Further reading............................................................................................................. 11
Introduction................................................................................................................. 12
Accounting and organisational strategy........................................................................ 13
Accounting information and decision making................................................................ 14
Management accountants in their organisations........................................................... 16
Suggested questions from your textbook....................................................................... 18
A reminder of your learning outcomes........................................................................... 18
Sample examination questions...................................................................................... 18
Chapter 2: Relevant information in decision making............................................ 19
Aim.............................................................................................................................. 19
Learning outcomes....................................................................................................... 19
Essential reading.......................................................................................................... 19
Further reading............................................................................................................. 19
Introduction................................................................................................................. 19
Relevance and value of information.............................................................................. 21
Bases and implications of outsourcing (or build-or-buy)............................................... 24
Identifying relevant costs.............................................................................................. 25
A reminder of your learning outcomes........................................................................... 26
Sample examination questions...................................................................................... 27
Chapter 3: Decision making with constraints and uncertainty............................. 29
Aim.............................................................................................................................. 29
Learning outcomes....................................................................................................... 29
Essential reading.......................................................................................................... 29
Further reading............................................................................................................. 29
Introduction................................................................................................................. 29
Resource allocation, constraint factors.......................................................................... 30
Uncertainty of information............................................................................................ 31
Performance evaluation................................................................................................ 32
Suggested questions from your textbook ...................................................................... 33
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AC3097 Management accounting
Further reading............................................................................................................. 59
Introduction................................................................................................................. 59
Job, batch and process costing...................................................................................... 60
Limitations and developments of traditional costing for decision making........................ 61
Suggested questions from your textbook....................................................................... 62
A reminder of your learning outcomes........................................................................... 62
Sample examination questions...................................................................................... 62
Chapter 9: Application of traditional costing methods......................................... 63
Aim.............................................................................................................................. 63
Learning outcomes....................................................................................................... 63
Essential reading.......................................................................................................... 63
Recommended reading................................................................................................. 63
Introduction................................................................................................................. 63
Example of overhead absorption and allocation applied................................................ 64
Cost centres................................................................................................................. 66
Role in decision making................................................................................................ 67
Suggested questions from your textbook....................................................................... 67
A reminder of your learning outcomes........................................................................... 67
Sample examination questions...................................................................................... 67
Chapter 10: Inventory and process costing........................................................... 69
Aim.............................................................................................................................. 69
Learning outcomes....................................................................................................... 69
Essential reading.......................................................................................................... 69
Further reading............................................................................................................. 69
Introduction................................................................................................................. 69
Variable costing, absorption costing and performance measurement.............................. 70
Throughput costing and process costing........................................................................ 72
Capacity concepts and capacity management................................................................ 75
Suggested questions from your textbook....................................................................... 76
A reminder of your learning outcomes........................................................................... 76
Sample examination questions...................................................................................... 77
Chapter 11: Activity-based costing (ABC)............................................................. 79
Aim.............................................................................................................................. 79
Learning outcomes....................................................................................................... 79
Essential reading.......................................................................................................... 79
Further reading............................................................................................................. 79
Introduction................................................................................................................. 80
Activity-based costing................................................................................................... 80
Example of activity-based costing applied..................................................................... 82
Suggested questions from your textbook....................................................................... 84
A reminder of your learning outcomes........................................................................... 84
Sample examination questions...................................................................................... 84
Chapter 12: Activity-based management (ABM)................................................... 87
Aim.............................................................................................................................. 87
Learning outcomes....................................................................................................... 87
Essential reading.......................................................................................................... 87
Further reading............................................................................................................. 87
Introduction................................................................................................................. 88
Activity-based management and budgeting................................................................... 89
Profitability analysis...................................................................................................... 90
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AC3097 Management accounting
iv
Contents
vi
Introduction
Introduction
Aims
This course is designed to equip you with the knowledge of concepts and
the ability to apply techniques of management accounting, in order to
be able to contribute to the success of a firm. Management accounting
has evolved from being purely concerned with the recording and
measurement of costs, to supporting decision makers in their daily and
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AC3097 Management accounting
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
critically evaluate the uses of managerial accounting information for
strategic decision making in various business contexts
select, devise and apply different types of cost allocation and explain
their different roles for supporting strategic managerial decisions
design and prepare budgets and explain their use in strategic planning
and control
design and use variances to support feedback analysis and strategic
control
discuss various approaches to performance measurement and control
in various types of organisations, and devise and evaluate simple
indicators of performance
discuss the changing role of management accounting.
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Introduction
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AC3097 Management accounting
4
Introduction
Essential reading
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education, 2015) fifteenth international edition
[ISBN9780133428704].
This textbook provides plenty of examples. In fact, it is mostly based on
case studies. Throughout this subject guide, when you are referred to
the textbook or your textbook, this is generally the book in question
(unless stated otherwise). I recommend that you have access to this
textbooks contents (including its companion website) at least for the
period of time when you are preparing for this course. You can use either
the current 15th or the previous 14th and 13th editions. However, the
changes introduced in the 13th edition are meaningful and make earlier
editions obsolete, whereas the changes introduced in the 15th edition are
important updates but not essential.
Mongiello, M. International financial reporting. (BookBoon.com, 2009) first
edition [ISBN9788776814243].
This text will help you to recall some concepts of financial accounting
and the value of accounting information that are fundamental for your
understanding of management accounting. The text is downloadable free
of charge here:
http://bookboon.com/uk/student/finance/basics-of-international-
financial-reporting
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Further reading
Please note that as long as you read the Essential reading you are then
free to read around the subject area in any text, paper or online resource.
You will need to support your learning by reading as widely as possible
and by thinking about how the principles you have learnt apply in the real
world. To help you read extensively, you have free access to the VLE and
University of London Online Library (see below).
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AC3097 Management accounting
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AC3097 Management accounting
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions
from previous years Study Weekends have been recorded and made
available.
Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
8
Introduction
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations
for relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
This course is examined by a written unseen examination which lasts for
three hours 15 minutes (including 15 minutes of reading time). There are
two sections. Section A contains four questions which require the use of
calculations to answer the questions. Section B has four essay questions.
Candidates must answer at least two questions from Section A, one
question from Section B and one other from either section. All questions
carry equal marks, 25 in total. Where the questions require you to answer
different parts, the relative weighting of marks is given. Typically, those
questions which ask you to perform calculations also ask you to interpret
your results in a later part. Some of the essay questions may give you a
further choice of two questions. At the end of each chapter in the subject
guide you will be given one or two sample questions. Note that the
questions cannot usually be answered with reference to only one chapter
in the subject guide, but will require you to integrate the material with
other chapters, textbook and journal article readings, and also with other
subjects, such as AC1025 Principles of accounting.
The Examiners commentaries contain valuable information about how to
approach the examination and so you are strongly advised to read them
carefully. Past examination papers and the associated reports are valuable
resources when preparing for the examination.
Past examination papers and commentaries are available online but you
should be aware that the syllabus and subject guide were revised for 2012
and bear this in mind as you look at past examination papers. You should
also consult the Examination section of your Student handbook.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
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AC3097 Management accounting
Abbreviations
Following is a list of abbreviations that you may encounter in this subject
guide and in the readings for this course.
ABC activity-based costing
ABM activity-based management
AVCO average cost
CVP cost-volume-profit analysis
EVA economic added value
FIFO first in, first out
IRR internal rate of return
JIT just-in-time inventory system
LIFO last in, first out
NPV net present value
R&D research and development
ROI return on investment
TOC theory of constraints
WACC weighted average cost of capital
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Chapter 1: Management accounting and its strategic context
Aim
The aim of this chapter is to clarify the importance of the management
accounting function in organisations, in light of their business model and
strategy. This entails exploring the role of the management accountant in
organisational practice.
Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activity, you should be able to:
distinguish between financial accounting, management accounting and
cost accounting
discuss the importance of the management accounting function for the
strategic success of an organisation
use the value chain framework for classifying and analysing
dimensions of performance according to its functions
discuss the challenges and role of management accountants in an
organisations decision-making process.
Essential reading
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education, 2015) 15th international edition
[ISBN 9780133428704] Chapter 1.
Mongiello, M. International financial reporting. (BookBoon.com, 2009) first
edition [ISBN 9788776814243]. Free from: http://bookboon.com/uk/
student/finance/basics-of-international-financial-reporting
Further reading
Ahrens, T. and C.S. Chapman New measures in performance management in
Bhimani, A. (ed.) Contemporary issues in management accounting. (Oxford:
Oxford University Press, 2006) [ISBN 9780199283361] pp.119.
Ahrens, T. and C.S. Chapman Occupational identity of management
accountants in Britain and Germany, European Accounting Review 9(4)
2000, pp.47798.
Chapman, C.S. and W.F. Chua Technology-driven integration, automation
and standardisation of business processes: implications for accounting in
Bhimani, A. (ed.) Management accounting in the digital economy. (Oxford:
Oxford University Press, 2003) [ISBN 9780199260386] pp.7494.
Cooper, R. and R.S. Kaplan The promise and peril of integrated cost
systems, Harvard Business Review 76(4) 1998, pp.109119.
Davila, A. and G. Foster The adoption and evolution of management control
systems in entrepreneurial companies: evidence and a promising future
in Chapman, C.S., A.G. Hopwood and M.D. Shields (eds) Handbook of
management accounting research, volume 3. (Oxford: Elsevier, 2009)
[ISBN9780080554501] pp.132336.
Drury, C. Management and cost accounting. (London: Cengage, 2015) ninth
edition [ISBN 9781408093931] Chapter 1.
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AC3097 Management accounting
Friedman, A.L. and S.R. Lyne Activity-based techniques and the death of the
bean counter, European Accounting Review 6(1) 1997, pp.1944.
Ittner, C. and D. Larcker Extending the boundaries: nonfinancial performance
measures in Chapman, C.S., A.G. Hopwood and M.D. Shields (eds)
Handbook of management accounting research, volume 3. (Oxford: Elsevier,
2009) [ISBN 9780080554501] pp.123552.
Ittner, C. and D. Larcker Moving from strategic measurement to strategic
data analysis in Chapman, C.S. (ed.) Controlling strategy: management,
accounting and performance measurement. (Oxford: Oxford University Press,
2005) [ISBN 9780199280636] pp.86105.
Johnson, H. and R. Kaplan Relevance lost: the rise and fall of management
accounting. (Boston: Harvard Business School Press, 1987)
[ISBN9780875841380].
Roslender, R. and S.J. Hart In search of strategic management accounting:
theoretical and field study perspectives, Management Accounting Research
14(3) 2003, pp.25579.
Simmonds, K. Strategic management accounting, Management Accounting
59(4) 1981, pp.2629.
Introduction
The basic concepts and terms of management accounting have been
introduced in AC1025 Principles of accounting. In particular,
Chapters 13 to 19 of that subject guide should provide you with an initial
framework to place management accounting into the context of the
modern business environment and the provision of information. I strongly
recommend that you go back and revisit this learning material prior to
proceeding with this chapter.
This chapter aims at developing the subject of management accounting
by explaining in more detail how management accounting supports and
contributes to the strategic achievements of an organisation. This chapter
should help you to get the best out of Chapter 1 of Horngren et al. (2015)
and the related online learning material provided in the textbooks
companion website www.myaccountinglab.com. I also recommend that
the free ebook International financial reporting is read in conjunction with
this guide (see Essential reading). This will provide you with an essential
overview of the main concepts and terms of financial accounting and the
interpretation of corporate accounts, which you should combine with your
learning from AC1025 Principles of accounting.
As a starting point it is worth reflecting on the fact that management
accounting builds on financial accounting information, as it requires
measurements and records of business transactions from diverse
sources, such as creditor and debtor records, the payroll, the fixed asset
inventory and other records. In addition, management accountants
can create additional ad-hoc and notional (or figurative) accounting
information; for example, by calculating opportunity costs for the use
of capital. Imagine two companies which belong to the same group and
provide similar services to two different geographical areas. Assume
that they provide similar output levels, with one company using twice
as much working capital (debtors, inventory, cash) as the other. In terms
of reported profit, based on financial accounting records, these two
companies are very similar. However, the company that produces its results
using less working capital is more efficient and most likely more profitable,
too. Management accountants may therefore decide to include a notional
or figurative interest charge on working capital when calculating the
financial contribution of the companies. This incentivises the CEO of each
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Chapter 1: Management accounting and its strategic context
Activity 1.1
Apply the concept of a value chain to any familiar production process and reflect on what
categories of costs would apply to each phase (or part in Horngren et al.s terminology)
of the value chain. Repeat the same exercise with another familiar production process
and compare the two, phase by phase. It should be possible to draw some conclusions
based on the strategic relevance of each phase in different contexts. The exercise is
particularly interesting when reflecting on firms that are operating in similar conditions
but clearly have different strategic goals, for example, one firms main key success factor
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AC3097 Management accounting
is being innovative, whereas the other firms main key success factor may be increasing
efficiency to facilitate lower prices. Refer to Insight 1.1 for supporting information about
different strategies. This activity can be enhanced by obtaining the annual reports of the
firms previously considered and discovering some information about the firms respective
focus in the allocation of their resources.
Upon completing this activity, refer to your textbook for a list and explanation of typical
key success factors.
Insight 1.1
A useful digression on strategies
The relevance of managerial accounting information for strategic decisions depends on
the firms different strategies.
Two generic strategies that are frequently distinguished are price leadership and
differentiation. Price leadership implies low prices combined with a standardised
offering. The strategic effort goes into developing a customer proposition that appeals to
large numbers of customers and can be provided at low cost. Product variation or even
tailoring products to individual customers wishes is then not usually part of the product
offering. Budget airlines are an extreme example of this strategy.
By contrast, differentiation emphasises the satisfaction of individual customers wishes
as closely as possible, be it with respect to quality of manufacture, ease of use, flexibility
of application or delivery, product variety, reliability, pre-sale and after-sale assistance
or any combination of these. An example would be luxury motor vehicle manufacturers.
Product cost is also a concern for organisations that pursue this strategy, but not to the
same extent as for those that pursue price leadership.
Even though the academic literature on strategy often portrays price leadership and
differentiation as strategic opposites, in practice there is usually a combination of both;
for example, in the various markets for electronic consumer goods. There are different
reasons for this. In large organisations some divisions may tend towards one strategy
and some towards the other. During their life cycle, certain products may start out as
differentiated products that are tailored towards the high price segment (perhaps because
they are innovative), and later they may be marketed to compete mainly on price (perhaps
because many competitors have entered this market, production volumes have increased
and high quality is no longer a differentiating factor).
caused by a product, and which is the subject of Chapter 11. A more general suggestion
to enhance the managerial relevance of management accounting was Simmonds
(1981) concept of strategic management accounting. It focused on the incorporation of
marketing knowledge into management accountants roles. A study by Roslender and
Hart (2003) suggested that even though the term strategic management accounting
itself was not common in practice, on the whole, the management accountants whom
they studied could be said to hold more strategic roles then, than they had in the past.
Studies of the role of the management accountant in organisational management
in different countries have found that commercially aware and active management
accountants distinguish commercial involvement from the old bean counter mentality
(e.g. Friedman and Lyne, 1997). By bean counting they meant an overriding concern
with administration, record keeping and elementary financial reporting work. In terms of
the classic distinction between the roles of the management accountant namely, record
keeping, attention directing and problem solving this implies a shift in emphasis from
the first to the last two.
If the calls for greater strategic relevance have been an important criticism that led to
conceptual changes within management accounting, an important facilitator of those
changes has been the technical advances in information technology. Contemporary
accounting and information systems are significantly more powerful and easier to operate
than they were only a few years ago.
Generally speaking, it is now easier to extract information from the systems that are
used in organisations. Management accountants can offer information that is better
tailored to answer the questions of managers. In some cases, managers can now directly
access information. As a consequence, less effort is needed on the part of management
accountants to administer information systems and serve simply as mediators between
an organisations management and its information systems. There is now the potential
for management accountants to become much more actively involved in management
decision making.
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Chapter 1: Management accounting and its strategic context
More specifically, the greater proximity the role has to the CFO, the more
responsibility and influence it will have on treasury, risk management, tax
planning, investor relations, internal audit and overall control.
The strategic relevance of management accounting is represented by
its ability to support the management in taking strategic decisions,
which include the definition of the organisational strategy. Management
accountants collaborate with the organisations managers in preparing
alternative scenarios and evaluating different possible courses of
actions. For example, the management accountants can calculate
the cost implications of design choices and factor in the revenue that
can be expected from new product attributes (e.g. style, durability,
multi-functionality, etc.). With a similar perspective, using ABC and
management, the management accountant can provide valuable
information with respect to each activitys added value. A strategic
view will be required to evaluate the activities respective added value,
provided that an activity can be equally valuable or wasteful according to
its contribution to the firms fulfilment of its strategic goals. For example,
an activity aimed at improving the quality of service above and beyond
the minimum necessary may be wasteful in a budget airline and highly
valuable in a luxury airline.
Management accountants must reflect on the ethical implications of their
job, which implies also addressing the question of to whom they respond
with their actions and decisions. Management accountants respond to
the owners along with many other organisational stakeholders. The
social environment of an organisation is much wider than just its owners,
employees and customers. Creditors, competitors, other organisations,
neighbours and suppliers may be equally affected by the decisions taken
in an organisation. For example, manufacturing firms are accountable to
the wider community for their contribution to the external environment
pollution and safety. All firms are accountable for spreading good
commercial practices and providing sound advice to clients in a way that
contributes to the overall economic systems stability. Universities can be
held accountable by students, parents and the wider scientific, business
and social communities. Hospitals are subject to the concerns of patients,
their relatives, the professional associations of doctors, the governments
drug regulators, etc. Overall, these concerns go under the name of
corporate social responsibility and constitute a pillar of contemporary
firms strategies for survival and success.
Typically, production engineers and marketing managers tend to have
different views of where the priorities are and what solutions are
most appropriate. Both groups have incentives to depict particular
organisational problems in ways that emphasise certain aspects rather
than others and will more or less consciously bias the information that
they provide to management accountants.
If you reflect on the meaning of the term organisational goals you will
realise that these are in fact the aggregate of the goals of individual
organisational members, which may well be conflicting goals. The
implications for the role of management accounting in decision making
are profound. When producing management accounting information,
should the management accountant factor in that their choices may favour
the view of one or another member of the organisation? The management
accountant will have to invoke not only their technical abilities but also
their ethical principles.
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AC3097 Management accounting
18
Chapter 2: Relevant information in decision making
Aim
The aim of this chapter is to lay the foundations of management
accounting theory and practice. This chapter will link management
accounting concepts and tools to the five-step decision-making process
presented in Horngren et al. (2015), showing their strategic use in
practice. This decision-making process will be used throughout the
subject guide. The particular focus of this chapter is on the definition and
identification of relevant costs.
Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
apply an effective decision-making process to make decisions
explain the concept of cost
identify the categories of sunk and opportunity costs
distinguish relevant from irrelevant information for decisions.
Essential reading
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education, 2015) fifteenth international edition
[ISBN 9780133428704] Chapter 11.
Further reading
Drury, C. Management and cost accounting. (London: Cengage, 2015) ninth
edition [ISBN 9781408093931] Chapters 1, 2, 9 and 12.
Hopper, T., T. Koga and J. Goto Cost accounting in small and medium sized
Japanese companies: an exploratory study, Accounting & Business Research
30(1) 1999, pp.7387.
Introduction
Managerial accounting was derived for the purpose of supporting
managers in making decisions. Decision-making processes have been
introduced in Chapter 1, and in this chapter we will explore the concepts
of relevance of both costs and revenues in a decision-making context and
how different types of information influence the process.
Managers take decisions at all levels of an organisation. At the highest
level, managers define the strategy of their organisation by identifying
its ultimate goals and developing long-term plans to achieve them.
Implementing such strategies requires managerial control (i.e. the
translation of long-term plans into detailed short-term action plans). At an
even more detailed level managers must take operational decisions, which
entail putting procedures and controls in place. These go under the name
of operational control and are aimed at ensuring that the action plans are
realised.
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AC3097 Management accounting
Decisions taken at any level may often have strategic relevance. This is
more obvious when an organisation is defining strategy, and less obvious
when implementing operational procedures. However, the consequences of
implementing the wrong procedure may have serious implications for the
realisation of an organisations strategy. For example, a systematic mistake
in the production process may damage the customers satisfaction, and
may consequently compromise loyalty and damage the entire customer
relationship. Alienating customers may well act as an obstruction to
the realisation of an organisations strategy. As a consequence, a lack of
managerial control at an operational level could have a direct impact at a
strategic level.
Activity 2.1
Reflect on the various roles that you have assumed or you expect to assume when
working for an organisation. How do you define the progress in your expected career?
Most likely you will refer to the breadth and scope of the decisions that you will be
expected to take and how they will affect the organisation.
Now reflect on the amount of information that you will require in order to take informed
decisions throughout your career and on the increasing importance for this information to
be useable for your decision purposes.
Activity 2.2
Reflect on the above considerations and Horngren et al.s (2015) framework for decision
making: the key message throughout is that specific managerial accounting information
is necessary for decision making at all levels of an organisation, but why do Horngren et
al. refer to expected future costs and expected future revenues? Why not future cash
flows as referred to in, for example, in Drury (2015, p.199)? The answer may lie in the
assumption that all costs and revenues at some point in the future will turn into cash
flows. Food for thought!
Decisions that refer to strategic goals and plans are normally taken on
an annual basis, but this schedule may be re-considered when relevant
internal or external changes occur. Management control is a more frequent
and regular process and may follow different cycles (i.e. weekly, monthly,
quarterly, annually), according to the type of processes and activities
it involves. Operational decisions may occur on a continuous basis as
operational control focuses on ensuring that specific tasks are efficiently
and effectively performed.
In this context, changed means that costs existing in one option will be
(partly or totally) avoidable in the other option and costs that would not
exist in one option would emerge in the other. Namely they are: avoidable
and emerging costs.
In reality, this straightforward postulation often seems to clash with
managerial behaviour. Decision makers are biased by their own past
decisions. For example, take the following scenario: a consulting firm
has accepted the order of a large consulting project, which requires the
use of bespoke software. The firms CIO (Chief Information Officer)
researches the market and decides to commit substantial resources to
the development of the required bespoke software. Add to this scenario
that the payment of external developers is done by instalments, which
are currently still being paid. Assume, now, that off-the-shelf software
has become available on the market, its price is substantial and it would
require some customisations, but its functionality is much more advanced
than the in-house developed software, which enables the consulting firm
to be more efficient and reap higher margins from the large consulting
project. The CIO is faced with the decision to either keep using the
developed bespoke software or scrap it and purchase the off-the-shelf
alternative. The only relevant information the CIO should consider refers
to the future costs and future revenues of either options (i.e. the future
margins that the large project can yield by adopting either software). Say
that the margins that the firm can obtain from this large consulting project
are $1,000,000 if it uses the in-house developed software or $1,300,000 if
it adapts and uses the off-the-shelf software.
It appears obvious that the CIO should advise the firm to scrap the in-
house developed software and purchase and adapt the off-the-shelf one.
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AC3097 Management accounting
However, in reality, the CIO is likely to be biased by the fact that such a
decision may be perceived in the firm as a failure of the CIO themselves.
The fact that instalments for the external developers cost are still being
paid adds to the difficulty of taking the decision to move on and take the
more profitable option. Refer to the following Example 2.1.
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Chapter 2: Relevant information in decision making
Activity 2.3
(adapted and expanded from the 2011 subject guide)
A customer offers to buy electrical engines from your company. They are of an old design
and a slight modification to its electricity intake is needed to make them work. You have
plenty of those old engines in stock and have no prospect of being able to sell them
to anyone else. Their scrap value is negligible. Both the workers and the supervisors of
your factory are paid fixed monthly salaries. You expect to have some spare production
capacity over the coming weeks. The material cost of one old engine was $500. To
manufacture the altered design specified in the order, you would have to modify some
of your production machinery. An engineer would have to work on it for eight hours
and use materials worth $30,000. The customer offers to pay $300 per engine after the
alterations have been made.
Is it worth considering this order? What further information do you require to decide
whether you should accept the order?
A typical mistake would be to turn the order down because the selling price is lower than
the production cost. In fact, the production cost is a sunk cost, hence irrelevant to the
decision.
However, $30,000 is an emerging cost, hence relevant to the decision. You should accept
the order only if the emerging revenues cover the emerging cost and this happens if the
order is in excess of 100 engines. $30,000 / $300 = 100. Before accepting the order you
will also have to check that your workers and supervisors have enough spare production
capacity available to fulfil the order.
We have so far referred to outlay costs (i.e. costs which the firm actually
incurred or will incur). Of these, only those that can be influenced by
a managerial decision are relevant to that decision. Those that cannot
be influenced by a managerial decision are irrelevant to that decision.
However, there are other costs that will not actually materialise and yet
are relevant to the decision-making process. These are opportunity costs.
If we define cost as any decrease in wealth brought about by a decision to
use a particular resource or set of resources, by measuring the decrease in
wealth by reference to the next best alternative, we are effectively using
the economic concept of opportunity cost. Economists define opportunity
cost as the benefits foregone by not adopting the next best alternative,
where benefits can relate to any economic benefit, not only cash.
Opportunity costs arise in situations where different scenarios are
mutually exclusive and this in turn is determined by certain resources
being scarce. If no resources were scarce the decision maker would be able
to pursue different courses of action at the same time. Because the courses
of action are mutually exclusive and choosing one excludes the possibility
of pursuing the other, the benefits forgone by not pursuing that course
of action represents an opportunity cost. In this very moment, when you
are reading these lines, you could be doing something else. Potentially
this something else could give you some other satisfaction or rewards
than enhancing your knowledge. The satisfaction or rewards that you are
forgoing are an opportunity cost of choosing to read this text and study
this course. Hopefully you still believe that the satisfaction and rewards
that emerge from studying this course outweigh its opportunity costs!
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AC3097 Management accounting
Activity 2.4
Refer to a similar situation as in Activity 2.3. However, this time, the customer offers to
buy 100 electrical engines of a current design, again, with a slight modification to its
electricity intake. This order would be over and above orders already received so far. Both
the workers and the supervisors of your factory are paid fixed monthly salaries. Assume
you have just enough spare production capacity over the coming weeks. The material cost
of one engine is estimated to be $500. To manufacture the altered design specified in the
order, you would have to modify some of your production machinery. An engineer would
have to work on it for eight hours and use materials worth $30,000. The customer offers
to pay $850 per engine. Your companys list price for the current design is $880.
Is it worth considering this order? What further information do you require to decide
whether you should accept the order?
Feedback on Activity
In this case the emerging costs will be $500 per engine and $30,000 to enable the
alterations. Emerging revenues would be the price $850 for the altered engines, times the
number of altered engines. But, what about the current price of $880 per current engine?
The current price of $880 for a current design engine is irrelevant, if you do not expect
to receive further orders. Hence, emerging costs would be ($500 100) + $30,000 =
$80,000. Emerging revenues would be 850 100 = $85,000.
However, if you expect to receive further orders, the current price of $880 for a current
design engine becomes relevant. It would be an opportunity cost (i.e. it would measure
the lost opportunity to make revenues out of the current design engines, making the
offer most certainly not appealing). Why would you forgo $880 for a product that would
cost you $500, in order to receive only $850 for a product that would cost you more
than $500? The minimum price for accepting this order would be, in this case, $880 +
($30,000 / 100) = $1,180.
Upon completing this and the previous activities, revise the concept of One-Time-Only
Special Orders in your textbook.
Activity 2.5
Think about the opportunity costs that you incurred by enrolling on the University of
Londons International Programmes.
(i.e. the price per unit of components that will be paid to the external
contractor) and fixed (i.e. the fixed fee required by the contractor to
enter in this deal).
emerging margins (i.e. the difference between emerging revenues and
emerging costs caused by the use of the capacity freed by outsourcing
part of the production).
A practical guide to identifying relevant costs is given below, with
reference to a resource needed if the firm accepts a contract with a
customer for a specific project.
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AC3097 Management accounting
use it after the contract is fulfilled, but not for its full set of functionalities.
The latter circumstance would imply estimating the market price of
another less sophisticated machine that would provide your firm with
those less sophisticated functionalities for the remaining two years and
use that value as the residual value in the contract under consideration.
In essence you are trying to address the following question: how much
money would my firm have to spend if it will not inherit this machine from
the contract under consideration?
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Chapter 2: Relevant information in decision making
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AC3097 Management accounting
Notes
28
Chapter 3: Decision making with constraints and uncertainty
Aim
The aim of this chapter is to build on the foundations of management
accounting theory and practice. In particular, this chapter will focus on
analysing and solving situations where a production resource is limited
and it must be allocated to different jobs in a way that maximises the
benefits of its use.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
solve resource allocation problems in situations of capacity constraint
and choices between products
discuss the effects of performance evaluation for managerial control
purposes.
Essential reading
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education, 2015) 15th international edition
[ISBN 9781408093931] Chapter 11.
Further reading
Drury, C. Management and cost accounting. (London: Cengage, 2015) ninth
edition [ISBN 9781408093931] Chapter 9.
Hopper, T., T. Koga and J. Goto Cost accounting in small and medium sized
Japanese companies: an exploratory study, Accounting & Business Research
30(1) 1999, pp.7387.
Introduction
Most managers, most of the time, face situations where a production
resource is scarce (i.e. it limits the firms capacity to produce enough
products or services to satisfy the entire predicted demand for those
products or services).
In these situations managers must identify the most effective allocation of
that scarce resource. There are two aspects to this managerial decision:
the first is maximising the total margin under the current assumptions; the
second is adjusting the decision based on consideration of the uncertainty
of the initial assumptions and further strategic considerations.
This chapter focuses on techniques aimed at the strategic optimisation
of resource allocation, under conditions of uncertainty, and performance
evaluation.
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AC3097 Management accounting
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Chapter 3: Decision making with constraints and uncertainty
Uncertainty of information
All the examples given above assume that the outcomes of decisions are
identifiable and defined. In reality we know that decisions may lead to
different possible outcomes to each of which we can attach a probability.
There are different ways of dealing with uncertainty. The most
straightforward is to calculate expected values. An expected value is the
weighted average of the possible outcomes where the weights are their
respective probabilities of happening. This method is useful because it
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AC3097 Management accounting
reduces multiple outcomes to one value only and enables you to apply the
models of cost analysis mentioned above. On the other hand sometimes
this method is counterintuitive. For example, assume that you are in the
process of deciding what equipment to take with you in a boat fishing
trip according to the expected weather. Assume that you can only take
equipment that is suitable for very hot weather or very cold weather. You
cannot take both. Finally, assume that you are told that there is a 40 per
cent probability that it will be very hot and a 60 per cent probability that
it will be very cold. The expected value of this is an average temperature
that is not expected to actually be experienced! It would be necessary
to consider the (positive or negative) utility attached to each possible
outcome (i.e. how bad it would be to be out on the boat with the wrong
equipment).
Another technique is referred to as the decision tree analysis, which is
particularly useful when there is a sequence of possible uncertain events,
rather than one only.
Read the appendix to Chapter 3 of Horngren et al. (2015). You should
reflect on the use of these techniques and the consequences of applying
them when evaluating business decisions. For example, ask yourself: what
if the negative scenario occurs?
Performance evaluation
It should now be clearer that these models may have far-reaching
implications if applied without due consideration to other consequences
of managerial decisions. The likely bias they may create is determined by
their rigorous nature, which is often misinterpreted as an all-encompassing
characteristic. In other words, because the results of these quantitative
models are rationally logical, it is assumed that they are more relevant
than a less compelling strategic analysis. This bias is augmented by the
indicators of performance applied to evaluate managerial behaviour,
when such indicators link managerial incentives to the achievement of
quantifiable results.
Put the outsourcing example presented above in the context of a cost-
cutting firm, where managers are praised and rewarded for cutting
costs. This is likely to be a powerful signal for a manager who spots an
opportunity for making substantial saving by outsourcing the production
of a certain component or service. On the other hand, there is no hard
evidence for the long-term effects of outsourcing.
Similarly, put the scarce resource example presented above in the context
of a firm where the top management has clearly signalled that profitable
fast expansion is the current main goal. A manager will be inclined to
propose the optimal mix of products that delivers the highest margin, for
which they will have hard quantitative evidence, rather than considering
the long-term effects of allowing a competitor to penetrate that market.
Activity 3.1
In many countries, consulting firms that provide auditing and other consulting services are
banned from providing both auditing and other consulting services to the same clients.
Reflect on the considerations that a top manager of such a firm should make when faced
with the choice of discontinuing a portfolio of consulting services with a client in order to
be able to be its auditor. What would be the arguments of the two subordinate managers
respectively responsible for audit and non-audit services? How would this social dynamic
change if, instead of being organised in audit and non-audit services managers, the firm
was organised with account managers, that is to say managers responsible for clients?
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Chapter 3: Decision making with constraints and uncertainty
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AC3097 Management accounting
expenses of 2,000.
Type three projects are charged an average of 43,000 to the client and
normally take:
25 days of Lillians time
five days of Johannas time
expenses of 3,000.
Next years market demand for projects is expected to be as follows:
Type one: 20
Type two: 20
Type three: 10.
Assume that the total number of working days in a year are 230 per person
and that Lillian does not calculate any salary for herself but Johannas cost
is included in the expenses mentioned above.
a. Devise the most profitable portfolio of projects, showing calculations
and the total margin that your proposed portfolio is expected to
achieve.
b. Abigail has similar skills to Lillian and would be happy to join Lillians
business. She would require a salary of 150,000 (this is the all-
inclusive cost for Lillian). Is it worth it for Lillian to hire Abigail?
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Chapter 4: Cost volume profit analysis
Aim
The aim of this chapter is to enable you to analyse costs and their
behaviour as a consequence of managerial decisions. This chapter focuses
on the fundamental economic concepts of cost behaviour. Hence, the
distinction between fixed and variable costs is defined and explained.
Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
conveniently classify costs according to appropriate criteria, depending
on the purposes of the classification
discuss how cost accounting supports cost management.
Essential reading
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education, 2015) 15th international edition
[ISBN 9780133428704] Chapters 2, 3 and first four sections of Chapter 10.
You should also revisit Chapter 15 of the subject guide for AC1025
Principles of accounting.
Introduction
Cost behaviour is concerned with enabling managers to make educated
predictions of how costs will respond to their decisions.
The main aim of studying management and cost accounting is to
support managers decision making in their quest for the most efficient
and effective allocation of resources with the aim to maximise the
shareholders wealth. Therefore, decision making is concerned with
obtaining the highest sustainable spread between revenues and costs.
Mastering the concepts and techniques of cost behaviour is essential for
managerial decision making.
Given that costs measure the consumption of resources that a firm uses
in its operations, they are extremely diverse and it would be impractical
for a manager to consider each cost separately. Therefore, in order to
analyse costs and predict useful patterns it is necessary to categorise them.
Once a manager is able to refer a cost to a specific category, and the cost
behaviour of that category is known, then it will be easier to predict how
that cost will respond to decisions.
We have already come across the classification of relevant and irrelevant
costs. Among them, emerging and avoidable costs are relevant, whereas
sunk or committed costs are irrelevant. But what makes a cost emerge
when, for example, the decision is taken to increase the volume of
production? And by how much will this cost increase? These questions are
addressed by referring to the classification of fixed and variable costs.
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AC3097 Management accounting
Cost classifications
Variable and fixed costs
Variable costs are those costs whose value changes in proportion to changes
in the volume of production. In reality, very few costs behave exactly like
this. Economists demonstrate that not only will the resource consumption
they measure grow faster or slower than the production, but also the rate
of growth will change over time (see Figure 3.1 first and second chart).
For example, the more a resource is used, the more efficient its use may
become as the workforce becomes more skilful, the supervisors become
more aware of how to reduce wastages, managers are able to put in place
more effective control systems, consultants can apply past experience
to solve similar problems and so forth. The contrary is also true; when
producing amounts that are very close to the maximum capacity, resources
tend to consume more per unit, due to pressure, stress and fatigue. Think
of a consultant who normally organises their day by seeing one client per
hour for approximately 30 minutes, the remaining 30 minutes of each hour
are employed for preparation time, when they will be able to consider
the demands of each client and build on the experience learned from the
previous and maybe even relax. If this consultants schedule is changed and
they will now see two clients per hour, not only will the consultants service
quality be negatively affected, but they will also need to spend overtime
hours to catch up and will, most likely, take sick leave more often.
It is nevertheless true that if the variation in the volume of output is
within a limited range, then the changes in the value of certain costs are
not too far from being proportional to the changes in production volume
(see Figure 4.1 third chart). Hence, classifying such costs as variable
costs is justifiable due to their economic behaviour (within that range of
production volume), and this makes them easier to analyse.
Total cost of
resource (a)
Volume of production
Total cost of
resource (b)
Volume of production
resources (a) or (b)
Within a sufficiently
Total cost of
Volume of production
Volume of
production
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AC3097 Management accounting
providing a service, labour costs that can be identified as the work needed
in manufacturing a product or providing a service, and any other expense
that is directly related to a product or service. Direct costs are also known
as prime costs. Indirect costs are all the other costs (i.e. those that are
needed for the production of more than one type of product or service).
Indirect costs are also known as overheads.
Look at the examples of direct costs given in Horngren et al. (2015,
Chapter 2). Overheads are often divided into the following categories:
1. production overheads supervisors costs, cost of the energy that
powers the machines, cost of depreciation of machines, costs of
internal logistics
2. administration overheads cost of administrative staff, cost of the
middle and top management
3. selling overheads costs of marketing
4. distribution overheads costs of packaging, transporting, delivering
finished product or transporting staff who deliver services.
Activity 4.1
Reflect on the definitions of direct and indirect costs and think of examples of costs that
are in your opinion difficult to attach to either of the two definitions. You will soon realise
that allocating costs to one or the other category may depend on the type of decisions
you want to support by analysing those costs.
Upon completing this activity read the first five sections of Chapter 2 of Horngren et al.
(2015).
A cost matrix
As you will have realised, some indirect costs are variable, whereas no
direct costs can be fixed. So, recalling some of the concepts explained
above: costs that refer to resources employed exclusively for certain
products or services are called prime or direct costs, whereas resources
that are used for more than one product or service are overhead costs.
For example, raw materials are indeed used for many different products,
however each unit of raw material is used for one product only, hence they
are prime or direct costs. Similarly, the variable component of electricity
refers to the kilowatts used for the production of a specific product,
making it a variable cost, which however is indirect because the electricity
feeds a machine that produces the product. On the other hand, the fixed
monthly fee of the electricity bill is required for all products that need
electricity for production, making it a fixed overhead cost.
Normally, direct costs are treated as variable costs, whereas indirect costs
may be treated as variable or fixed. Direct and variable costs are also
prime costs. For example, raw materials are variable, direct, prime costs.
The variable component of electricity is a variable, indirect, overhead cost.
The fixed monthly fee is a fixed, indirect, overhead cost.
The following matrix (Table 4.1), representing some examples of costs,
illustrates the concept of these classifications and reflects on their use in
decision making.
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Chapter 4: Cost volume profit analysis
Direct Indirect
Variable Raw materials Electricity (variable component)
Direct labour
(Prime costs) (Production overhead costs)
Fixed N/A Electricity (fixed component)
Supervisors
(Production overhead costs)
Administrative
Distribution
(Other overhead costs)
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AC3097 Management accounting
40
Chapter 4: Cost volume profit analysis
is a market for at least 100 $75 tickets. Finally, you want to check the
probability of being able to sell at least 100 tickets.
Assume that you forecast selling 250 tickets, hence expecting a profit of
$9,000. A second step of this analysis will refer to the degree of risk that
you are prepared to accept for this event. If everyone deserts your event
you will be liable to pay $6,000 regardless. You may consider this too risky.
A solution would be to re-negotiate with the owner of the venue and offer
them a different deal, whereby you will pay $2,000 to hire the venue for
the night and $23 per spectator. This is summarised in Table 4.3.
Revenues Revenues
Number of Number of
tickets tickets
100 80
(Break-even point) (Break-even point)
Activity 4.2
Rehearse the above example by applying the decision-making model from Horngren et al.
(2015).
Assume that your aim is to achieve a $10,000 profit, and that the owner of the venue
is equally happy with both deals. Apply the same decision-making model to analyse and
evaluate both options to support your decision.
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AC3097 Management accounting
42