Management Accounting [6 ed.] 0077185536, 9780077185534

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W I L L S E A L    C A R S T E N R O H D E RAY H. GARRISON   E R I C W. N O R E E N

MANAGEMENT ACCOUNTING SIXTH EDITION

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W I L L S E A L    C A R S T E N R O H D E RAY H. GARRISON   E R I C W. N O R E E N

MANAGEMENT ACCOUNTING SIXTH EDITION

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Management Accounting 6e Will Seal, Carsten Rohde, Ray H. Garrison and Eric W. Noreen ISBN-13 9780077185534 ISBN-10 0077185536

Published by McGraw-Hill Education 338 Euston Road London NW1 3BH Telephone: 44 (0) 20 3429 340 Website: www.mheducation.co.uk British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data The Library of Congress data for this book has been applied for from the Library of Congress Portfolio Lead, Higher Education (Business & Economics): Matthew Simmons Senior Content Developer: Rosie Churchill Content Product Manager: Adam Hughes Marketing Manager: Geeta Chandolia Text Design by Kamae Design Cover design by Adam Renvoize Published by McGraw-Hill Education. Copyright © 2019 by McGraw-Hill Education. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGrawHill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Fictitious names of companies, products, people, characters and/or data that may be used herein (in case studies or in examples) are not intended to represent any real individual, company, product or event. ISBN-13 9780077185534 ISBN-10 0077185536 © 2019. Exclusive rights by McGraw-Hill Education for manufacture and export. This book cannot be re-exported from the country to which it is sold by McGraw-Hill Education.

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Brief table of contents Part 1: An introduction to management and cost accounting: cost terms, systems design and cost behaviour 1. Management accounting and the business environment 2. An introduction to cost terms, concepts and classifications 3. Cost behaviour: analysis and use 4. Job-order and service department costing 5. Process costing

Part 2: Information for decision making 6. Cost—volume—profit relationships 7. Profit reporting under variable costing and absorption costing 8. Performance measurement and reporting on segments 9. Activity-based costing  10. Relevant costs for decision making 

Part 3: Planning and control 11. 12. 13. 14. 15.

Profit planning and the role of budgeting Standard costs and variance analysis Flexible budgets and performance reporting Capital investment decisions Pricing and intra-company transfers

Part 4: Value metrics and performance management in a strategic context 16. 17. 18. 19.

Strategic management accounting and the balanced scorecard Management control and corporate governance Business process management: towards the lean operation Strategic perspectives on cost management

1 2 22 60 101 157

191 192 239 271 317 374

433 434 479 519 576 640

685 686 719 750 791

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Detailed table of contents About the authors

xiii

Changes in the business environment and management accounting 12 New business processes and technologies 12 Enterprise resource planning systems 12 Deregulation, privatization and re-regulation 13 The increased importance of service sector management 13 Managing for value 14 Managing for environmental sustainability 15 Corporate governance, professional and business ethics 15 Some implications for the roles of management accountants 16

Preface xiv Acknowledgements xvi Guided tour

xviii

Technology to enhance learning and teaching xx

Part 1: An introduction to management and cost accounting: cost terms, systems design and cost behaviour 1 1

Management accounting and the business environment 2 The work of management and the need for management accounting information 3 Planning 3 Directing and motivating 4 Controlling 4 The end results of managers’ activities 4 The planning and control cycle 5 Decision making 5 Comparison of financial and management accounting 6 Emphasis on the future 6 Relevance and flexibility of data 6 Less emphasis on precision 7 Segments of an organization 7 International Financial Reporting Standards (IFRS) 8 Management accounting – not mandatory 8 Basic organizational structure 8 Decentralization 8 Line and staff relationships 9 Expanding and changing role of management accounting 9 The sources of management accounting knowledge 10 International diversity in management accounting traditions 10 Globalization and international competition 11

2

An introduction to cost terms, concepts and classifications 22 General cost classifications 23 Manufacturing costs 24 Non-manufacturing costs 25 Product costs versus period costs 25 Cost classifications on financial statements 27 The statement of financial position 27 The statement of profit or loss 28 Schedule of cost of goods manufactured 30 Product costs – a closer look 31 Inventoriable costs 32 An example of cost flows 32 Costing in service organizations: a first look 34 Cost classifications for predicting cost behaviour 34 Variable cost 34 Fixed cost 35 Cost classifications for assigning costs to cost objects 36 Direct cost 37 Indirect cost 37 Cost classifications for decision making 37 Differential cost and revenue 37 Opportunity cost 38 Sunk cost 39

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et complete eBook Order by email at [email protected] Detailed table of contents  vii 3

4

Cost behaviour: analysis and use 60 Types of cost behaviour patterns 61 Variable costs 61 The activity base 62 True variable versus step-variable costs 63 The linearity assumption and the relevant range 64 Fixed costs 66 Types of fixed costs 66 The trend toward fixed costs 68 Is labour a variable or a fixed cost? 68 Fixed costs and the relevant range 68 Mixed costs 70 The analysis of mixed costs 71 The high–low method 72 The scattergraph method 74 The least-squares regression method 76 Multiple regression analysis 77 The contribution format 78 Why a new statement of profit or loss format? 78 The contribution approach 79 Job-order and service department costing 101 Process and job-order costing 102 Process costing 102 Job-order costing 103 Job-order costing – an overview 104 Measuring direct materials cost 104 Job cost sheet 105 Measuring direct labour cost 106 Application of manufacturing overhead 107 Choice of an allocation base for overhead cost 109 Computation of unit costs 110 Summary of document flows 110 Job-order costing – the flow of costs 111 The purchase and issue of materials 111 Labour cost 113 Manufacturing overhead costs 113 The application of manufacturing overhead 114 Non-manufacturing costs 116 Cost of goods manufactured 116 Cost of goods sold 117 Summary of cost flows 117 Problems of overhead application 120

Underapplied and overapplied overhead 121 Disposition of underapplied or overapplied overhead balances 123 A general model of product cost flows 124 Multiple predetermined overhead rates 125 Job-order costing in service companies 125 The predetermined overhead rate and capacity 126 5

Process costing 157 Comparison of job-order and process costing 158 Similarities between job-order and process costing 158 Differences between job-order and process costing 159 A perspective of process cost flows 159 Processing departments 159 The flow of materials, labour and overhead costs 161 Materials, labour and overhead cost entries 161 Equivalent units of production 164 Weighted-average method 164 Production report – weightedaverage method 166 A comment about rounding errors 171 FIFO method 172 Equivalent units – FIFO method 172 Comparison of equivalent units of production under the weighted-average and FIFO methods 172 Production report – FIFO method 174 A comparison of costing methods 176 Standard costing method 177 Operation costing 178

Part 2: Information for decision making 6

191

Cost–volume–profit relationships 192 The basics of cost–volume– profit (CVP) analysis 194 Contribution margin 194 Contribution margin ratio (CM ratio) 196 Some applications of CVP concepts 197 Importance of the contribution margin 201

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et complete viii  Detailed tableeBook of contents Order by email at [email protected] Break-even analysis Break-even computations CVP relationships in graphic form Preparing the CVP graph Target profit analysis The CVP equation The contribution margin approach The margin of safety CVP considerations in choosing a cost structure Cost structure and profit stability Operating leverage Automation: risks and rewards from a CVP perspective Structuring sales commissions The concept of sales mix The definition of sales mix Sales mix and break-even analysis Assumptions of CVP analysis 7

8

201 201 203 203 204 205 205 205

Revenue and contribution margin 278 Traceable and common fixed costs 278 Traceable costs can become common costs 279 Segment margin 280 There is more than one way to segment a company 281 Hindrances to proper cost assignment 282 Omission of costs 282 Inappropriate methods for allocating costs among segments 283 Arbitrarily dividing common costs among segments 283 Rate of return for measuring managerial performance 284 The return on investment (ROI) formula 284 Operating profit and operating assets 284 Plant and equipment: net book value or gross cost? 285 Controlling the rate of return 286 Increase revenue 288 Reduce expenses 288 Reduce operating assets 289 Criticisms of ROI 289 Residual income – another measure of performance 289 Motivation and residual income 290 Divisional comparison and residual income 291 The problem of single-period metrics: the bonus bank approach 292

206 206 208 209 211 211 211 211 213

Profit reporting under variable costing and absorption costing 239 Overview of absorption and variable costing 240 Absorption costing 240 Variable costing 240 Unit cost computations 241 Profit comparison of absorption and variable costing 242 Extended comparison of profit data 245 Effect of changes in production on profit 249 Variable costing 249 Absorption costing 249 The impact on the manager 253 Choosing a costing method 254 External reporting 254 Decision making 254 Advantages of variable costing and the contribution approach 254 Impact of JIT methods 255 Performance measurement and reporting on segments 271 Decentralization in organizations 272 Advantages and disadvantages of decentralization 272 Decentralization and segment reporting 273 Cost, profit and investment centres 273 Responsibility centres 274 Segment reporting and profitability analysis 274 Levels of segmented statements 276

9

Activity-based costing 317 How costs are treated under activitybased costing 319 Non-manufacturing costs and activity-based costing 319 Manufacturing costs and activity-based costing 319 The costs of idle capacity in activity-based costing 320 Designing an activity-based costing (ABC) system 320 Identifying activities to include in the ABC system 323 The mechanics of activity-based costing 324 Tracing overhead costs to activities and cost objects 324 Assigning costs to activity cost pools 325

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et complete eBook Order by email at [email protected] Detailed table of contents  ix Computation of activity rates 327 Targeting process improvements: activity-based management 329 Assigning costs to cost objects 331 Overhead costs computed using the ABC system 331 Product margins and customer profitability computed using the ABC system 332 Comparison of traditional and ABC product costs 333 Product margins computed using the traditional cost system 333 The differences between ABC and traditional product costs 334 ABC product costs – an action analysis 336 Ease of adjustment codes 336 The action analysis view of the ABC data 336 Service costing and management: the benefits of an ABC approach 339 Time-driven ABC 340 Activity-based costing and external reports 341 A simplified approach to activity-based costing 341 10 Relevant costs for decision making 374 Cost concepts for decision making 375 Identifying relevant costs and benefits 375 Different costs for different purposes 376 Sunk costs are not relevant costs 376 Book value of old equipment 377 Future costs that do not differ are not relevant costs 379 An example of irrelevant future costs 379 Why isolate relevant costs? 380 Adding and dropping product lines and other segments 381 An illustration of cost analysis 381 A comparative format 383 Beware of allocated fixed costs 383 The make or buy decision 384 An example of make or buy 385 The matter of opportunity cost 386 Special orders 387 Utilization of constrained resources 388 Contribution in relation to a constrained resource 388 Managing constraints 389

The problem of multiple constraints in the short run: linear programming Sensitivity analysis Shadow prices The limitations of the linear programming model as a management accounting technique Joint product costs and the contribution approach The pitfalls of allocation Sell or process further decisions Activity-based costing and relevant costs

391 392 393

393 394 395 395 397

Part 3: Planning and control 433 11 Profit planning and the role of budgeting 434 The basic framework of budgeting 435 Definition of budgeting 435 Personal budgets 436 Differences between planning and control 436 Advantages of budgeting 436 Responsibility accounting 437 Choosing a budget period 437 The participative or self-imposed budget 437 The matter of human relations 439 The budget committee 440 The master budget inter-relationships 441 Sales forecasting – a critical step 442 Preparing the master budget 442 The sales budget 443 The production budget 444 The direct materials budget 446 The direct labour budget 447 The manufacturing overhead budget 448 The ending finished goods inventory budget 450 The selling and administrative expense budget 450 The cash budget 451 The budgeted statement of profit or loss 453 The budgeted statement of financial position 454 Expanding the budgeted statement of profit or loss 456 Activity-based budgeting 457

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et complete Order by email at [email protected] x  Detailed table eBook of contents Some criticisms of budgeting as a performance management system 458 Reform or abandon budgeting? 458 The Beyond Budgeting Round Table 459 12 Standard costs and variance analysis 479 Standard costs – management by exception 481 Who uses standard costs? 481 Setting standard costs 482 Ideal versus practical standards 482 Setting direct materials standards 483 Setting direct labour standards 484 Setting variable manufacturing overhead standards 485 Are standards the same as budgets? 485 A general model for variance analysis 486 Price and quantity variances 486 Using standard costs – direct materials variances 487 Materials price variance – a closer look 489 Materials quantity variance – a closer look 490 Using standard costs – direct labour variances 491 Labour rate variance – a closer look 492 Labour efficiency variance – a closer look 492 Using standard costs – variable manufacturing overhead variances 493 Manufacturing overhead variances – a closer look 494 Structure of performance reports 495 Variance analysis and management by exception 495 Evaluation of controls based on standard costs 497 Advantages of standard costs 497 Potential problems with the use of standard costs 497 13 Flexible budgets and performance reporting 519 Flexible budgets 520 Characteristics of a flexible budget 520 Deficiencies of the static budget 521 How a flexible budget works 522 Using the flexible budgeting concept in performance evaluation 523 The measure of activity – a critical choice 526 Variable overhead variances – a closer look 526

The problem of actual versus standard hours 526 Spending variance alone 527 Both spending and efficiency variances 528 Overhead rates and fixed overhead analysis 530 Flexible budgets and overhead rates 530 Overhead application in a standard cost system 532 The Fixed overhead variances 533 The budget variance – a closer look 534 The volume variance – a closer look 534 Graphic analysis of fixed overhead variances 536 Cautions in fixed overhead analysis 536 Overhead variances and underor overapplied overhead cost 537 Appendix 13A: Sales mix, quantity variances, production mix and yield variances 538 Appendix 13B: Variance analysis in merchandise and service settings 542 14 Capital investment decisions 576 Capital budgeting – planning investments 578 Typical capital budgeting decisions 578 The time value of money 578 Discounted cash flows – the net present value method 578 The net present value method illustrated 578 Emphasis on cash flows 580 Recovery of the original investment 581 Simplifying assumptions 582 Choosing a discount rate 582 An extended example of the net present value method 582 Discounted cash flows – the internal rate of return method 583 The internal rate of return method illustrated 583 Salvage value and other cash flows 584 The process of interpolation 585 Using the internal rate of return 585 The cost of capital as a screening tool 586 Comparison of the net present value and the internal rate of return methods 586 Expanding the net present value method 587

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et complete eBook Order by email at [email protected] Detailed table of contents  xi The total-cost approach 587 The incremental-cost approach 588 Least-cost decisions 588 Capital budgeting and non-profit organizations 589 Preference decisions – the ranking of investment projects 590 Internal rate of return method 591 Net present value method 591 Other approaches to capital budgeting decisions 592 The payback method 592 The simple rate of return method 595 Post-audit of investment projects 597 Appendix 14A: The concept of present value 598 The mathematics of interest 598 Computation of present value 599 Present value of a series of cash flows 600 Appendix 14B: Inflation and capital budgeting 601 Appendix 14C: Future value and present value tables 603 Appendix 14D: The impact of corporate taxation 606 Appendix 14E: Investment decision making and risk 607 Risk and uncertainty 607 Investment decision making and risk 608 Interrelated risks: the decision tree 609 The value of extra information 612 Pay-off strategies 612 15 Pricing and intra-company transfers 640 The economists’ approach to pricing 641 Elasticity of demand 641 The profit-maximizing price 642 The absorption costing approach to cost-plus pricing 644 Setting a target selling price using the absorption costing approach 645 Determining the mark-up percentage 645 Problems with the absorption costing approach 647 Target costing 647 An example of target costing 648 Service companies – time and material pricing 648 Time component 649 Material component 649 An example of time and material pricing 649 Revenue and yield management 650

Transfer pricing 651 Negotiated transfer prices 652 Transfers at the cost of the selling division 655 Transfers at market price 656 Divisional autonomy and suboptimization 657 International aspects of transfer pricing 658

Part 4: Value metrics and performance management in a strategic context 685 16 Strategic management accounting and the balanced scorecard 686 Profit planning with a given industry and product: cost structure and business orientation 688 Value-based management 689 Some basic techniques of strategic management accounting 691 SMA and the concept of strategic positioning 691 Strategic investment appraisal: investment appraisal with strategic ‘bolt-ons’? 692 The Mavis Machines case 692 Strategic investment appraisal: an iterative model 694 Strategy as collision: lean enterprises and business process re-engineering 694 Modelling and monitoring strategy: the balanced scorecard and other non-financial measures 695 Divisional performance measures and the balanced scorecard 695 Common characteristics of balanced scorecards 696 Some obstacles to SMA 703 17 Management control and corporate governance 719 General models of management control and performance measurement 721 The levers of control approach to strategy implementation 723 Corporate governance: a financial perspective 725 Management accounting and the integrity of financial information 726

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et complete xii  Detailed tableeBook of contents Order by email at [email protected] Management accounting and regulatory approaches to corporate governance 726 Corporate governance and risk management 727 Wealth creation and good corporate governance: the role of boundary systems 730 Enterprise governance 731 A broader view on corporate governance: stakeholder, social and environmental responsiveness 731 The Performance Prism 731 Environmental management accounting 733 An example of environmental management accounting 735 Organizational control and service delivery in the public sector: beyond incrementalism? 735 New political and management structures 736 The introduction of policy-led budgeting 736 Informal versus formal control systems 738 18 Business process management: towards the lean operation 750 Optimizing inventory: the economic order quantity (EOQ) and the reorder point 752 Costs associated with inventory 752 Computing the economic order quantity (EOQ) 753 Just-in-time (JIT) and the economic order quantity (EOQ) 755 Production lot size 756 Reorder point and safety inventory 757 Reducing inventory: just-in-time (JIT) 758 The JIT concept 759 Key elements in a JIT system 760 Benefits of a JIT system 762 Inventory control and enterprise resource planning (ERP) 762 E-commerce: new challenges for management accounting 763 Quality and business processes: measurement and management 764 The cost of quality model 764 Prevention costs 765 Appraisal costs 766 Internal failure costs 766 External failure costs 766

Distribution of quality costs 766 Quality cost reports 767 From modelling the costs of quality to quality management 770 Total quality management (TQM) 770 The plan–do–check–act cycle 770 Some criticisms of TQM 771 Benchmarking 771 Some problems with benchmarking 772 Business process re-engineering (BPR) 772 What does a re-engineered process look like? 773 Some criticisms of re-engineering 773 Six Sigma 773 Lean production 774 An emphasis on eliminating waste 775 Lean accounting 775 Obstacles to organizational change and the advantages of a fresh start 775 19 Strategic perspectives on cost management 791 The theory of constraints 792 TOC and continuous improvement 792 An example of TOC 793 The impact of TOC on management accounting 793 Throughput accounting 793 Strategic approaches to cost management: target costing and life-cycle costing 794 Target costing and life-cycle costing 794 Some problems with target and life-cycle costing 796 The make-or-buy decision from a strategic perspective: supply chain management 797 Integration versus sub-contracting 798 Traditional supply relationships 799 Strategic partnering 799 The implications for management accounting of strategic approaches to make or buy 801 Corporate unbundling: shared service centres and service outsourcing 802 The shared service centre model 805 Variable costs 806 Fixed costs 807 Should actual or budgeted costs be allocated? 808 Service outsourcing 808 Glossary 817 Bibliography 829 Index 838

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PART 1 An introduction to management and cost accounting: cost terms, systems design and cost behaviour

1 Management accounting and the business environment 02 2 An introduction to cost terms, concepts and classifications22 3 Cost behaviour: analysis and use

60

4 Job-order and service department costing

101

5 Process costing

157

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CHAPTER 1 Management accounting and the business environment

LEARNING OBJECTIVES After studying Chapter 1, you should be able to: LO1

Describe what managers do and why they need accounting information

LO2

Identify the major differences and similarities between financial and management accounting

LO3

Describe the role of a management accountant in an organization

LO4

Discuss the impact of international competition on businesses and on management accounting

LO5

Review the impact of organizational and technological change on management accounting

LO6

Identify emerging issues: increasing importance of services, managing for value, the sustainability agenda and corporate governance

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et complete eBook Order email atneed [email protected] The work of by management and the for management accounting information   3 CONCEPTS IN CONTEXT It was during the 1980s that writers began to criticize management accounting for not adequately serving the needs of senior managers in the formulation of strategy and sustaining a competitive advantage. At the same time a body of literature emerged around the development of strategic management accounting (SMA) that promised to answer the criticism. However, to date there has been no agreement on what constitutes SMA. Neither has the term entered the lexicon of accounting professionals. A study based on 14 interviews with finance professionals working in business, indicate that despite not using the term SMA, accountants can, and do, make an active contribution to the strategic management process. The range of techniques utilized may not be as extensive as previous studies into SMA have suggested. Also the degree to which accountants are able to become involved is influenced by organizational factors, the range of attributes possessed by the accountant, and the practicalities involved in enabling the accountant to perform his/her role. The closest term that defines the role of accountants when involved in the strategic management process is that of ‘business partnering’. Source: CIMA 2015. Management Accounting in Support of the Strategic Management Process, CIMA Executive Summary Report, 11(1). Available at: http://www.cimaglobal.com/Documents/Thought_leadership_docs/Management%20and%20 financial%20accounting/Academic-Research-Report-Strategic-Management-Process.pdf

Management accounting is concerned with providing information to managers – that is, people inside an organization who direct and control its operations. In contrast, financial accounting is concerned with providing information to shareholders, creditors and others who are outside an organization. Management accounting provides the essential data with which organizations are actually run. Financial accounting provides the scorecard by which a company’s past performance is judged. Because it is manager oriented, any study of management accounting must be preceded by some understanding of what managers do, the information managers need, and the general business environment. As the organizations and the business environment changes then the role of management accounting changes. Accordingly, the purpose of this chapter is briefly to examine these subjects.

LO1

The work of management and the need for management accounting information Every organization – large and small – has managers. Someone must be responsible for making plans, organizing resources, directing personnel and controlling operations. In this chapter, we will use a particular organization – a department store, Happybuy Ltd – to illustrate the work of management. What we have to say about the management of Happybuy Ltd, however, is very general and can be applied to virtually any organization. Managers at Happybuy Ltd, like managers everywhere, carry out four major activities – planning, directing and motivating, controlling and decision making. Planning involves selecting a course of action and specifying how the action will be implemented. Directing and motivating involves mobilizing people to carry out plans and run routine operations. Controlling involves ensuring that the plan is actually carried out and is appropriately modified as circumstances change. Decision making involves selecting a course of action from competing alternatives. Now let’s take a closer look at the content of these four pillars and how they relate to each other.

Planning The first step in planning is to identify alternatives and then to select from among the alternatives the one that does the best job of furthering the organization’s objectives and targets. The basic objective of Happybuy Ltd is to earn profits for the owners of the company by providing superior service at competitive prices in as many markets as possible. To further this objective, every year top management carefully considers a range of options, or alternatives, for expanding into new geographic markets. This year management is considering opening new stores in Shanghai, Helsinki and Milan.

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et complete eBook Order by email at [email protected] 4  Chapter 1: Management accounting and the business environment When making this and other choices, management must balance the opportunities against the demands made on the company’s resources. Management knows from bitter experience that opening a store in a major new market is a big step that cannot be taken lightly. It requires enormous amounts of time and energy from the company’s most experienced, talented and busy professionals. When the company attempted to open stores in both Beijing and Paris in the same year, resources were stretched too thinly. The result was that neither store opened on schedule, and operations in the rest of the company suffered. Therefore, entering new markets is planned very, very carefully. Among other data, top management looks at the sales volumes, profit margins and costs of the company’s established stores in similar markets. These data, supplied by the management accountant, are combined with projected sales volume data at the proposed new locations to estimate the profits that would be generated by the new stores. In general, virtually all important alternatives considered by management in the planning process have some effect on revenues or costs, and management accounting data are essential in estimating those effects. After considering all of the alternatives, Happybuy Ltd’s top management decided to open a store in the burgeoning Shanghai market in the third quarter of the year, but to defer opening any other new stores to another year. As soon as this decision was made, detailed plans were drawn up for all parts of the company that would be involved in the Shanghai opening. For example, the Personnel Department’s travel budget was increased, since it would be providing extensive on-site training to the new personnel hired in Shanghai. As in the Personnel Department example, the plans of management are often expressed formally in budgets, and the term budgeting is applied generally to describe this part of the planning process. Typically, budgets are prepared annually and represent management’s plans in specific, quantitative terms. In addition to a travel budget, the Personnel Department will be given goals in terms of new hires, courses taught, and detailed breakdowns of expected expenses. Similarly, the manager of each store will be given a target for sales volume, profit, expenses, pilferage losses and employee training. These data will be collected, analysed, and summarized for management use in the form of budgets prepared by management accountants.

Directing and motivating In addition to planning for the future, managers must oversee day-to-day activities and keep the organization functioning smoothly. This requires the ability to motivate and effectively direct people. Managers assign tasks to employees, arbitrate disputes, answer questions, solve on-the-spot problems, and make many small decisions that affect customers and employees. In effect, directing is that part of the managers’ work that deals with the routine and the here and now. Management accounting data, such as daily sales reports, are often used in this type of day-to-day decision making.

Controlling In carrying out the control function, managers seek to ensure that the plan is being followed. Feedback, which signals whether operations are on track, is the key to effective control. In sophisticated organizations this feedback is provided by detailed reports of various types. One of these reports, which compares budgeted to actual results, is called a performance report. Performance reports suggest where operations are not proceeding as planned and where some parts of the organization may require additional attention. For example, before the opening of the new Shanghai store in the third quarter of the year, the store’s manager will be given sales volume, profit and expense targets for the fourth quarter of the year. As the fourth quarter progresses, periodic reports will be made in which the actual sales volume, profit and expenses are compared to the targets. If the actual results fall below the targets, top management is alerted that the Shanghai store requires more attention. Experienced personnel can be flown in to help the new manager, or top management may come to the conclusion that plans will have to be revised. As we shall see in following chapters, providing this kind of feedback to managers is one of the central purposes of management accounting.

The end results of managers’ activities As a customer enters one of the Happybuy stores, the results of management’s planning, directing and motivating, and control activities will be evident in the many details that make the difference between a

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et complete eBook Order email atneed [email protected] The work of by management and the for management accounting information   5 pleasant and an irritating shopping experience. The store will be clean, fashionably decorated and logically laid out. Checkout staff will be alert, friendly and efficient. In short, what the customer experiences does not simply happen; it is the result of the efforts of managers who must visualize and fit together the processes that are needed to get the job done.

The planning and control cycle The work of management can be summarized in a model such as the one shown in Exhibit 1.1. The model, which depicts the planning and control cycle, illustrates the smooth flow of management activities from planning through directing and motivating, controlling, and then back to planning again. All of these activities involve decision making, so it is depicted as the hub around which the other activities revolve.

Formulating long- and short-term plans (Planning)

Comparing actual to planned performance (Controlling)

Decision making

Implementing plans (Directing and motivating)

Measuring performance (Controlling)

Exhibit 1.1  The planning and control cycle

Decision making Perhaps the most basic managerial skill is the ability to make intelligent, data-supported decisions. Broadly speaking, many of those decisions revolve around the following three questions. What should we be selling? Who should we be serving? How should we execute? Exhibit 1.2 provides examples of decisions pertaining to each of these three categories. The left-hand column of Exhibit 1.2 suggests that every company must make decisions related to the products and services that it sells. For example, each year the South African retailer Woolworth must decide what

What should we be selling?

Who should be serving?

How should we execute?

What products and services should be the focus of our marketing efforts?

Who should be the focus of our marketing efforts?

How should we supply our parts and services?

What new products and services should we offer?

Who should we start serving?

How should we expand our capacity?

What prices should we charge for our products and services?

Who should pay price premiums or receive price discounts?

How should we reduce our capacity?

What products and services should we discontinue?

Who should we stop serving?

How should we improve our efficiency and effectiveness?

Exhibit 1.2  Examples of decisions

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et complete eBook Order by email at [email protected] 6  Chapter 1: Management accounting and the business environment new products and services to offer to serve its different customer segments. The Danish company Lego must decide what new toys to introduce to its different markets and how to spend its marketing resources most efficiently. Norwegian Airlines must decide what ticket prices to establish for each of its hundreds of flights every day. The Korean company KIA Motors must decide whether to discontinue certain models of automobiles. The middle column of Exhibit 1.2 indicates that all companies must make decisions related to the customers that they serve. For example, Zara must decide how to allocate its marketing budget between clothes that tend to appeal to male versus female customers. FedEx must decide whether to expand its services into new markets across the globe. Canon must decide what price discounts to offer corporate clients that purchase large volumes of its printers. A bank must decide whether to discontinue customers that may be unprofitable. The right-hand column of Exhibit 1.2 shows that companies also make decisions related to how they execute. For example, Mercedes and Peugeot must decide whether to rely on outside vendors to manufacture many of the parts used to make its cars. ISS must decide whether to expand its facility management services in a given geographic region by adding square metres to an existing facility or by constructing an entirely new facility. In an economic downturn, a manufacturer might have to decide whether to eliminate one 8-hour shift at three plants or to close one plant. Finally, all companies have to decide among competing improvement opportunities. For example, a company may have to decide whether to implement a new software system, to upgrade a piece of equipment, or to provide extra training to its employees. This portion of the chapter has explained that the four pillars of management accounting are planning, directing and motivating, controlling and decision making. This book helps prepare you to become an effective manager by explaining how to make intelligent data-driven decisions, how to create financial plans for the future, and how to continually make progress toward achieving goals by obtaining, evaluating and responding to feedback.

LO2

Comparison of financial and management accounting Financial accounting reports are prepared for the use of external parties such as shareholders and creditors, whereas management accounting reports are prepared for managers inside the organization. This contrast in basic orientation results in a number of major differences between financial and management accounting, even though both financial and management accounting rely on the same underlying financial data. These differences are summarized in Exhibit 1.3. As shown in Exhibit 1.3, in addition to the difference in who the reports are prepared for, financial and management accounting also differ in their emphasis between the past and the future, in the type of data provided to users and in several other ways. These differences are discussed in the following paragraphs.

Emphasis on the future Since planning is such an important part of the manager’s job, management accounting has a strong future orientation. In contrast, financial accounting primarily provides summaries of past financial transactions. These summaries may be useful in planning, but only to a point. The difficulty with summaries of the past is that the future is not simply a projection of what has happened in the past. Changes are constantly taking place in economic conditions, customer needs and desires, competitive conditions and so on. All of these changes demand that the manager’s planning be based in large part on estimates of what will happen rather than on summaries of what has already happened.

Relevance and flexibility of data Financial accounting data are expected to be objective and verifiable. However, for internal uses the manager wants information that is relevant even if it is not completely objective or verifiable. By relevant, we mean appropriate for the problem at hand. For example, it is difficult to verify estimated sales volumes for a proposed new store at Happybuy Ltd, but this is exactly the type of information that is most useful to managers in their decision making. The management accounting information system should be flexible enough to provide whatever data are relevant for a particular decision.

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et complete eBook Order by emailComparison at [email protected] of financial and management accounting  7 Accounting

• Recording • Estimating • Organizing • Summarizing

Financial and Operational Data

Financial Accounting

• Reports to those outside the organization: Owners Lenders Tax authorities Regulators

• Emphasis is on summaries of financial consequences of past activities

• Objectivity and verifiability of data are emphasized

• Precision of information is required

• Only summarized data for the entire organization are prepared

Management Accounting

• Reports to those inside

the organization for: Planning Directing and motivating Controlling Performance evaluation Decision making

• Emphasis is on decisions affecting the future

• Relevance and flexibility of data are emphasized

• Timeliness of information is required

• Detailed segment reports, about departments, products, customers and employees are prepared

• Must follow IFRS

• Need not follow IFRS

• Mandatory for external reports

• Not mandatory

Exhibit 1.3  Comparison of financial and management accounting

Less emphasis on precision Timeliness is often more important than precision to managers. If a decision must be made, a manager would much rather have a good estimate now than wait a week for a more precise answer. A decision involving tens of millions of pounds does not have to be based on estimates that are precise down to the penny, or even to the pound. Estimates that are accurate to the nearest million pounds may be precise enough to make a good decision. Since precision is costly in terms of both time and resources, management accounting places less emphasis on precision than financial accounting. In addition, management accounting places considerable weight on non-monetary data. For example, information about customer satisfaction is of tremendous importance even though it would be difficult to express such data in a monetary form.

Segments of an organization Financial accounting is primarily concerned with reporting for the company as a whole. By contrast, management accounting focuses much more on the parts, or segments, of a company. These segments may be product lines, customers, sales territories, divisions, departments, or any other categorization of the company’s activities that management finds useful. Financial accounting does require some breakdowns of revenues and costs by major segments in external reports, but this is a secondary emphasis. In management accounting, segment reporting is the primary emphasis.

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et complete eBook Order by email at [email protected] 8  Chapter 1: Management accounting and the business environment International Financial Reporting Standards (IFRS) Financial accounting statements prepared for external users must be prepared in accordance with generally accepted accounting principles such as the International Financial Reporting Standards (IFRS) proposed by the International Accounting Standards Board (IASB). External users must have some assurance that the reports have been prepared in accordance with some common set of ground rules. These common ground rules enhance comparability and help reduce fraud and misrepresentation, but they do not necessarily lead to the type of reports that would be most useful in internal decision making. Management accounting is not bound by generally accepted accounting principles. Managers set their own ground rules concerning the content and form of internal reports. The only constraint is that the expected benefits from using the information should outweigh the costs of collecting, analysing and summarizing the data. Nevertheless, as we shall see in subsequent chapters, it is undeniably true that financial reporting requirements have heavily influenced management accounting practice.

Management accounting – not mandatory Financial accounting is mandatory; that is, it must be done. Various outside parties such as the Stock Exchange regulators and the tax authorities require periodic financial statements. Management accounting, on the other hand, is not mandatory. A company is completely free to do as much or as little as it wishes. There are no regulatory bodies or other outside agencies that specify what is to be done, or, for that matter, whether anything is to be done at all. Since management accounting is completely optional, the important question is always, ‘Is the information useful?’ rather than, ‘Is the information required?’

Basic organizational structure Since organizations are made up of people, management must accomplish its objectives by working through people. Managing directors of companies like Happybuy Ltd could not possibly execute all of their company’s strategies alone; they must rely on other people. This is done by creating an organizational structure that permits decentralization of management responsibilities.

Decentralization Decentralization is the delegation of decision-making authority throughout an organization by providing managers at various operating levels with the authority to make decisions relating to their area of responsibility. Some organizations are more decentralized than others. Because of Happybuy Ltd’s geographic dispersion and the peculiarities of local markets, the company is highly decentralized. Happybuy Ltd’s managing director sets the broad strategy for the company and makes major strategic decisions such as opening stores in new markets, but much of the remaining decision-making authority is delegated to managers on various levels throughout the organization. These levels are as follows: the company has a number of retail stores, each of which has a store manager as well as a separate manager for each section such as women’s clothing and household appliances. In addition, the company has support departments such as a central Purchasing Department and a Personnel Department. The organizational structure of the company is depicted in Exhibit 1.4. The arrangement of boxes shown in Exhibit 1.4 is called an organization chart. The purpose of an organization chart is to show how responsibility has been divided among managers and to show formal lines of reporting and communication, or chain of command. Each box depicts an area of management responsibility, and the lines between the boxes show the lines of formal authority between managers. The chart tells us, for example, that the store managers are responsible to the operations manager. In turn, the latter is responsible to the company managing director who, in turn, is responsible to the board of directors. Following the lines of authority and communication on the organization chart, we can see that the manager of the Hong Kong store would ordinarily report to the operations director rather than directly to the managing director of the company. Informal relationships and channels of communication often develop outside the formal reporting relationships on the organization chart as a result of personal contacts between managers. The informal structure does not appear on the organization chart, but it is often vital to effective operations.

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et complete eBook Order by email [email protected] Expanding changing role of management accounting  9 Board of Directors Managing Director

Purchasing Department

Personnel Department

Operations Director

Finance Director

Treasurer Manager Hong Kong Store

Manager Women’s Clothing

Chief Accountant

Manager Tokyo Store

Manager Men’s Clothing

Manager Women’s Clothing

Manager Household Appliances

Manager Men’s Clothing

Manager Household Appliances

Other Stores

Exhibit 1.4  Organization chart, Happybuy Ltd

Line and staff relationships An organization chart also depicts line and staff positions in an organization. A person in a line position is directly involved in achieving the basic objectives of the organization. A person in a staff position, by contrast, is only indirectly involved in achieving those basic objectives. Staff positions support or provide assistance to line positions or other parts of the organization, but they do not have direct authority over line positions. Refer again to the organization chart in Exhibit 1.4. Since the basic objective of Happybuy Ltd is to sell recorded merchandise at a profit, those managers whose areas of responsibility are directly related to the sales effort occupy line positions. These positions, which are shown in green in the exhibit, include the managers of the various departments in each store, the store managers, the operations manager and members of top management. By contrast, the manager of the central Purchasing Department occupies a staff position, since the only function of the Purchasing Department is to support and serve the line departments by doing their purchasing for them. The finance function, which is responsible for the organization’s management accounting, is also seen as a staff position. The finance office often combines a number of important functions including the management of the company’s computer services and other business information systems.

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Expanding and changing role of management accounting Management accounting has its roots in the industrial revolution of the 19th century. During this early period, most firms were tightly controlled by a few owner-managers who borrowed based on personal relationships and their personal assets. Since there were no external shareholders and little unsecured debt, there was little need for elaborate financial reports. In contrast, management accounting was relatively sophisticated and provided the essential information needed to manage the early large-scale production of textiles, steel and other products.1

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et complete eBookaccounting Order bybusiness email at [email protected] 10  Chapter 1: Management and the environment After the turn of the 20th century, financial accounting requirements burgeoned because of new pressures placed on companies by capital markets, creditors, regulatory bodies and taxation of income. Johnson and Kaplan (1987) state that ‘many firms needed to raise funds from increasingly widespread and detached suppliers of capital. To tap these vast reservoirs of outside capital, firms’ managers had to supply audited financial reports. And because outside suppliers of capital relied on audited financial statements, independent accountants had a keen interest in establishing well-defined procedures for corporate financial reporting. The inventory costing procedures adopted by public accountants after the turn of the century had a profound effect on management accounting.’2 As a consequence, for many decades, management accountants increasingly focused their efforts on ensuring that financial accounting requirements were met and financial reports were released on time. The practice of management accounting stagnated. Johnson and Kaplan’s book and their thesis of ‘Relevance Lost’ stimulated a major debate among both academics and practitioners. Johnson and Kaplan (1987) argued that in the early part of the 20th century, as product lines expanded and operations became more complex, forward-looking companies such as Du Pont, General Motors, and General Electric saw a renewed need for management oriented reports that were separate from financial reports. But, in most companies, management accounting practices up through the mid-1980s were largely indistinguishable from practices that were common prior to the First World War. Over the past decades, however, new economic forces have led to many important innovations in management accounting. These new practices will be discussed in detail later, and especially in Chapters 16–19. These chapters have been written to compare approaches that accept physical and organizational limitations and optimize subject to given constraints with more recent approaches that are based on management practices aimed at shifting constraints. These chapters reflect the way that management accounting practices have evolved since the publication of the ‘Relevance Lost’ thesis.

The sources of management accounting knowledge The practice and principles of management accounting have been developed over many decades, even centuries. In the early days the main source of practice was practitioners such as early industrialists at Josiah Wedgewood’s potteries or at Alfred Sloan’s General Motors. More recently other inputs have come from business schools, management consultants and even management gurus (Thrift, 2005). In the particular case of accounting, other contributors to managerial knowledge production include professional bodies. Managerial and business knowledge may be visualized as being produced via a circulation of ideas and practices. Yet the processes that impact on the production and circulation of managerial knowledge should not be seen as infallible. Academic theories may be rejected by practitioners on the grounds of ‘irrelevance’ and practices may develop that weaken rather than enhance long-run business performance (Johnson and Kaplan, 1987). The latest practices may not really be ‘best practice’ but rather introduced because of managerial fashions and fads (Seal, 2010). One of the aims of this book is to enable the reader to develop a critical understanding of the principles behind management accounting so that faulty practices may be recognized even if they cannot always be changed in a particular organizational setting.

International diversity in management accounting traditions Management accounting is sometimes presented as a universal tool kit. Yet this image of the subject hides the different traditions in different countries. For example, although we might expect to find basic economic calculations on costs and revenues to be of interest to managers in any system of competitive capitalism, these calculations may be the province of different professional groupings (such as engineers or business economists) in different countries. Although the professional organization of auditors is very widespread throughout the world, the professional organization of management accounting is far less prevalent. The variation in professional organization does not mean that management accounting techniques cannot be applied in different countries but rather that the occupations that control them differ in different countries for all sorts of complex historical,3 institutional4 and cultural reasons.5 Different traditions mean that historical debates such as the ‘Relevance Lost thesis’ may have resonance in the US or the UK but not necessarily in Germany or Japan. Indeed, many critics of US (and, by extension, UK)

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et complete eBook Order by email at [email protected] Globalization and international competition  11 management accounting techniques were informed partly by a historical analysis of the US experience and partly by a perceived competitive weakness compared to the economic successes of Japan in the 1970s and 80s. There is some evidence that management accounting practices are tending to converge under some of the influences such as globalization and new technology, which will be discussed below.6

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Globalization and international competition Over the last few decades, competition has become worldwide in many industries. This has been caused by reductions in tariffs, quotas and other barriers to free trade; improvements in global transportation systems; increasing sophistication in international markets; and the use of the internet. These factors work together to reduce the costs of conducting international trade and make it possible for foreign companies to compete on a more equal footing with local firms. Expansion of the European Union (EU) as well as competition from rapidly growing countries such as China and India have led to global economic restructuring with new locations for the outsourcing of manufacturing (China) and services (India) by Western and Japanese multinational companies.

FOCUS ON PRACTICE The journey to services To stay competitive in a globalized economy, manufacturing companies increasingly rely on servitization, a process by which product providers add complementary services to their product proposition. Manufacturing firms have increasingly been servitizing as the result of a combination of market pull and technological push in order to focus their business on higher-margin services relative to products and, hence, to create superior competitive advantage. With servitization, firms offer services and solutions associated with their manufactured products, in what may be seen as a Product Service System (PSS). Similarly to the manufacturing industry, the music industry had to transition its offerings from selling music in product format (CDs) to a broader offering of intangible electronic files (iTunes) and ultimately subscription service (Spotify), largely because of the impact of digitalization and the Internet. Exercise: Apply the servitization concept to a company such as IBM in the information technology industry. How has it changed the focus of its business? Source: Based on Helo, P., Gunasekaran, A. and Rymaszewska, A. 2017. Designing and Managing Industrial Product-Service Systems, Springer Briefs in Operations Management. Cham: Springer. DOI 10.1007/978-3-319-40430-1_2, 1-90.

Reductions in trade barriers have made it easier for agile and aggressive companies to expand outside of their home markets. As a result, very few firms can afford to be complacent. A company may be very successful today in its local market relative to its local competitors, but tomorrow the competition may come from halfway around the globe. As a matter of survival, even firms that are presently doing very well in their home markets must become world-class competitors. On the bright side, the freer international movement of goods and services presents tremendous export opportunities for those companies that can transform themselves into world-class competitors. And, from the standpoint of consumers, heightened competition promises an even greater variety of goods, at higher quality and lower prices. What are the implications for management accounting of increased global competition? It would be very difficult for a firm to become world-class if it plans, directs and controls its operations and makes decisions using a second-class management accounting system. An excellent management accounting system will not by itself guarantee success, but a poor management accounting system can stymie the best efforts of people in an organization to make the firm truly competitive. Throughout this text we will highlight the differences between obsolete management accounting systems that get in the way of success and well-designed management accounting systems that can enhance a firm’s

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et complete eBookaccounting Order bybusiness email at [email protected] 12  Chapter 1: Management and the environment performance. It is noteworthy that elements of well-designed management accounting systems have originated in many countries. More and more, management accounting has become a discipline that is worldwide in scope.7

Changes in the business environment and management accounting LO5

New business processes and technologies Global competition has been good news for consumers, since intensified competition has generally led to lower prices, higher quality and more choices. However, the last three decades have been a period of wrenching change for many businesses and their employees. Many managers have learned that cherished ways of doing business do not work any more and that major changes must be made in how organizations are managed and in how work gets done. These changes are so great that some observers view them as a second industrial revolution. This revolution is having a profound effect on the practice of management accounting – as we will see throughout the rest of the text. First, however, it is necessary to have an appreciation of the ways in which organizations are transforming themselves to become more competitive. Since the early 1980s, many companies have gone through several waves of improvement programmes, starting with just-in-time (JIT) and passing on to total quality management (TQM), process re-engineering, and various other management programmes often summarized by the term lean production. When properly implemented, these improvement programmes can enhance quality, reduce cost, increase output, eliminate delays in responding to customers and ultimately increase profits. They have not, however, always been wisely implemented, and there is considerable controversy concerning the ultimate value of each of these programmes. Nevertheless, the current business environment cannot be properly understood without an appreciation of what each of these approaches attempts to accomplish. These management approaches have implications for management accounting. In particular, they open up the possibility of managing areas like quality, inventory and constraints rather than optimizing a given situation. For example, the traditional optimizing approach for inventory management, the economic order quantity (EOQ), has to be placed alongside approaches such as just in time (JIT) that try to eliminate inventory. Later in the book, we contrast a number of optimizing models with more contemporary, active management approaches. Another significant change that we analyse in later chapters is the influence of new technology, especially in computers and telecommunications. These technologies have not just resulted in the automation of existing manual management accounting systems but have enabled the restructuring of whole industries and economies. Even if some of the hype surrounding the internet has died down a little since the heady days of the late 1990s, the internet has, and is, changing the way business is done. New forms of competition, organization and technologies have implications for management accounting. Some of the more traditional merits of management accounting (such as the idea that businesses plan to make profits!) may have reasserted themselves after the collapse of the ‘dotcom’ bubble, but the longer lasting changes in business process require a response from management accounting if the subject is to remain relevant. One sector that has changed dramatically in recent years is the airline business, particularly with the success in both Europe and North America of the ‘no-frills’ airlines such as easyJet, Norwegian, Ryanair and Southwest Airlines. The low-cost airline illustrates many of the features of the combined impact of new organizational forms, business processes, new technology and new personnel approaches. The low-cost airline example illustrates a combination of new thinking about air travel combined with wellknown principles of standardization. The use of new technologies such as internet and databases makes it possible to standardize and integrate a number of previously separated activities such as booking, ticketing and payment processing.

Enterprise resource planning systems Some technological changes have not just affected the environment of management accounting but have also had a direct impact on the collection and dissemination of management information.8 The increasing use

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et complete eBook Order Changes by email at [email protected] in the business environment and management accounting   13 of sophisticated real time information systems known as enterprise resource planning (ERP) provided by companies such as Microsoft, Oracle and SAP, has changed the nature of management accounting work and the role of the finance function.9 One of the emerging implications for the management accountant is that there is more emphasis on business support rather than routine information gathering. Furthermore, not only is there a greater dispersion of finance personnel into process areas, but accounting information itself has become more dispersed throughout the organization as it becomes more accessible to non-accounting personnel. We will explore the impact of ERP in more detail in Chapter 18.

Deregulation, privatization and re-regulation It is also worth noting that the increased competition in the airline industry was not possible until the deregulation effects of ‘open skies’ policies. Deregulation and privatization of former state-owned monopolies had a significant impact in Europe especially in the UK, which pioneered these policies. The changes in ownership and increased competition has not only affected the huge public utilities that were privatized, they also had a knock-on effect on the companies that supplied these giants. After financial scandals at Enron around the turn of the millennium and the more recent collapse of banking (popularly known as the credit crunch), the trend has been towards tighter, rather than lighter, regulation in corporate governance. Any companies listed in North America are subject to the Sarbanes-Oxley Act (2002), while UK companies are expected to comply with the UK Corporate Governance Code (2012) on corporate governance. Although it is too early to know the details, the recent problems faced by Western banks, especially in the US and the UK, may lead to new banking regulations in the UK as well. Although many of these issues are seen as financial reporting and auditing issues, there is an emerging awareness that corporate governance also involves the aspects of strategic control systems covered in Chapters 16 and 17.10 LO6

The increased importance of service sector management Management accounting has expanded its influence from its traditional base in manufacturing to service sectors, which themselves have become increasing sources of employment and income in many economies. Many traditional management accounting approaches to issues such as costing were developed with manufacturing industry in mind. In comparison with traditional manufacturing, where the product is easy to see and touch, products in service industries are less tangible. A bank may offer a number of different ‘products’ such as types of account or loans which are defined by dimensions such as accessibility or repayment terms, secured or unsecured and so on. Services cannot be stored in inventory so that managers in banks and other service industries may be less interested in product cost but, rather, which customers are profitable and which customers are not. Service industries provide new challenges and opportunities for management accounting information, particularly as competitive success is especially dependent on intangible assets such as employee expertise and customer relations. Not only are service activities becoming more important relative to manufacturing but they are increasingly subject to reorganization in both public and private sectors.11 In particular, we have seen the emergence of shared service centres where the support services of an entire corporation are concentrated in a single geographical location. Other companies have gone a stage further by subcontracting them to independent companies in a practice known as outsourcing.12

FOCUS ON PRACTICE The ‘not so new’ New Public Management Since the 1980s, the performance of the public sector has been addressed through the concept of New Public Management (NPM) resulting in reform initiatives of the public sector. The term NPM is to be understood as a wide set of beliefs, doctrines and codified experiences that altogether aids the process of evaluation and redesign of the public sector. Generally, NPM is distinguished by striving for economic rationality and strong confidence in market-based discipline, managerial control and hands-on management. Although the public sector has been reformed for the nearly past thirty years,

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et complete eBookaccounting Order bybusiness email at [email protected] 14  Chapter 1: Management and the environment the implications of NPM on public sector performance remains contentious. The OECD also recognizes that the effects of the reform programmes remain ambiguous, acknowledging that many of the important changes which had been implemented within public management and been presented as best practices, later turned out to foster undesired and unanticipated after-effects. Exercise: How can the public sector be better managed and be made more efficient while avoiding drawbacks and pitfalls? Discuss the major differences between management in the private and the public sector. Source: Based on Verbeeten, F.H. and Speklé, R.F. 2015. Management control, results-oriented culture and public sector performance: Empirical evidence on New Public Management. Organization Studies, 36(7): 953-978.

Reductions in trade barriers have made it easier for agile and aggressive companies to expand outside of their home markets. As a result, very few firms can afford to be complacent. A company may be very successful today in its local market relative to its local competitors, but tomorrow the competition may come from halfway around the globe. As a matter of survival, even firms that are presently doing very well in their home markets must become world-class competitors. On the bright side, the freer international movement of goods and services presents tremendous export opportunities for those companies that can transform themselves into world-class competitors. And, from the standpoint of consumers, heightened competition promises an even greater variety of goods, at higher quality and lower prices. Management accounting’s spread into the public sector is driven by government demands for new measures of performance and new delivery systems. Although its precise form and motivation varies in different countries, this phenomenon, often referred to as the ‘New Public Management’,13 may be seen as a global movement.14 These developments are not without controversy, especially where there is an attempt to apply, in the not-forprofit, public sector organizations, the same management philosophies and techniques that were originally developed for private, profit-making organizations.

Managing for value Traditionally, accountants were portrayed as ‘bean-counters’ or ‘corporate policemen’ with an emphasis on past performance and organizational control. While these functions are still part of an accountant’s role, the trend recently has been to emphasize the creation and management of value. Pressures from corporate raiders and new sources of capital, such as private equity, mean that managers have to be increasingly aware of shareholder value. As will be explored in Chapters 14, 16 and 17, there are challenges both to measure shareholder value and to discover how to create it through the adoption and implementation of corporate strategies. Managers are also aware of the importance of customer value and its relationship to shareholder value. Managing for value has to balance the possible gains to short-run profitability arising from cost-cutting exercises to possible long-run damage to shareholder value as costs may be cut at the expense of customer satisfaction. For the management accountant the challenge is not just to devise appropriate financial and non-financial metrics to measure value but to try and understand cause-and-effect relationships.15

FOCUS ON PRACTICE Corporate sustainability at a crossroads Although significant progress has been made, corporate sustainability is at a crossroads. On one hand, corporate leaders engaged in sustainability remain outnumbered, and are irregularly distributed across regions and industries. On the other hand, a group of companies are demonstrating that sustainability can drive innovation, efficiency and long-term value creation. However, since the launch of the idea of sustainable development 30 years ago through the report ‘Our Common Future’, from the United Nations World Commission on Environment and Development (known as

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et complete eBook Order by email atgovernance, [email protected] Corporate professional and business ethics  15 the Bruntland report) much has happened within the area of sustainability. In general, today’s business leaders show much higher commitment to corporate sustainability than was the case when the Bruntland report was published in 1987. In a recent survey conducted with leading world business leaders, 9 out of 10 executives see sustainability as important; however, only 3 out of 5 companies have articulated a sustainability strategy, and only 1 out of 4 companies have developed a clear business case involving their efforts for a sustainable development. Exercise: Consider the enormous challenges for power companies relying on fossil fuels in countries like the UK that prohibit the use of coal plants after 2025. Source: Kiron, D., Unruh, G., Kruschwitz, N., Reeves, M., Rubel, H. and zum Felde, A.M. 2017. Corporate sustainability at a crossroads: Progress toward our common future in uncertain times. MIT Sloan Management Review, May.

Managing for environmental sustainability Whilst concern about the environment has been around for some decades, the threat of rapid human-induced climate change has raised the profile of a whole range of environmental sustainability issues. Even managers who focus on shareholder value may be concerned about the environment for three main reasons. First, there is a compliance motive – companies may find that they are forced through regulation and green taxes to manage environmental resources more carefully. Second, eco-efficiency not only may save the planet but also reduce the business costs. Finally, there may be strategic reasons – companies may have customers who demand green business policies and who are increasingly suspicious of ‘environmental window dressing’ through environmental reporting. Environmental management accounting is not about reporting. It involves the collection and analysis of physical information on flows of energy, water and other materials as well as monetary information on environmental costs and benefits in order to make environmentally sensitive decisions.16

Corporate governance, professional and business ethics A thorough analysis of what makes a profession goes beyond the scope of this book. Technical competence is one part of being professional. Another important aspect is the adherence to a code of ethics. For example, the Chartered Institute of Management Accountants, which is the largest body specifically for management accountants in the UK, have themselves pointed out that being a professional means having responsibilities beyond the narrow pursuit of profit at any cost. In common with other accountancy bodies, they have a code of practice and mechanisms for monitoring and enforcing professional ethics. If ethical standards were not generally adhered to, there would be undesirable consequences for everyone. Essentially, abandoning ethical standards would lead to a lower standard of living with lower-quality goods and services, less to choose from, and higher prices. In short, following ethical rules is not just a matter of being ‘nice’; it is absolutely essential for the smooth functioning of an advanced market economy. For example, one of the short-term consequences of the Enron scandal17 is that investors have become suspicious about the reliability of reported accounting numbers. Other problems have arisen in other parts of the financial services industry in the UK, where managers offered unsustainable guaranteed returns or incentivized the sales personnel so that they gave faulty investment or pensions advice. Even more dramatically, we have seen how the bonus culture in Western banks encouraged the creation of huge speculative bubbles in property. The consequences of the collapse of these bubbles are still being felt with depressed output, lost jobs and huge public sector deficits. The common theme in so many of these scandals and collapses is that the single-minded emphasis placed on short-term profits in some companies may make it seem as if the only way to get ahead is to act unethically. When top managers say, in effect, that they will only be satisfied with bottom-line results and will accept no excuses, they are asking for trouble. High-profile business scandals such as Enron, Lehmann Brothers and Satyam show that accountants are often placed in difficult ethical positions. Other issues such as transfer pricing practice in multinational companies (which we look at in Chapter 15) and the ‘laundering’ of illegally obtained money provide particularly pressing challenges to the integrity of all finance professionals.

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et complete eBookaccounting Order bybusiness email at [email protected] 16  Chapter 1: Management and the environment Although we argued earlier in this chapter that management accounting is mainly concerned with internal reporting, management accountants cannot totally avoid taking responsibility for the integrity of the basic financial data that forms the basis of both financial and management reports (see Exhibit 1.3). Indeed, as we shall learn in the next four chapters, the classification and computation of cost can have a significant impact on reported profit. In Chapter 17 we will look in more detail at the relationships between corporate strategy, risk management and corporate governance.

Some implications for the roles of management accountants As discussed above, the changes in the business environment have potentially left management accountants with a multitude of roles. The roles may depend on the size of the organization, its line of business and a whole range of issues discussed above and in subsequent chapters. But the role played by the management accountant may also depend on their location in the large corporation. For example, in Exhibit 1.5, we can see that in the so-called back office area, the focus will be on operational matters associated with information technology, accounting, business processes and organizational structure. In the head office, issues of corporate governance and strategy as well as how to comply with accounting standards and other rules and regulations may be a major concern. In the front office, the management accountant may be operating outside the designated finance function in multi-functional teams with more direct contact with customers and suppliers, and helping to manage frontline processes. In order to fulfil these multiple roles, management accountants need to master a diversity of techniques, concepts and practices which will be elaborated on in the following chapters.18

Equity analysts Enterprise governance Sarbanes-Oxley IFRS

Head office

Back office

ERP systems CPM applications SSCs and BPO1

Front office

Front line

1Enterprise

resource planning (ERP), corporate performance management (CPM), shared service centres (SSCs) and business process outsourcing (BPO).

Exhibit 1.5  The diverse roles of management accountants within large corporations Reproduced with permission from CIMA 2007. Improving Decision Making in Organizations. CIMA Technical Report, p. 5.

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et complete eBook Order by email at [email protected] Key terms for review  17 FOCUS ON PRACTICE New IT and business analysis Rachel has trained as a management accountant and is now director of divisional finance in a large restaurant and pub chain. The company has an advanced accounting system in which transactions recording and reporting has been automated. Freed up from routine data gathering, Rachel liaises between the regional operational managers and the company’s board as she and her team of analysts monitor and manage the financial performance of the many restaurant and pub brands that make up the business. Exercise: Note how advances in IT have automated the ‘score-keeping’ aspects of accounting and enabled managers not only to have more up to the minute business intelligence but also freeing up their time for value creation.

SUMMARY

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Management accounting assists managers in carrying out their responsibilities, which include planning, directing and motivating, controlling, and decision making. Since management accounting is geared to the needs of the manager rather than to the needs of outsiders, it differs substantially from financial accounting. Management accounting is oriented more towards the future, places less emphasis on precision, emphasizes segments of an organization (rather than the organization as a whole), is not governed by generally accepted accounting principles, and is not mandatory. Most organizations are decentralized to some degree. The organization chart depicts who works for whom in the organization and which units perform staff functions rather than line functions. Accountants perform a staff function – they support and provide assistance to others inside the organization. The business environment in recent years has been characterized by increasing competition and a relentless drive for continuous improvement. Several approaches have been developed to assist organizations in meeting these challenges, including just-in-time (JIT), total quality management (TQM), and the theory of constraints (TOC). Organizations have also restructured with outsourcing and relocation of company activities. Reformed public sectors are increasingly applying management accounting techniques. Ethical standards serve a very important practical function in an advanced market economy. Without widespread adherence to ethical standards, the economy would slow down dramatically. Ethics are the lubrication that keeps a market economy functioning smoothly.

KEY TERMS FOR REVIEW At the end of each chapter, a list of key terms for review is given. These terms are highlighted in colour. Full definitions can be found in the glossary at the end of the book. Carefully study each term to be sure you understand its meaning, since these terms are used repeatedly in the chapters that follow. The list for Chapter 1 follows: Budgets (p. 4)

Corporate governance (p. 13)

Budgeting (p. 4)

Decentralization (p. 8)

Business process (p. 12)

Decision making (p. 3)

Constraints (p. 10)

Directing and motivating (p. 3)

Control (p. 4)

Enterprise resource planning (ERP) (p. 13)

Controlling (p. 3)

Environmental management accounting (p. 15)

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et complete eBookaccounting Order bybusiness email at [email protected] 18  Chapter 1: Management and the environment Feedback (p. 4)

Performance report (p. 4)

Financial accounting (p. 3)

Planning (p. 3)

Just-in-time (JIT) (p. 12)

Planning and control cycle (p. 5)

Line (p. 9)

Segments (p. 7)

Management accounting (p. 3)

Shared service centres (p. 13)

Organization chart (p. 8)

Staff (p. 9)

Outsourcing (p. 13)

Total quality management (TQM) (p. 12)

Level of difficulty:

BASIC

INTERMEDIATE

ADVANCED

Questions 1-1 What is the basic difference in orientation between financial and management accounting? 1-2 What are the three major activities of a manager? 1-3 Describe the four steps in the planning and control cycle. 1-4 Why do companies prepare budgets? 1-5 What function does feedback play in the work of the manager? 1-6 Distinguish between line and staff positions in an organization. 1-7 What are the major differences between financial and management accounting? 1-8 Briefly describe the impact of new technology, globalization and deregulation on the practice of management accounting. 1-9 Suggest three ways in which management accounting in services may differ from its practice in manufacturing industry. 1-10 Suggest three reasons why value-seeking companies should care about the environment. 1-11 Why is adherence to ethical standards important for the smooth functioning of an advanced market economy?

Exercises E1-1

Time allowed: 10 minutes

Listed below are a number of terms that relate to organizations, the work of management and the role of management accounting: Budgets

Chief Accountant

Decentralization

Directing and motivating

Feedback

Financial accounting

Line

Management accounting

Non-monetary data

Performance report

Planning

Precision

Staff

 

 

Choose the term or terms above that most appropriately complete the following statements:   1 A position on the organization chart that is directly related to achieving the basic objectives of an organization is called a _____ position.

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et complete eBook Order by email at [email protected] Problems  19   2 When _____ , managers oversee day-to-day activities and keep the organization functioning smoothly.   3 The plans of management are expressed formally in _____.   4 _____ consists of identifying alternatives, selecting from among the alternatives the one that is best for the organization, and specifying what actions will be taken to implement the chosen alternative.   5 A _____ position provides service or assistance to other parts of the organization and does not directly achieve the basic objectives of the organization.   6 The delegation of decision-making authority throughout an organization by allowing managers at various operating levels to make key decisions relating to their area of responsibility is called _____ .   7 Management accounting places less emphasis on _____ and more emphasis on _____ than financial accounting.   8 _____ is concerned with providing information for the use of those who are inside the organization, whereas _____ is concerned with providing information for the use of those who are outside the organization.   9 The accounting and other reports coming to management that are used in controlling the organization are called _____ . 10 The manager in charge of the accounting department is generally known as the _____ . 11 A detailed report to management comparing budgeted data against actual data for a specific time period is called a _____.

Problems P1-2

Preparing an organization chart Time allowed: 30 minutes

Upton University is a large private university located in the Midlands. The university is headed by a vicechancellor who has five pro-vice chancellors reporting to him. These pro-vice chancellors are responsible for, respectively, auxiliary services, admissions and records, academics, financial services (controller), and physical plant. In addition, the university has managers over several areas who report to these pro-vice chancellors. These include managers over central purchasing, the university press, and the university bookstore, all of whom report to the pro-vice chancellor for auxiliary services; managers over computer services and over accounting and finance, who report to the pro-vice chancellor for financial services; and managers over grounds and custodial services and over plant and maintenance, who report to the pro-vice chancellor for physical plant. The university has four colleges – business, humanities, fine arts, and engineering and quantitative methods – and a law school. Each of these units has a dean who is responsible to the academic pro-vice chancellor. Each college has several departments. Required 1

Prepare an organization chart for Upton University.

2

Which of the positions on your chart would be line positions? Why would they be line positions? Which would be staff positions? Why?

3

Which of the positions on your chart would have need for accounting information? Explain.

P1-3

Ethics and the manager

Richmond plc operates a chain of department stores. The first store began operations in 1965, and the company has steadily grown to its present size of 44 stores. Two years ago, the board of directors of Richmond approved a large-scale remodelling of its stores to attract a more upmarket clientele. Before finalizing these plans, two stores were remodelled as a test. Linda Potter, assistant controller, was asked to oversee the financial reporting for these test stores, and she and other management personnel were offered bonuses based on the sales growth and profitability of these stores. While completing the financial reports,

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et complete eBookaccounting Order bybusiness email at [email protected] 20  Chapter 1: Management and the environment Potter discovered a sizeable inventory of outdated goods that should have been discounted for sale or returned to the manufacturer. She discussed the situation with her management colleagues; the consensus was to ignore reporting this inventory as obsolete, since reporting it would diminish the financial results and their bonuses. Required 1

Would it be ethical for Potter not to report the inventory as obsolete?

2

Would it be easy for Potter to take the ethical action in this situation?

P1-4

Ethics

Suppose all garages routinely followed the practice of attempting to sell customers unnecessary parts and services by recommending unnecessary or expensive repairs. Required 1

How would this unethical behaviour affect customers?

2

How might customers attempt to protect themselves against this unethical behaviour?

3

How would this unethical behaviour probably affect profits and employment in the garage industry?

Group exercise GE1-5

Ethics on the job

Ethical standards are very important in business, but they are not always followed. If you have ever held a job – even a summer job – describe the ethical climate in the organization where you worked. Did employees work a full day or did they arrive late and leave early? Did employees honestly report the hours they worked? Did employees use their employer’s resources for their own purposes? Did managers set a good example? Did the organization have a code of ethics and were employees made aware of its existence? If the ethical climate in the organization you worked for was poor, what problems, if any, did it create?

Cases Deregulation, new technology and the reorganization of the finance function C1-6 Time allowed: 40 minutes Iberdrola S.A. is a large international utilities company. The company’s business environment has changed rapidly in recent years as a result of the various phases of privatization, deregulation, and the resultant industry restructuring. During the past two years, a shared service centre (SSC) has been established in Bilbao, Spain, consolidating processes that were formerly dealt with in individual business units (such as power generating stations) in many separate locations. The manager in charge of the finance function explained some of the issues as follows: ‘We actually run ourselves on process lines – “Purchase-to-Pay” or “Procurement-to-Pay”, and “Orderto-Cash”. The Sales Ledger is consolidated nationally but the rest is all done locally – we run software systems that these days allow you to have both remote sites and central operations and there is still visibility and transparency across the organization. The same applies to the nominal ledger and other accounting. We do all the statutory accounts centrally now and the main database, the main nominal ledger, is based on a server in this building. But, of course, the data can be accessed anywhere. The accounts are still “owned” by the local Finance Director, Finance Controller and finance teams out in each one of the local business units. The finance people in the local business units need to “own” the statutory accounts even though they don’t prepare them these days. If they don’t “own” the accounts, then they are signing something without understanding what’s there.’

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et complete eBook Order by email at [email protected] Endnotes  21 Required Discuss how the organization and culture of the finance function in Iberdrola S.A. has been affected by new information technology, the deregulation of power generation and the more recent post-Enron concerns with financial probity. You might find it helpful to refer to Zoni, Dossi and Morelli (2012).

Internet exercise IE1-7 Access the website of the Association for Accountancy and Business Affairs (visar.csustan.edu/aaba/home), click on one of the issues and follow the links to newspaper cuttings and other sources.

Further reading For an interesting perspective on the changing role of the management accountant see Burns and Baldvinsdottir (2007). The Chartered Institute of Management Accountants also has several publications that focus on the roles of management accountants (e.g. Collins et al., 2011). 

Endnotes   1 Chandler (1977).   2 Johnson and Kaplan (1987), pp. 129–30.   3 Again see Johnson and Kaplan (1987). See also Loft (1995); Ezzamel, Hoskin and Macve (1990).   4 See, for example, Armstrong (1985) and Armstrong (1987).   5 See, for example, Rikhardsson, Rohde, Christensen and Bath (2016).   6 Granlund and Lukka (1998b). See also Greve et al (2017)   7 See Granlund and Lukka (1998b).   8 See Scapens, Ezzamel, Burns and Baldvinsdottir (2003).   9 See May (2002). See also Rom and Rohde (2006). 10 See, for example, Seal (2006). 11 See, for example, Bain and Taylor (2000). 12 Hayward (2002); CIMA (2001a). 13 Hood (1995). 14 Olson, Guthrie and Humphrey (1998). 15 For a historical view on value based management see Ittner and Larker (2001). For a recent attempt to analyse the cost of customer satisfaction see Cugini, Caru and Zerbini (2007). 16 See IFAC (2005). 17 See, for example, Gordon (2002). 18 See Burns and Baldvinsdottir (2007).

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CHAPTER 2 An introduction to cost terms, concepts and classifications

LEARNING OBJECTIVES After studying Chapter 2, you should be able to: LO1

Identify each of the three basic cost elements involved in the manufacture of a product

LO2

Distinguish between product costs and period costs and give examples of each

LO3

Prepare a schedule of cost of goods manufactured

LO4

Explain the flow of direct materials cost, direct labour cost, and manufacturing overhead cost

LO5

Begin to appreciate the differences between costing for manufacturing and for services

LO6

Identify and give examples of variable costs and fixed costs

LO7

Define and give examples of direct and indirect costs

LO8

Define cost classifications used in making decisions: differential costs, opportunity costs and sunk costs

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et complete eBook Order by email at [email protected] General cost classifications  23 CONCEPTS IN CONTEXT This chapter introduces different cost classification concepts. These are extremely important for decision making, planning and performance measurement in companies. However, one should be careful not to specify and allocate costs arbitrarily because it can lead to wrong decisions, as explained below. Drawbacks of fixed-cost allocations Rather than using contribution reports, the accounting systems in many companies allocate fixed costs to individual customer segments. This traditional accounting approach provides incorrect information because costs that are common to multiple segments are allocated on the basis of arbitrary measures of activity, such as sales volume. Consequently, the traditional system does not capture vital information about the controllability and ‘behaviour’ of costs. For example, if a segment of customers is found to be unprofitable and is therefore discontinued, the fixed costs allocated to that segment will simply be reallocated to the remaining customers. Those customers may then become unprofitable and as a consequence also discontinued. That is what the literature sometimes refers to as the ‘death spiral’.1

As explained in Chapter 1, the work of management focuses on planning, which includes setting objectives and outlining how to attain these objectives; and control, which includes the steps to take to ensure that objectives are realized. To carry out these planning and control responsibilities, managers need information about the organization. From an accounting point of view, this information relates to costs and revenues of the organization. In management accounting, the term ‘cost’ is used in many different ways. This is because there are many types of costs, and these costs are classified differently according to the immediate needs of management. For example, managers may want cost data to prepare external financial reports, to prepare budgets, or to make decisions. Each different use of cost data demands a different classification and definition of costs. For example, the preparation of external financial reports requires the use of historical cost data, whereas decision making may require current cost data. In this chapter, we discuss many of the possible uses of cost data and how costs are defined and classified for each use. Our first task is to explain how costs are classified for the purpose of preparing external financial reports – particularly in manufacturing companies. To set the stage for this discussion, we begin the chapter by defining some terms commonly used in manufacturing.

General cost classifications Costs are associated with all types of organizations – business, non-business, manufacturing, retail and service. Generally, the kinds of costs incurred and the way in which these costs are classified depends on the type of organization involved. Management accounting is as applicable to one type of organization as to another. For this reason, we will consider in our discussion the cost characteristics of a variety of organizations – manufacturing, merchandising and service. Our initial focus in this chapter is on manufacturing companies, since their basic activities include most of the activities found in other types of business organizations. Manufacturing companies are involved in acquiring raw materials, producing finished goods, marketing, distributing, billing and almost every other business activity. Therefore, an understanding of costs in a manufacturing company can be very helpful in understanding costs in other types of organizations. Yet, as we argued in the previous chapter, service activities are becoming increasingly important in many advanced economies so that we also need to develop cost concepts that apply to non-manufacturing organizations. For example, these cost concepts apply to TV companies such as the BBC; consulting firms such as McKinsey & Company and PWC; and your local hospital. The exact terms used in these industries may not be the same as those used in manufacturing, but the same basic concepts apply. With some slight modifications, which will be discussed later in this chapter, these basic concepts also apply to merchandising companies such as Tesco, Sainsbury’s, Wal-mart, Aldi, Ikea and Jydsk, that resell finished goods acquired from manufacturers and other sources. With that in mind, let us begin our discussion of manufacturing costs.

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et complete by email at [email protected] 24  Chapter 2: AneBook introduction toOrder cost terms, concepts and classifications LO1

Manufacturing costs Most manufacturing companies divide manufacturing costs into three broad categories: direct materials, direct labour, and manufacturing overhead. A discussion of each of these categories follows.

Direct materials The materials that go into the final product are called raw materials. This term is somewhat misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refer to any materials that are used in the final product; and the finished product of one company can become raw material of another company. For example, the plastics produced by Du Pont are a raw material used by Compaq Computers in its personal computers. Direct materials are those materials that become an integral part of the finished product and that can be physically and conveniently traced to it. This would include, for example, the seats Airbus purchases from subcontractors to install in its commercial aircraft. Also included is the small loudspeaker that is installed in your mobile phone. Sometimes it is not worth the effort to trace the costs of relatively insignificant materials to the end products. Such minor items would include the solder used to make electrical connections in a Sony TV. Materials such as solder and glue are called indirect materials and are included as part of manufacturing overhead, which is discussed later in this section.

Direct labour The term direct labour is reserved for those labour costs that can easily (i.e., physically and conveniently) be traced to individual units of product. Direct labour is sometimes called touch labour, since direct labour workers typically touch the product while it is being made. The labour costs of assembly-line workers, for example, would be direct labour costs, as would the labour costs of carpenters, bricklayers and machine operators. Labour costs that cannot be physically traced to the creation of products, or that can be traced only at great cost and inconvenience, are termed indirect labour and treated as part of manufacturing overhead, along with indirect materials. Indirect labour includes the labour costs of caretakers, supervisors, materials handlers and night security guards. Although the efforts of these workers are essential to production, it would either be impractical or impossible accurately to trace their costs to specific units of product. Hence, such labour costs are treated as indirect labour. In some industries, major shifts are taking place in the structure of labour costs. Sophisticated automated equipment, run and maintained by skilled indirect workers, is increasingly replacing direct labour. In a few companies, direct labour has become such a minor element of cost that it has disappeared altogether as a separate cost category. More is said in later chapters about this trend and about the impact it is having on cost systems. However, the vast majority of manufacturing and service companies throughout the world continue to recognize direct labour as a separate cost category.

Manufacturing overhead Manufacturing overhead, the third element of manufacturing cost, includes all costs of manufacturing except direct materials and direct labour. Manufacturing overhead includes items such as indirect materials; indirect labour; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation and insurance on manufacturing facilities. A company also incurs costs for heat and light, property taxes, insurance, depreciation and so forth, associated with its selling and administrative functions, but these costs are not included as part of manufacturing overhead. Only those costs associated with operating the factory are included in the manufacturing overhead category. Various names are used for manufacturing overhead, such as production overhead, indirect manufacturing cost, factory overhead, and factory burden. All of these terms are synonymous with manufacturing overhead.

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et complete eBook Order by email at [email protected] General cost classifications  25 Manufacturing overhead combined with direct labour is called conversion cost. This term stems from the fact that direct labour costs and overhead costs are incurred in the conversion of materials into finished products. Direct labour combined with direct materials is called prime cost.

Non-manufacturing costs Generally, non-manufacturing costs are sub-classified into two categories: 1 2

Marketing or selling costs Administrative costs

Marketing or selling costs include all costs necessary to secure customer orders and get the finished product or service into the hands of the customer. These costs are often called order-getting and order-filling costs. Examples of marketing costs include advertising, shipping, sales travel, sales commissions, sales salaries and costs of finished goods warehouses. Administrative costs include all executive, organizational and clerical costs associated with the general management of an organization rather than with manufacturing, marketing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations and similar costs involved in the overall general administration of the organization as a whole.

LO2

Product costs versus period costs In addition to the distinction between manufacturing and non-manufacturing costs, there are other ways to look at costs. For instance, they can also be classified as either product costs or period costs. To understand the difference between product costs and period costs, we must first refresh our understanding of the matching principle from financial accounting. Generally, costs are recognized as expenses on the statement of profit or loss (alternatively known as the income statement or the profit and loss account) in the period that benefits from the cost.2 For example, if a company pays for liability insurance in advance for two years, the entire amount is not considered an expense of the year in which the payment is made. Instead, half of the cost would be recognized as an expense each year. This is because both years – not just the first – benefit from the insurance payment. The unexpensed portion of the insurance payment is carried on the statement of financial position (traditionally known as the balance sheet) as an asset called prepaid insurance. You should be familiar with this type of accrual from your financial accounting course. The matching principle is based on the accrual concept and states that costs incurred to generate particular revenues should be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place – that is, when the benefit occurs. Such costs are called product costs.

Product costs For financial accounting purposes, product costs include all the costs that are involved in acquiring or making a product. This is the concept called absorption costing. In the case of manufactured goods, these costs consist of direct materials, direct labour and manufacturing overhead. Product costs are viewed as ‘attaching’ to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventories awaiting sale. So, initially, product costs are assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventories as expenses (typically called cost of goods sold) and matched against sales revenue. Since product costs are initially assigned to inventories, they are also known as inventoriable costs. We want to emphasize that product costs are not necessarily treated as expenses in the period in which they are incurred. Rather, as explained above, they are treated as expenses in the period in which the

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et complete by email at [email protected] 26  Chapter 2: AneBook introduction toOrder cost terms, concepts and classifications related products are sold. This means that a product cost such as direct materials or direct labour might be incurred during one period but not treated as an expense until a following period when the completed product is sold.

Period costs Period costs are all the costs that are not included in product costs. These costs are expensed in the statement of profit or loss in the period in which they are incurred, using the usual rules of accrual accounting you have already learned in financial accounting. Period costs are not included as part of the cost of either purchased or manufactured goods. Sales commissions and office rent are good examples of the kind of costs we are talking about. Neither commissions nor office rent are included as part of the cost of purchased or manufactured goods. Rather, both items are treated as expenses on the statement of profit or loss in the period in which they are incurred. Thus, they are said to be period costs. As suggested above, all selling and administrative expenses are considered to be period costs. Therefore, advertising, executive salaries, sales commissions, public relations, and other non-manufacturing costs discussed earlier would all be period costs. They will appear in the statement of profit or loss as expenses in the period in which they are incurred. Exhibit 2.1 contains a summary of the cost terms that we have introduced so far.

Manufacturing Costs (also called Product Costs or Inventoriable Costs)

Direct Materials

Direct Labour

Manufacturing Overhead

Materials that can be physically and conveniently traced to a product (such as wood in a table)

Labour cost that can be physically and conveniently traced to a product (such as assembly-line workers in a plant)

All costs of manufacturing a product other than direct materials and direct labour (such as indirect materials, indirect labour, factory utilities and depreciation of factory buildings and equipment)

Prime Cost

Conversion Cost

Non-manufacturing Costs (also called Period Costs)

Marketing or Selling Costs

Administrative Costs

All costs necessary to secure customer orders and get the finished product or service into the hands of the customer (such as sales commissions, advertising and depreciation of delivery equipment and finished goods warehouse)

All costs associated with the general management of the company as a whole (such as executive compensation, executive travel costs, secretarial salaries and depreciation of office buildings and equipment)

Exhibit 2.1  Summary of cost terms

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et complete eBook Order by email at Cost [email protected] classifications on financial statements  27 Cost classifications on financial statements In introductory financial accounting, you learn that firms prepare periodic financial reports for creditors, shareholders and other stakeholders to show the financial condition of the firm and the firm’s earnings performance over some specified interval. The reports you study were probably those of merchandising companies, such as retail shops, which simply purchase goods from suppliers for resale to customers. The financial statements prepared by a manufacturing company are more complex than the statements prepared by a merchandising company. Manufacturing companies are more complex organizations than merchandising companies because the manufacturing company must produce its goods as well as market them. The production process gives rise to many costs that do not exist in a merchandising company, and somehow these costs must be accounted for on the manufacturing company’s financial statements. In this section, we focus our attention on how this accounting is carried out in the statement of financial position and in the statement of profit or loss.

The statement of financial position The statement of financial position or balance sheet, of a manufacturing company is similar to that of a merchandising company. However, there are differences in the inventory accounts. A merchandising company has only one class of inventory – goods purchased from suppliers that are awaiting resale to customers. By contrast, manufacturing companies have three classes of inventories – raw materials, work in progress and finished goods. Work in progress consists of goods that are only partially completed, and finished goods consists of goods that are ready to be sold. The breakdown of the overall inventory figure into these three classes of inventories is usually provided in a footnote to the financial statements. We will use two companies – Graham Manufacturing and Reston Books – to illustrate the concepts discussed in this section. Graham Manufacturing makes precision brass fittings for yachts. Reston Books is a small bookshop. The footnotes to Graham Manufacturing’s Annual Report reveal the following information concerning its inventories: Graham Manufacturing Corporation Inventory accounts   Raw materials Work in progress Finished goods Total inventory accounts

Beginning balance £60,000

Ending balance £50,000

90,000

60,000

125,000

 175,000

£275,000

£285,000

Graham Manufacturing’s raw materials inventory consists largely of brass rods and brass blocks. The work in progress inventory consists of partially completed brass fittings. The finished goods inventory consists of brass fittings that are ready to be sold to customers. In contrast, the inventory account at Reston Books consists entirely of the costs of books the company has purchased from publishers for resale to the public. In merchandising companies like Reston, these inventories may be called merchandise inventory. The beginning and ending balances in this account appear as follows: Reston Books Inventory account   Merchandise inventory

Beginning balance

Ending balance

£100,000

£150,000

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