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Summary of cost and managerial accounting
- Instelling
- Maastricht University (UM)
summary with calculations and examples
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CHAPTER 1: Introduction to Management AccountingThe American Accounting Association describes accounting as the process of identifying, measuring and
communicating economic information to permit informed judgements and decisions by users of the information.
à Accounting is concerned with providing both financial and non-financial information that will help decision-
makers to make good decisions.
1.1 The Users of Accounting Information
Accounting is a language that communicates economic information to various parties (stakeholders) who have an
interest in the organization. Stakeholders fall into several groups and each of these groups has its own
requirements for information:
• Managers require information that will assist them in their decision-making and control activities;
• Shareholders require information on the value of their investment and the income that is derived from their
shareholding.
• Employees require information on the ability of the firm to meet wage demands and avoid redundancies.
• Creditors and the providers of loan capital require information on a firm’s ability to meet its financial
obligations.
• Government agencies collect accounting information and require such information as the details of sales
activity, profits, investments, stocks, dividends paid, the proportion of profits absorbed by taxation and so on.
In addition, government taxation authorities require information on the amount of profits that are subject to
taxation. All this information is important for determining policies to manage the economy.
Individuals sometimes have to provide information about their own financial situation. Non-profit- making
organizations also require accounting information for decision-making, and for reporting the results of their
activities.
The users of accounting information can be divided into two categories:
1. Internal users within the organization;
2. External users such as shareholders, creditors and regulatory agencies, outside the organization.
It is possible to distinguish between two branches of accounting, which reflect the internal and external users of
accounting information. Management accounting is concerned with the provision of information to people within
the organization to help them make better decisions and improve the efficiency and effectiveness of existing
operations, whereas financial accounting is concerned with the provision of information to external parties
outside the organization. Thus, management accounting could be called internal reporting and financial
accounting could be called external reporting.
1.2 Differences Between Management Accounting and Financial Accounting
The major differences between these two branches of accounting are:
• Legal requirements. There is a statutory requirement for public limited companies to produce annual financial
accounts. Management accounting is entirely optional, and information should be produced only if it is
considered that the benefits it offers management exceed the cost of collecting it.
• Focus on individual parts or segments of the business. Financial accounting reports describe the whole of the
business, whereas management accounting focuses on small parts of the organization.
• Generally accepted accounting principles. Financial accounting statements must be prepared to conform with
the legal requirements and the generally accepted accounting principles established by the regulatory. These
requirements are essential to ensure uniformity and consistency, which make intercompany and historical
comparisons possible. Financial accounting data should be verifiable and objective. In contrast, management
accountants are not required to adhere to generally accepted accounting principles. Instead, the focus is on
the serving management’s needs and providing information that is useful to managers when they are carrying
out their decision-making, planning and control functions.
• Time dimension. Financial accounting reports what has happened in the past in an organization, whereas
management accounting is concerned with future information as well as past information. Decisions are
concerned with future events and management requires details of expected future costs and revenues.
• Report frequency and less emphasis on precision. A detailed set of financial accounts is published annually,
and less detailed accounts are published semi-annually. Managers are often more concerned with timeliness
rather than precision. They prefer a good estimate now rather than a precise answer much later.
Consequently, management accounting reports on various activities may be prepared at daily, weekly or
monthly intervals.
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,1.3 The Decision-Making, Planning and Control Process
Information produced by management accountants must be
judged in the light of its ultimate effect on the outcome of
decisions. Figure 1.1 presents a diagram of the decision-
making, planning and control process. The first four stages
represent the decision-making or planning process. The final
two stages represent the control process, which is the
process of measuring and correcting actual performance to
ensure the alternatives that are chosen and the plans for
implementing them are carried out.
Identifying objectives
Before good decisions can be made there must be some guiding aim or direction that will enable the decision-
makers to assess the desirability of choosing one course of action over another. Hence, the first stage in the
decision-making process should be to specify the company’s goals or organizational objectives.
This is an area in which there is considerable controversy. Economic theory normally assumes that firms seek to
maximize profits for the owners of the firm (the maximization of shareholders’ wealth is equivalent to the
maximization of the present value of future cash flows). Various arguments have been used to support the profit
maximization objective. There is the legal argument that the ordinary shareholders are the owners of the firm,
which therefore should be run for their benefit by trustee managers. Another argument is that profit
maximization leads to the maximization of overall economic welfare àby doing the best for yourself, you are
unconsciously doing the best for society. Moreover, it seems a reasonable belief that the interests of firms will be
better served by a larger profit than by a smaller profit, so that maximization is at least a useful approximation.
- Simon (1959): many managers are content to find a plan that provides satisfactory profits rather than to
maximize profits.
- Cyert and March (1969) have argued that the firm is a coalition of various different groups, each of whom
must be paid a minimum to participate in the coalition. Any excess benefits after meeting these minimum
constraints are seen as being the object of bargaining between the various groups. A firm is subject to
constraints of a societal nature. Maintaining a clean environment, employing disabled workers and providing
social and recreation facilities are all examples of social goals that a firm may pursue.
Another common goal is security, and the removal of uncertainty regarding the future may override the pure
profit motive. Organizations may also pursue more specific objectives. Nevertheless, broadly, firms seek to
maximize future profits. There are three reasons for us to concentrate on this objective:
1. It is unlikely that any other objective is as widely applicable in measuring the ability of the organization to
survive in the future.
2. It is unlikely that maximizing future profits can be realized in practice, but by establishing the principles
necessary to achieve this objective you will learn how to increase profits.
3. It enables shareholders as a group in the bargaining coalition to know how much the pursuit of other
goals is costing them by indicating the amount of cash distributed among the members of the coalition.
The search for alternative courses of action
The second stage in the decision-making model is a search for a range of possible courses of action (or strategies)
that might enable the objectives to be achieved. If the business is to survive, management must identify potential
opportunities and threats in the current environment and take specific steps now so that the organization will not
be taken by surprise by future developments. In particular, the company should consider one or more of the
following courses of action:
1 developing new products for sale in existing markets;
2 developing new products for new markets;
3 developing new markets for existing products.
Select appropriate alternative courses of action
In order for managers to make an informed choice of action, data about the different alternatives must be
gathered. For example, managers might ask to see projected figures on:
• The potential growth rates of the alternative activities under consideration;
• The market share the company is likely to achieve;
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,• Projected profits for each alternative activity.
The alternatives should be evaluated to identify which course of action best satisfies the objectives of an
organization. The selection of the most advantageous alternative is central to the whole decision-making process
and the provision of information that facilitates this choice is one of the major functions of management
accounting.
Implementation of the decisions
Once the course of action has been selected, it should be implemented as part of the budgeting and long-term
planning process. The budget is a financial plan for implementing the decisions that management has made. The
budgets are expressed in terms of cash inflows and outflows, and sales revenues and expenses. These budgets are
initially prepared at the departmental/responsibility centre level and merged together into a single unifying
statement for the organization as a whole that specifies the organization’s expectations for future periods. This
statement is known as a master budget and consists of budgeted profit and cash flow statements. The budgeting
process communicates to everyone in the organization the part that they are expected to play in implementing
management’s decisions.
Comparing actual and planned outcomes and responding to divergencies from plan
The final stages in the process involve comparing actual and planned outcomes and responding to divergencies
from plan. The managerial function of control consists of the measurement, reporting and subsequent correction
of performance in an attempt to ensure that the firm’s objectives and plans are achieved.
To monitor performance, the accountant produces performance reports and presents them to the managers who
are responsible for implementing the various decisions. These reports compare actual outcomes (costs and
revenues) with planned outcomes (budgeted costs and revenues) and should be issued at regular intervals.
Performance reports provide feedback information and should highlight those activities that do not conform to
plans. This process represents the application of management by exception. Effective control requires that
corrective action is taken so that actual outcomes conform to planned outcomes. Alternatively, the plans may
require modification if the comparisons indicate that the plans are no longer attainable.
The process of taking corrective action or modifying the plans is indicated by the arrowed lines in Figure 1.1
linking stages 6 and 4 and 6 and 2. These arrowed lines represent ‘feedback loops’. They signify that the process is
dynamic and stress the interdependencies between the various stages in the process. The feedback loop between
stages 6 and 2 indicates that the plans should be regularly reviewed, and if they are no longer attainable then
alternative courses of action must be considered for achieving the organization’s objectives. The second loop
stresses the corrective action taken so that actual outcomes conform to planned outcomes.
1.4 The Impact of The Changing Business Environment on Management Accounting
Global competition, deregulation, declines in product life cycles, advances in manufacturing and information
technologies, environmental issues and a competitive environment have changed the nature of the business
environment. These changes have significantly altered the ways in which firms operate, which in turn, have
resulted in changes in management accounting practices.
Global competition
During the last few decades reductions in tariffs and duties on imports and exports, and improvements in
transportation and communication systems, have resulted in many firms operating in a global market. Prior to
this, many organizations operated in a protected competitive environment. Barriers of communication and
geographical distance, and sometimes protected markets, limited the ability of overseas companies to compete in
domestic markets. There was little incentive for firms to maximize efficiency and improve management practices,
or to minimize costs. During the 1990s organizations began to encounter competition from overseas competitors.
Manufacturing companies can now establish global networks for acquiring raw materials and distributing goods
overseas, and service organizations can communicate with overseas offices instantaneously using internet and
digital technologies. These changes have enabled competitors to gain access to domestic markets throughout the
world. This new competitive environment has increased the demand for information relating to quality and
customer satisfaction and cost information relating to cost management and profitability analysis by
product/service lines and geographical locations.
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, Changing product life cycles
A product’s life cycle is the period of time from initial expenditure on research and development to the time at
which support to customers is withdrawn. Intensive global competition and technological innovation, and
increasingly sophisticated customer demands, have resulted in a decline in product life cycles. To be successful
companies must now speed up the rate at which they introduce new products to the market and constantly
develop new products and services. In many industries, a large fraction of a product’s life cycle costs are
determined by decisions made early in its life cycle. This has created a need for management accounting to place
greater emphasis on providing information at the design stage because many of the costs are committed or
locked in at this time. Therefore, to compete successfully, companies must be able to manage their costs
effectively at the design stage, have the capability to adapt to new, different and changing customer
requirements and reduce the time to market of new and modified products.
Advances in manufacturing technologies
Excellence in manufacturing can provide a competitive weapon to compete in worldwide markets. In order to
compete effectively, companies must be capable of manufacturing innovative products of high quality at a low
cost, and also provide a good customer service. They must have the flexibility to cope with short product life
cycles, demands for greater product variety from more discriminating customers and increasing international
competition. World-class manufacturing companies have responded to these competitive demands by replacing
traditional production systems with lean manufacturing systems that seek to reduce waste by implementing just-
in-time (JIT) production systems, focusing on quality, simplifying processes and investing in advanced
manufacturing technologies (AMTs).
The impact of information technology
During the past two decades the use of information technology (IT) to support business activities has increased
and the development of electronic business communication technologies known as e-business, e-commerce or
internet commerce have had a major impact. Internet trading allows buyers and sellers to undertake transactions
from diverse locations. E-commerce has allowed considerable cost savings to be made by streamlining business
processes and has generated extra revenues from the adept use of online sales facilities. The proficient use of e-
commerce has given many companies a competitive advantage.
The developments in IT have had a significant impact on the work of management accountants. They have
substantially reduced information gathering and the processing of information. They can access the system on
their personal computers to derive the information they require directly and do their own analyses. This has freed
accountants to adopt the role of advisers and internal consultants to the business. Management accountants
have now become more involved in interpreting the information generated from the accounting system and
providing business support for managers.
Environmental and sustainability issues
Increasing attention is now being given to making companies accountable for ethical, social and environmental
issues and the need for organizations to be managed in a sustainable way. There is now a general recognition that
environmental resources are limited and should be preserved for future generations. Customers are no longer
satisfied if companies simply comply with the legal requirements. They expect company managers to be more
proactive in terms of their social responsibility, safety and environmental issues. Environmental costs can be large
for some industrial sectors. Moreover, regulatory requirements involving huge fines for non-compliance have
increased à selecting the least costly method of compliance has become a major objective. Lastly, society is
demanding that companies focus on being more environmentally friendly. Companies are finding that becoming a
good social citizen and being environmentally responsible improves their image. These developments have
created the need for companies to develop systems of measuring and reporting environmental costs, the
consumption of scarce environmental resources and details of hazardous materials or pollutants. Managers need
to redesign processes to minimize the usage of scarce environmental resources and the emission pollutants and
to also make more sensitive environmental decisions.
Pressures to adopt higher standards of ethical behaviour
It was earlier pointed out that it is too simplistic to assume that the only objective of a business firm is to
maximize profits. The profit maximization objective should be constrained by the need for firms to also give high
priority to their social responsibilities and ensure that their employees adopt high standards of ethical behaviour.
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