Cost Accounting and Control Colin Drury ae CENGAGE ‘Australia + Brazil Canada + Mexi1 %e CENGAGE Cost Accounting and (© 2022 Cengage Learning Asia Pte Lid ene | This edition is reprinted for sale in the Philippines only Colin Drury | ALL RIGHTS RESERVED. No part of this work covered by the copyright Cover image: | herein may be reproduced, transmitted, stored or used in any form or by © Siriporn Kaenseeya/ —-|-_-any means graphic, electronic, or mechanical, including but not limited to fyetm ‘Getyimages | photocopying recording, scanning, dgtaling, taping, Web distribution, information networks, or information storage and retrieval systems, except 2a permitted under Section 107 or 108 of the 1976 United States Copyright ‘Act, without the prior written permission of the publisher. |For product information and technology assistance, contact us at | Cengage Learning Philippines Customer Support, 632-869-9660 For permission to use material from this text or product, submit all requests online at [Link]/permissions Further permissions questions can be emailed to asia, permissionrequest@[Link] ISBN: 978-981-49-8670-0 Cengage Learning Asia Pte Ltd 151 Lorong Chuan +#02-08 New Tech Park ‘Singapore 556741 ‘Cengage Learning Asia Pte Ltd (Pl Unit 1103, 11th Corporate Center 11th Avenue, corner Triangle Drive, North Bonifacio Bonifacio Global City, Taguig City Philippines 1634 ippine Branch) Cengage Learning isa leading provider of customized learning solutions with office locations around the globe, including Singapore, the United Kingdom, Australia, Mexico, Brazil, and japan. Locate your local office at [Link]/global To learn more about Cengage Learning Solutions, visit [Link] Printed in the Philippines Print Number: 01 Print Year: 2021About the Author ix 1 INTRODUCTION TO MANAGEMENT ACCOUNTING 1 The users of accounting information 2 Differences between management accounting and financial accounting 3 The decision-making, planning and control process. 4 ‘The impact of the changing business environment on management accounting. 7 Focus on customer satisfaction and new management approaches 11 Globalization and management accounting international practices 13 Functions of management accounting 14 Summary 16 Key terms and concepts 17 Key examination points 18 Review questions 19 2 AN INTRODUCTION TO COST TERMS AND CONCEPTS 21 Cost objects 22 _ ‘ Manufacturing, merchandising and service organizations 22 Direct and indirect costs 23 Period and product costs 26 Cost behaviour 29 . Relevant and irrelevant costs and revenues 32 Avoidable and unavoidable costs 93 Sunk costs 33 Opportunity costs 35 Incremental and marginal costs 96 The cost and management accounting information system 36 Summary 37 Key terms and concepts 38 Key examination points 39 Review questions 40 Review problems 41 3 ACCOUNTING FOR DIRECT COSTS 47 Accounting treatment of various labour cost items 48 Materials recording procedure 49 r Pricing the issues of materials 52 Issues relating to accounting for materials 56fy CONTENTS, Quantitative models for the planning and control of inventories 58 Relevant costs for quantitative models under conditions of certainty 58 Determining the economic order quantity 59 ‘Assumptions of the EOQ formula 62 Determining when to place the order 63 Control of inventories through classification 64 Just-in-time systems 66 Materials requirement planning 67 Summary 67 Key terms and concepts 69 Key examination points 70 Review questions 71 Review problems 71 COST ASSIGNMENT FOR INDIRECT COSTS 79 Assignment of direct and indirect costs 80 Different costs for different purposes 81 Cost-benefit issues and cost systems design 82 Plant-wide (blanket) overhead rates 84 The two-stage allocation process 85 Anillustration of the two-stage process for a traditional costing system 86 Extracting relevant costs for decision-making 93 Budgeted overhead rates 93 Under- and over-recovery of overheads 94 Non-manufacturing overtieads 95 Cost assignment in non-manufacturing organizations 96 The indirect cost assignment process 98 Summary 98 ‘Appendix 4.1: Inter-service department reallocation 100 Key terms and concepts 104 Key examination points 105 Review questions 106 Review problems 107 ACCOUNTING ENTRIES FOR A JOB-ORDER COSTING SYSTEM 115 Control accounts 116 Recording the purchase of raw materials 116 Recording the issue of materials 117 ‘Accounting procedure for labour costs 120 Accounting procedure for manufacturing overheads 122 Non-manufacturing overheads 123 ‘Accounting procedures for jobs completed and products sold 123 Costing profit and loss account 124 Job-order costing in service organizations . 124 Interlocking accounting 124 Contract costing 126 Work in progress valuation and amounts recoverable on contracts 131CONTENTS v Summary 132 Key terms and concepts 133 Key examination points 134 Review questions 135 Review problems 135° PROCESS COSTING 145 Flow of production and costs in a process costing system 146 Process costing when all output is fully complete 146 Process costing with ending work in progress partially complete 154 Beginning and ending work in progress of uncompleted units 157 Partially completed output and losses in process 162 Process costing in service organizations 162 Batch/operating costing 162 Summary 163 Appendix 6.1: Losses in process and partially completed units 164 Key terms and concepts’ 168 Key examination points 168 : Review questions 170 Review problems 170 r 3 JOINT AND BY-PRODUCT COSTING 181 Joint products and by-products 182 Methods of allocating joint costs 182 irrelevance of joint cost allocations for decision-making 189 Accounting for by-products .190 Summary 191 Key terms and concepts 193 Key examination points 193 Review questions 194 Review problems 194 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 201 External and internal reporting 203 Variable costing 204 Absorption costing 205 Variable costing and absorption costing: a comparison of their impact on profit 206 ‘Some arguments in support of variable costing 208 Some arguments in support of absorption costing 210 Summary 211 ‘Appendix 8.1: Derivation of the profit function for an absorption costing system 212 Key terms and concepts 214 Key examination points 214 Review questions 215 Review problems 215wi CONTENTS 10 11 COST-VOLUME~PROFIT ANALYSIS 221 Curvilinear CVP relationships 222 Linear CVP relationships 223 A nnumerical approach to cost-volume-profit analysis 225 The profit-volume ratio 228 . , Relevant range 228 Margin of safety 228 Constructing the break-even chart 230 ce Alternative presentation of cost-volurie-profit analysis 231 Multi-product cost-volume-profit analysis 233 Cost-volume-profit analysis assumptions 235 The impact of information technology | 237 Summary 237 Key terms and concepts 238 Key examination points 239 Review questions 240 Review problems 241 COST ESTIMATION AND COST BEHAVIOUR 251 General principles applying to estimating cost functions 252 Cost estimation methods 253 Tests of reliability 260 ‘A summary of the steps involved in estimating cost functions 262 Summary 263 Key terms and concepts 265 Key examination points 265 Review questions 266 Review problems 266 MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING 273 Identifying relevant costs and revenues 274 Importance of qualitative/non-financial factors 275 Special pricing decisions 275 Evaluation of a longer-term order 278 Product mix decisions when capacity constraints exist 281 Replacement of equipment - the irrelevance of past costs 283 Outsourcing and make or buy decisions 284 Discontinuation decisions 288 Determining the relevant costs of direct materials 291 Determining the relevant costs of direct labour 291 Incorporating uncertainty into the decision-making process 292 Summary 292 Appendix 11.1: Calculating optimum selling prices using differential calculus 204 Key terms and concepts 295 Key examination points 296 Review questions 297 Review problems 298CONTENTS vit 12 ACTIVITY-BASED COSTING 311 ‘The need for a cost accumulation system in generating relevant cost information for decision-making 312 Acomparison of traditional and ABC systems 313 Volume-based and non-volume-based cost drivers 314 An illustration of the two-stage process for an ABC system 318 Designing ABC systems 325 Activity hierarchies 327 Cost versus benefits considerations 328 : Surveys of company practices relating to ABC usage 330 Summary 330 Key terms and concepts 332 Key examination points 332 Review questions 333 Review problems 334 Index 341ABOUT THE AUTHOR The late Colin Drury was at Huddersfield University from 1970 until his retirement in 2004, when he was’ awarded the title of Emeritus Professor. For the last 35 years, Professor Colin Drury had been at the forefront of helping students learn the key concepts and processes in management and cost accounting through his bestselling textbooks, which have been widely recommended by the main professional accounting bodies for their examinations. He was an active researcher throughout his career and his research had been published in around 100 professional and academic journals. In recognition for his contribution to accounting education and research, Drury was given a lifetime achievement award by the British Accounting Association in 2009.Gea INTRODUCTION TO MANAGEMENT ACCOUNTING LEARNING OBJECTIVES After studying this chapter, you should be able to: © distinguish between management accounting and financial accountin: identify and describe the elements involved in the decision-making, planning and control process; justify the view that a major objective of commercial organizations is _ to broadly seek to maximize future profits; explain the important changes that have taken place in the business environment that have influenced management accounting practice; outline and describe the key success factors that directly affect customer satisfaction; identify and describe the functions of a cost and management accounting system. here are many definitions of accounting, but the one that captures the theme of this book is the definition formulated by the American Accounting Association. It describes accounting as: the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information. In other words, accounting is concerned with providing both financial and non- financial information that will help decision-makers to make good decisions.2 CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING In order to understand accounting, you need to know something about the decision- making process, and also to be aware of the various users of accounting information. During the past two decades many organizations in both the manufacturing and service sectors have faced dramatic changes in their business environment. Deregulation and extensive competition from overseas companies in domestic markets has resulted in a situation where most companies now operate in a highly competitive global market. At the same time there has been a significant reduction in product life cycles arising from technological innovations and the need to meet increasingly discriminating customer demands. To succeed in today’s highly competitive environment, companies have made customer satisfaction an overriding priority. They have also adopted new management approaches and manufacturing companies have changed their manufacturing systems and invested in new technologies. These changes have had a significant influence on management accounting systems. The aim of this frst chapter is to give you the background knowledge that will enable you [Link] amore meaningful insight into the issues and problems of cost and management accounting that are discussed in the book. We begin by looking at the users of accounting information and identifying their requirements. This is followed by a description of the decision-making, planning and control process and the changing business environment. Finally, the different functions of management accounting are described. THE USERS OF ACCOUNTING INFORMATION Accounting is a language that communicates economic information to various parties (known as stakeholders) who have an interest in the organization. Stakeholders fall into several groups (e.g. managers, shareholders and potential investors, employees, creditors and the government) and each of these groups has its own requirements for information: ‘© Managers require information that will assist them in their decision-making and control activities; for example, information is needed on the estimated selling prices, costs, demand, competitive position and profitability of various products/ services that dre provided by the organization. © Shareholders require information on the value of their investment and the income that is derived from their shareholding. ‘© Employees require information on the ability of the firm to meet wage demands and avoid redundancies. © Creditors and the providers of loan capital require information on a firm’s ability to meet its financial obligations. ‘© Government agencies such as the Central Statistical Office collect accounting information and require such information as the details of sales activity, profits, investments, stocks (Le. inventories), dividends paid, the proportion of profits absorbed by taxation and so on. In addition, government taxation authorities require information on the amount of profits that are subject to taxation. All this information is important for determining policies to manage the economy. The need to provide accounting information is not confined to business organizations. Individuals sometimes have to provide information about their own financial situation; for example, if you want to obtain a mortgage or a personal loan, you may be asked for details of your private financial affairs. Non-profit-making organizations such as religiousCHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING and charitable organizations, clubs and government units such as local authorities, also require accounting information for decision-making, and for reporting the results of their activities. For example, a tennis club will require information on the cost of undertaking its various activities so that a decision can be made as to the amount of the annual subscription that it will charge to its members. Similarly, municipal authorities, such as local government and public sector organizations, need information on the costs of undertaking specific activities so that decisions can be made as to which activities will be undertaken and the resources that must be raised to finance them. As you can see, there are many different users of accounting information who require information for decision-making. The objective of accounting is to provide sufficient information to meet the needs of the various users at the lowest possible cost. Obviously, the benefit derived from using an information system for decision-making must be greater than the cost of operating the system. ‘The users of accounting information can be divided into two categories: 1 internal users within the organization; 2 external users such as shareholders, creditors and regulatory agencies, outside the organization. Itis possible to distinguish between two branches of accounting, which reflect the internal and external users of accounting information. Management ‘accounting is concerned with the provision of information to people within the organization to help them make better decisions and improve the efficiency and effectiveness of existing operations, whereas financial accounting is concerned with the provision of information to external parties outside the organization. Thus, management accounting could be called internal reporting and financial accounting could be called external reporting. This book concentrates on management accounting. DIFFERENCES BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING The major differences between these two branches of accounting are: © Legal requirements. There is a statutory requirement for public limited companies to produce annual financial accounts, regardless of whether or not management regards this information as useful. Management accounting, by contrast, is entirely optional and information should be produced only if it is considered that the benefits it offers management exceed the cost of collecting it. ‘© Focus on individual parts or segments of the business. Financial accounting reports describe the whole of the business, whereas management accounting focuses on ‘small parts of the organization; for example, the cost and profitability of products, services, departments, customers and activities. ® Generally accepted accounting principles. Financial accounting statements must be prepared to conform with the legal requirements and the generally accepted accounting principles established by the regulatory bodies such as the Financial Accounting Standards Board (FASB) in the USA, the Financial Reporting Council (FRC) in the UK and the International Accounting Standards 34 Planning process Contvol process ' CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Board (IASB). These requirements are essential to ensure uniformity and consistency, which make intercompany and historical comparisons possible. Financial accounting data should be verifiable and objective. In contrast, management accountants are not required to adhere to generally accepted accounting principles when providing managerial information for internal purposes. Instead, the focus is on serving management's needs and providing information that is useful to managers when they are carrying out their decision-making, planning and control functions. © Time dimension. Financial accounting reports what has happened in the past in an organization, whereas management accounting is concerned with future information as well as past information, Decisions are concerned with future events and management, therefore, requires details of expected future costs and revenues. © Report frequency and less emphasis on precision. A detailed set of financial accounts is published annually and less detailed accounts are published semi-annually. Management usually requires information more quickly than this if itis to act on it. Consequently, management accounting reports on various activities may be prepared at daily, weekly or monthiy intervals. THE DECISION-MAKING, PLANNING AND CONTROL PROCESS Information produced by management accountants must be judged in the light of its ultimate effect on the outcome of decisions. It is therefore important to have. an understanding of the decision-making, planning and control process. Figure 1.1 presents a diagram of the decision-making, planning and control process. The first four stages represent the decision-making or planning process. The final two stages represent the contro! process, which is the process of measuring and correcting actual performance to ensure the alternatives that are chosen and the plans for implementing them are carried out. We will now examine the stages in more detail. FIGURE 1.1 ® The decision-making, { planning and contro! lagen 2. Search for altemative courses of action process ' 3, Select a courses of ‘action | | 4. niplement the decisions eek | ‘i " NS ad EON en | —- 6. Respond to divergences fom plenCHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Identifying objectives Before good decisions can be made there must be some guiding aimn or direction that will enable the decision-makers to assess the desirability of choosing one course of action cover another. Hence, the first stage in thé decision-making process should be to specify the company's goals or organizational objectives. This is an area where there is considerable controversy. Economic theory normally assumes that firms seek to maximize profits for the owners of the firm or, more precisely, the maximization of shareholders’ wealth, which is equivalent to the maximization of the present value of future cash flows. Various arguments have been used to support the profit maximization objective. ‘There is the legal argument that the ordinary shareholders are the owners of the firm, which therefore should be run for their benefit by trustee managers. Another argument supporting the profit objective is that profit maximization leads to the maximization of overall economic welfare. That is, by doing the best for yourself, you are unconsciously doing the best for society. Moreover, it seems a reasonable belief that the interests of firms will be better served by alarger profit than bya smaller profit, so that maximization is atleast a useful approximation. ‘Some writers (e.g. Simon, 1959) believe that many managers are content to find a plan that provides satisfactory profits rather than to maximize profits. “Clearly itis too simplistic to say that the only objective of a business firm is to maximize profits. Some managers seek to establish a power base and build an’empire. Another common goal is security, and the removal of uncertainty regarding the future may override the pure profit motive, Organizations may also pursue more specific objectives, such as producing high quality products or being the markat leader within a particular market segment. Nevertheless, the view adopted in this book is that, broadly, firms seek to maximize future profits. There are two reasons for us to concentrate on this objective: 4 Itis unlikely that any other objective is as widely applicable in measuring the ability of the organization to survive in the future. 2’ It is unlikely that maximizing future profits can be realized in practice, but by establishing the principles necessary to achieve this objective you will learn how to increase profits. The search for alternative courses of action ‘The second stage in the decision-making model is a search for a range of possible courses of action (or'strategies) that might enable the objectives to be achieved. If the management of accompany concentrates entirely on its present product range and markets, and market shares and profits are allowed to decline, there is a danger that the company will be unable to survive in the future. If the business is to survive, management must identify potential opportunities and threats in the current environment and take specific steps now so that the organization will not be taken by surprise by future developments. In particular, the company should consider one or more of the following courses of action: 4. developing new products for sale in existing markets; 2 developing new products for new markets; 3 developing new markets for existing products. The search for alternative courses of action involves the acquisition of information concerning future opportunities and environments; it is the most difficult and important stage of the decision-making process.6 CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Select appropriate alternative courses of action In order for managers to make an informed choice of action, data about the differen, alternatives must be gathered. For example, managers might ask to see projected figures on; @ the potential growth rates of the alternative activities under consideration; © the market share the company is likely to achieve; © projected profits for each alternative activity. The alternatives should be evaluated to identify which course of action best satisfies ‘the objectives of an organization. The selection of the most advantageous alternative is central to the whole decision-making process and the provision of information that facilitates this choice is one of the major functions of management accounting. These aspect of management accounting are examined in Chapters 9 to 12. Implementation of the decisions Once the course of action has been selected, it should be implemented as part of the budgeting and long-term planning process. The budget is a financial plan for implementing the decisions that management has made. The budgets for all of the various decisions a company takes are expressed in terms of cash inflows and outflows, and sales revenues and expenses. These budgets are initially prepared at the departmental/responsibility centre level (i.e. a unit or department within an organization for whose performance a manager is held responsible) and merged together into a single unifying statement for the organization as a whole ‘that specifies the organization’s expectations for future periods. This statement is known as a master budget and consists of budgeted profit and cash flow statements. The budgeting process communicates to everyone in the organization the part that they are expected to play in implementing management's decisions. Comparing actual and planned outcomes and responding to divergencies from plan The final stages in the process outlined in Figure 1.1 involve comparing actual and planned ‘outcomes and responding to divergencies from plan. The managerial function of control consists of the measurement, reporting and subsequent correction of performance in an attempt to ensure that the firm’s objectives and plans are achieved, To monitor performance, the accountant produces performance reports and presents them to the managers who are responsible for implementing the various decisions. These reports compare actual outcomes (actual costs and revenues) with planned outcomes (budgeted costs and revenues) and should be issued at regular intervals. Performance reports provide feedback information and should highlight those activities that do not conform to plans, so that managers can devote their limited time to focusing mainly on these items. This process represents the application of management by exception. Effective control requires that corrective action is taken so that actual outcomes conform to planned outcomes. Alternatively, the plans may require modification if the comparisons indicate that the plans are no longer attainable. The process of taking corrective action or modifying the plans if the comparisons indicate that actual outcomes do not conform to planned outcomes, is indicated by the arrowed lines. in Figure 1.1 linking stages 6 and 4 and 6 and 2. These arrowed lines represent ‘feedbackCHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING 7 REAL WORLD VIEWS 1.1 addition to strong accounting fundamentals, CIMA teaches strategic business and management skills: Analysis ~ they analyze information and use it to make business decisions. Strategy - they formulate business strategy to create wealth and shareholder value. > Risk ~ they identify and manage risk. Planning - they apply accounting techniques to plan and budget. Communication - they determine what information management needs and Chartered Institute of Management Accountants (CIMA) ~ activities and skills What is management accounting? Management accounting combines accounting, finance and management with the leading edge techniques needed to drive successful businesses. Chartered management accountants: ‘Advise managers about the financial implications of projects. Explain the financial consequences of business decisions. : * Formulate business strategy. explain the numbers to non-financial + Monitor spending and financial control. managers. + Conduct internal business audits. + Explain the impact of the competitive penaee ae: ‘i Question 1 Provide “more detailed illustrations for each of the first four items in the first category of the above list of how the Bring a high level of professionalism and integrity to business. Management accounting skillset Our members are qualified to work across an organization, not just in finance. In management accountant can be of assistance in an organization with which you are familiar. loops’. They signify that the process is dynamic and stress the interdependencies between the various stages in the process. The feedback loop between stages 6 and 2 indicates that the plans should be regularly reviewed, and if they are no longer attainable then alternative courses of action must be considered for achieving the organization's objectives. The second loop stresses the corrective action taken so that actual outcomes conform to planned outcomes. THE IMPACT OF THE CHANGING BUSINESS ENVIRONMENT ON MANAGEMENT ACCOUNTING During the last few decades, global competition, deregulation, declines in product life cycles, advances in manufacturing and information technologies, environmental issues and a competitive environment requiring companies to become more customer driven,CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING have changed the nature of the business environment. These changes have significantly altered the ways in which firms operate, which in turn, have resulted in changes in management accounting practices. Globalicompetition During the last few decades reductions in tariffs and duties on imports and exports, and dramatic improvements in transportation and communication systems, have resulted in many firms operating in a global market. Prior to this, many organizations operated in a protected competitive environment. Barriers of communication and geographical distance, and sometimes protected markets, limited the ability of overseas companies to compete in domestic markets. There was littie incentive for firms to maximize efficiency and improve management practices, or to minimize costs, as cost increases could often be passed on to customers. During the 1990s, however, organizations began to encounter severe competition from overseas competitors who offered high-quality products at low prices. Manufacturing companies can now establish global networks for acquiring raw materials and distributing goods overseas, and service organizations can communicate with overseas offices instantaneously using internet and digital technologies. These changes have [Link] to gain access to domesti¢ markets throughout the world. Nowadays, organizations have to compete against the best companies in the world. This new competitive environment has increased the demand for cost information relating tocost management and profitability analysis by product lines and geographical locations. Changing product life cycles A product's life cycle'is the period of time from initial expenditure on research and development to the time at which support to customers is withdrawn, Intensive global competition and technological innovation, combined with increasingly discriminating and-sophisticated customer demands, have resulted in a dramatic decline in product life cycles. To be sucéessful, companies must now speed up the rate at which they introduce new products to the market and constantly develop new products and services. Being later to the market than the competitors can have a dramatic effect on product profitability. In many industries a large fraction of a product's life oycle costs are determined by decisions made early in its life cycle, This has created a need for management accounting to place greater emphasis on providing information at the design stage because many of the costs are committed or locked in at this time. Therefore, to compete successfully, companies must be able to manage their costs effectively at'the design stage, have the capability to adapt to new, different and changing customer requirements and reduce the time to market of new and modified products. Advances in manufacturing technologies Excellence in manufacturing can provide a competitive weapon to compete in sophisticated worldwide markets. In order to compete effectively, companies must be capable of manufacturing innovative products of high quality at a low cost, and also provide a first- class customer service. At the same time, they must have the flexibility to cope with short productlife cycles, demands for greater product variety from more discriminating customers and increasing international competition. World-class manufacturing companies have responded to these competitive demands by replacing traditional production systems with lean manufacturing systems that seek to reduce waste by implementing just-in-time (JIT)CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING REAL WORLD VIEWS 1.2 Changing product life cycles - consumer medical sciences Medical devices are normally associated with use by hospitals and medical practices. Some devices are used by normal consumers and, according to an article on the Medical Device and Diagnostic Industry web- site ([Link]), are proliferating. The market for devices such as insulin pumps and blood pressure monitors has become more consumer-driven and is Putting pressure on manufacturers to design better products and get them to the market faster. According to the article, ‘patients want their medical devices to have the same kind of design and appeals as iPods’. This con- vergence of medical and mass consumer electronics is creating many challenges for medical device manufacturers. These chal- lenges include widely divergent product life cycles, varying scenarios of use and safety, and efficacy concerns. The typical life cycle of a consumer device is likely to be measured more in months than years. Compare this to the long approval cycles ‘of drug and medical device regulatory authorities - which, according to the article, ‘can be anything from 27 to 36 months in the USA depending on the type of medical device. During this timeframe, an iPod/iPad has probably gone through at least two generations, and smart devices are now the norm. It may be that medical devices will never get as sawvy as a consumer iPad due to regulatory concerns and device efficacy. However, increasing consumer- driven requirements are likely to shorten the product life cycle over coming years as devices move further towards personal smart devices. As of April 2016, for exam- ple, a Financial Times article notes there are more than 165 000 health and fitness apps available at the Apple App Store. While Apple's devices are not medical devices they do pose a competitive threat. Questions 1 Do you think the costs of the electronic components in a smart device such as an iPod/iPad are more or less than those ina medical device like a blood pressure monitor? 2 Would decreasing the product life cycle of medical devices, or medical devices being more like consumer. electronics, pose any risks for manufacturers? production systems, focusing on quality, simplifying processes and investing in advanced manufacturing technologies (AMTs). The impact of information technology During the past two decades the use of information technology (IT) to support business activities has increased dramatically and the development of electronic business communication technologies known as e-business, e-commerce or internet commerce have had a major impact. For example, consumers are more discerning in their purchases because they can access the internet to compare the relative merits of different products and services. Internet trading also allows buyers and sellers to undertake transactions from diverse locations in different parts of the world, E-commerce (such as bar coding) has allowed considerable cost savings to be made by streamlining business processes and has generated extra revenues from the adept use of online sales facilities (such as10 CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING ticketless airline bookings and internet banking). The proficient use of e-commerce has given many companies a competitive advantage. The developments in IT have had a significant impact on the work of management’ accountants. They have substantially reduced the information gathering and processing of information. Instead of managers asking management accountants for information, they can access the system on their personal computers to derive the information they require directly and do their own analyses. This has freed accountants to adopt the role of advisers and internal consultants to the business. Management accountants have now: become more involved in interpreting the information generated from the accounting system and providing business support for managers. Environmental and sustainability issues Increasing attention is now being given to making companies accountable for social and environmental issues and the need for organizations to be managed in a sustainable way. There is now a general recognition that environmental resources are limited and should be preserved for future generations, Customers areno longer satisfied if companies simply comply with the legal requirements. of undertaking their activities. They expect company managers to be more proactive in terms of their social responsibility, safety and énvironmental issues. Environmental management accounting is becoming increasingly important in many organizations. There are several reasons for this. First, environmental costs can be large for some industrial sectors. Second, regulatory requirements involving huge fines for non-compliance have increased significantly over the past decade. Therefore, selecting the least costly method of compliance has become a major objective. Third, society is demanding that companies focus on being more environmentally friendly. Companies are finding that becoming a good social citizen and being environmentally responsible improves their image and enhances their ability to sell their products and services. These developments have created the need for companies to develop systems of measuring and reporting environmental costs, the consumption of scarce environmental resources and details of hazardous materials used or pollutants emitted to the environment. Knowledge of environmentalcosts, and their causes, provides the information that managers need to redesign processes to minimize the usage of scarce environmental resources and the emission pollutants and to also make more sensitive environmental decisions. Pressures to adopt higher standards of ethical behaviour Earlier in’this chapter it was suggested that management accounting practices were developed to provide information that assists managers to maximize future profits. It was, however, pointed out that itis too simplistic to assume that the only objective of a business. firm is to maximize profits. The profit maximization objective should be constrained by the need for firms to also give high priority to their social responsibilities and ensure that their ‘employees adopt high standards of ethical behaviour. A code of ethics has now become an essential part of corporate culture. Identification of what is acceptable ethical behaviour has attracted much attention in recent years with numerous examples of companies attracting negative publicity for ethical failings and their impact on reported profits. For example, Volkswagen (VW) Europe’s biggest car maker has suffered a dramatic decline in its reputation after the revelation that it fitted software designed to cheat emission tests to 11 million cars worldwide. VWCHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING has set aside €18.4 billion to cover the costs of legal action, compensation and refits. Public distrust and protests against corporate misdemeanours have resulted in calls for increased regulation and the need to focus on improving ethical behaviour. Management accountants have a critical part to play in the management of ethical performance and an obligation to uphold ethical standards. Professional accounting organizations play an important role in promoting a high standard of ethical behaviour by their members. Both of the professional bodies representing management accountants, in the UK (Chartered Institute of Management Accountants), and in the USA (The American Institute of Certified Public Accountants), have issued codes of ethical guidelines for their members and established mechanisms for monitoring and enforcing professional ethics. You can view each organization's ethical standards at [Link] and [Link]/research/standards/codesofconduct/pages/[Link] Deregulation and privatization Before the 1990s many organizations, such as those operating in the airlines, utilities and financial service industries, were either government-owned monopolies or operated in a highly regulated, protected and non-competitive environment. These organizations were not subject to any great pressure to improve the quality and efficiency of their operations or to improve profitability by eliminating services or products that were making losses. Prices. were set to cover operating costs and provide a predetermined return on capital. Hence cost increases could often be absorbed by increasing the prices of the products or services. Little attention was therefore given to developing management accounting systems that accurately measured the costs and profitability of individual products or services. Privatization of government-controlled companies and deregulation has resulted in the elimination in pricing and competitive restrictions. Deregulation, intensive competition and an expanding product range create the need for these organizations to focus on cost management and develop management accounting information systems that enable them to understand their cost base and determine the sources of profitability for their products, customers and markets. Customer orientation In order to survive in today’s competitive environment companies have had to become more customer-driven and to recognize that customers are crucial to their future success. This has resulted in companies making customer satisfaction an ‘overriding priority and to focus on identifying and achieving the key success factors that are necessary to be successful in today’s competitive environment. These key success factors are discussed in the next section. FOCUS ON CUSTOMER SATISFACTION AND NEW MANAGEMENT APPROACHES The key success factors which organizations must concentrate on to provide customer satisfaction are cost, quality, reliability, delivery and the choice of innovative new products. In addition, firms are attempting to increase customer satisfaction by adopting a philosophy of continuous improvement to reduce costs and improve quality, reliability and delivery. 12 CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Cost efficiency Keeping costs low and being cost efficient provides an organization with a strong competitive advantage. Increased competition has also made decision errors, due to poor Cost information, more potentially hazardous to an organization. Many companies have become aware of the need to improve their cost systems so that they can produce more accurate cost information to determine the cost’of their products and services, monitor trends in costs over time, pinpoint loss-making activities and analyze profits by products, sales outlets, customers and markets. Quality In addition to demanding low costs, customers are demanding high quality products and services. Most companies are responding to this by focusing on total quality management (TQM). TQMis aterm used to describea situation where all business functions are involved in a process of continuous quality improvement that focuses on delivering products or services of consistently high quality in a timely fashion. The emphasis on TQM has created fresh demands on the management accounting function to measure and evaluate the quality of products and services and the activities that produce them. Time as a competitive weapon Organizations are also seeking to increase customer satisfaction by providing a speedier response to customer requests, ensuring 100 per cent on-time delivery and reducing the time taken to develop and bring new products to market. For these reasons management accounting systems now place more emphasis on time-based measures, such as cycle time. This is the length of time from start to completion of a product or service. It consists of the sum of processing time, move time, wait time and inspection time. Only processing time adds value to the product, and the remaining activities are non-value added activities in the sense that they can be reduced or eliminated without altering the product's service potential to the customer. Organizations are therefore focusing on minimizing cycle time by reducing the time spent on such activities. The management accounting system has an important role to play in this process by identifying and reporting on the time devoted to value added and non-value added activities. Cycle time measures have also become important for service organizations. For example, the time taken to process mortgage loan applications by financial organizations can be considerable, involving substantial non-value added waiting time. Reducing the time to process applications enhances customer satisfaction and creates the potential for increasing sales revenue. Innovation and continuous improvement To be successful, companies must develop a steady stream of innovative new products and services and have the capability to adapt to changing customer requirements. Management accounting information systems have begun to report performance measures relating to innovation. Examples include: © the total launch time for new products/services; © anassessment of the key characteristics of new products relative to those of ‘competitors;CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING . 1 REAL WORLD VIEWS 1,3 A look ot a key feature of easyJet’s + Passion ~ We have genuine passion for business our customers, our people and the work i we do. ‘As one of the pioneers in the low cost airline ~ market, easyJet’s business model includes * |ntegrity - We stand by our word and do what we say. some core values: «Simplicity - We cut out the things that cane Sty aumnoor eps wily, tbe) don’t matter to keep us lean and make at the core of everything we do. it easy. * Pioneering = We challenge to find » new ways to make travel easy and Question altoreanle: 4 How can the management accounting + One team — Together we'll always find function provide information to support a away. low cost strategy? © feedback on customer satisfaction with the new features and characteristics of newly introduced products and the number of new products launched. Organizations are also attempting to enhance customer satisfaction by adopting a philosophy of continuous improvement. Traditionally, organizations have sought to study activities and establish standard-operating procedures. Management accountants developed systems and measurements that compared actual results with predetermined standards. This process created a climate whereby the. predetermined standards fepresented a target to be achieved and maintained. In today's competitive environment, ‘companies must adopt a philosophy of continuous improvement, an ongoing process that involves a continuous search to reduce costs, eliminate waste and improve the quality and performance of activities that increase customer value or satisfaction. Management accounting supports continuous improvement by identifying opportunities for change and then reporting on the progress of the methods that have been implemented. GLOBALIZATION AND MANAGEMENT ACCOUNTING INTERNATIONAL PRACTICES Globalization has had a significant impact on- management accounting. The growth in multinational companies has resulted in management accountants being responsible for overseeing the operation of management accounting systems in many different countries. Do management accounting practices differ across national borders? Grantund and Lukka (1998) argue that there is a strong current tendency towards global convergence of management accounting practices within the industrialized parts of the world. They distinguish between management accounting practices at the macro and micro levels. The macro level relates to concepts and techniques; in other words, it relates4 CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING mainly to the content of this book. In contrast, the micro level is concerned with the behavioural pattems relating to how management accounting information is actually u At the macro level, Granlund and Lukka suggest that the convergence of management accounting practices in different countries has occurred because of intensified global competition, developments in information technology, the increasing .tendepey: of transnational companies to standardize their practices, the global consultancy industry and the use of globally applied textbooks and teaching. Firms throughout the world are adopting standardized software packages that have resulted in the standardization of reporting patterns of accounting information. It 18 also ‘common for the headquarters/parent company of a transnational enterprise to force foreign divisions to adopt similar accounting practices to those of the headquarters/parent ‘company. Global consultancy companies tend to promote the same standard solutions globally. Finally, the same textbooks are used globally and university and professional accounting syllabuses tend to be similar in different countries. At the micro level, Granlund and Lukka acknowledge that differences in national and corporate culture can result in management accounting information being used in different ways across countries. For example, there is evidence to suggest that accounting information is used in a more rigorous/rigid manner to evaluate managerial performance in Cultures exhibiting certain national traits, and in @ more flexible way in cultures exhibiting different national traits. FUNCTIONS OF MANAGEMENT ACCOUNTING ‘A cost and management accounting system should generate information to meet the following requirements. It should: 4 allocate costs between cost of goods sold and inventories for internal and external Profit reporting; 2 provide relevant information to help managers make better decisions; 3 provide information for planning, control, performance measurement and continuous improvement. Financial accounting rules require that we match costs with revenues to calculate profit. Consequently, any unsold finished goods inventories (or partly completed work in progress) will not be included in the cost of goods sold, which is matched against sales revenue during a given period. In an organization that produces a wide range of different products it will be necessary, for inventory valuation purposes, to charge the costs to each individual product. The total value of the inventories of completed products and work in progress, plus any unused raw materials, forms the basis for determining the inventory valuation to be deducted from the current period's costs when calculating profit. This total is also the basis for determining the inventory valuation for inclusion in the balance sheet. Costs are therefore traced to each individual job or product for financial accounting requirements, in order to allocate the costs incurred during a period between cost of goods sold and inventories. (Note that the terms ‘stocks’ and ‘inventories’ are used synonymously throughout this book) This information is required for meeting external financial accounting requirements, but most organizations also produce internal profit reports at monthly intervals. Thus, product costs are also required for periodic internal profit reporting. Many service organizations, however, do not carry any inventories and product costs are therefore not required by these organizations for valuing inventories.CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING The second requirement of a cost and management accounting system is to Br6vide relevant financial information to managers to help them make better decisions. Information is required relating to the profitability of various segments of the business such as products, sefvices, customers and distribution channels, in order to ensure that only rofitable activities are undertaken. Information is also required for making resource allocation and product/service mix and discontinuation decisions. In some situations information extracted from the costing system also plays a crucial role in determining selling pricgs, particularly in markets where customized products and servicés that do not have readily available market prices are provided. “Management accounting systems should also provide information for planning, control, performance measurement and continuous improvement. Planning involves translating goals and objectives into the specific activities and resources that are required to achieve them. Companies develop both long-term and short-term plans and the management accounting function plays a critical role in this process. Short-term plans, in the form of the budgeting process, are prepared in more detail than the longer-term plans and are one of the mechanisms used by managers as a basis for control and performance evaluation. The control process involves the setting of targets or standards (often derived from the budgeting process) against which actual results are measured. The management accountant’s role is to provide managers with feedback information in the form of periodic reports, suitably analyzed, to enable them to determine if operations for which they are responsible are proceeding according to plan, and to identify those activities where corrective action is necessary. In particular, the management accounting function should provide economic feedback to managers to assist them in controlling costs and improving the efficiency and effectiveness of operations. : It is appropriate at this point to distinguish between cost accounting and management accounting. Cost accounting is concerned with cost accumulation for inventory valuation to meet the requirements of external reporting and internal profit measurement, whereas management accounting relates to the provision of appropriate information for decision- making, planning, control and, performance evaluation. However, a study of the literature reveals that the distinction between cost accounting and management accounting is not clear cut and the two terms are often used synonymously. In this book no further attempt will be made to distinguish between them. You should now be aware that a management accounting system serves multiple purposes. The emphasis throughout this book is that costs must be assembled in different ways for different purposes. Most organizations record cost information in a single database, with costs appropriately coded and classified, so that relevant information can be extracted to meet the requirements of different users. We shall examine this topic in the next chapter. 146 CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING SUMMARY The following items relate to the learning objectives listed at the beginning of the chapter. Distinguish between management accounting and financial accounting. Management accounting differs from financial accounting in several ways. Management accounting is concerned with the provision of information to internal users to help them make better decisions and improve the efficiency and effectiveness of operations. Financial accounting is concerned with the provision of information to external parties outside the organization. Unlike financial accounting there is no statutory requirement for management accounting to produce financial statements or follow externally imposed rules. Furthermore, management accounting provides information relating to different parts of the business whereas financial accounting reports focus on the whole business. Management accounting also tends to be more future otiented and reports are often published on a daily basis whereas financial accounting reports are published semi-annually. Identify and describe the elements involved in the decision-making, planning and control process. The following elements are involved in the decision-making, planning and control process: (a) identify the objectives that will guide the business; (b) search for a range of possible courses of action that might enable the objectives to be achieved; (C) select appropriate alternative courses of action that will enable the objectives to be achieved; (d) implement the decisions as part of the planning and budgeting process; (©) compare actual and planned outcomes; and (f) respond to divergencies from plan by taking corrective action so that actual outcomes conform to planned outcomes, or modify the plans if the comparisons indicate that the plans are no longer attainable. Justify the view-that a major objective of commercial organizations is to broadly seek to. maximize future profits. The reasons for identifying maximizing future profits ‘as a major objective are: (a) itis unlikely that any other objective is as widely applicable in measuring the ability of the organization to survive in the future; (b) although it is unlikely that maximizing future profits can be realized in practice itis stil important to establish the principles necessary to achieve this objective. Explain the important changes that have taken place in the business environment that have influenced management accounting practice. The factors influencing the change in the competitive environment are: (a) globalization of world trade; (b) deregulation in various industries; (c) changing product life cycles; (d) advances in manufacturing and information technologies; (e) focus on environmental issues and ethical issues; and (f) the need to become more customer-driven.CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Outline and describe the key success factors that directly affect customer satisfaction. The key success factors are: cost efficiency, quality, time and innovation and continuous improvement. Keeping costs low and being cost efficient provides an organization with a'strong competitive advantage. Customers also demand high quality products and services and this has resulted in companies making quality a key competitive variable. Organizations are also seeking to increase customer satisfaction by providing a speedier response to customer requests, ensuring 100 per cent on-time delivery and reducing the time taken to bring new products to the market. To be successful, companies must be innovative and develop a steady stream of new products and services and have the capability to rapidly adapt to changing customer requirements. + Identify and describe the functions of a cost and management accounting system. A cost and management accounting system should generate information to meet the following requirements: (a) allocate costs between cost of goods Sold and inventories for internal and external profit reporting and inventory valuation; (b) provide relevant information to help managers make better decisions; and (c) provide information for planning, control and performance measurement. KEY TERMS AND CONCEPTS Each chapter includes a section like this. You should make sure that you understand each of the terms listed below before you proceed to the next chapter. Budget a financial plan for implementing management decisions. ‘Continuous improvement an ongoing search to reduce costs, eliminate waste and improve the quality and performance of activities that increase customer value or satisfaction. Control a managerial function that consists of the measurement, reporting’ and subsequent correction of performance in order to achieve the organization's objectives. Controt process the process of setting targets or standards against which actual results are measured. Cost accounting accounting concerned with cost accumulation for inventory valuation to meet the requirements of external reporting and internal. profit measurement. Cycle time the length of time from start to completion of a product or service and is the sum of processing time, move time, wait time and inspection time. e-business the use of information and communication technologies to support any business activities, including buying and selling. e-commerce the use of information and communication technologies to support the purchase, sale and exchange of goods. Ethical behaviour behaviour that is consistent with the standards of honesty, fairness and social responsibility that have been adopted by the organization. 78 CHAPTER 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Financial accounting accounting concerned with the provision of information to par- ties that are external to the organization. internet commerce the buying and selling of goods and services over the internet. Lean manufacturing systems systems that seek to reduce waste in manufacturing by implementing just-in-time production systems, focusing on quality, simplifying processes and investing in advanced technologies. Management accounting accounting con- cerned with the provision of informa- tion t6 people within the organization to aid decision-making and improve the efficiency and effectiveness of existing operations. Management by exception a situation where management attention is focused on areas where outcomes do not meet targets. Master budget a single unifying statement of an organization's expectations for future periods comprising budgeted profit and cash flow statements. KEY EXAMINATION POINTS Non-value added activities activities that can be reduced or eliminated without altering the product's service potential to the customer. Performance reports regular reports to management that compare actual outcomes with planned outcomes. Product's life cycle the period of time from initial expenditure on research and development to the withdrawal of support to customers. ‘Stakeholders various parties that have an interest in an organization. Examples include managers, shareholders and potential investors, employees, creditors and the government. Strategies courses of action. designed to ‘ensure that objectives are achieved. Total quatity management (TQM) a custorner- oriented process of continuous improve- ment that focuses on delivering products or services of consistent high quality in a timely fashion. Chapter 1 has provided an introduction to the scope of management accounting. It is unlikely that examination questions will be set that refer to the content of an introductory chapter. However, questions are sometimes set requiring you to outline how a costing system can assist the management of an organization. Note that the examiner may not distinguish between cost accounting and management accounting. Cost account- ing is often used to also embrace management accounting. Your discussion of a cost accounting system should therefore include a description (with illustrations) of how the system provides information for decision-making, planning and control. Make sure that you draw off your experience from the whole of a first-year course and not just this introductory chapter.ASSESSMENT MATERIAL The review questions are short questions that enable you to assess your understanding of the main topics included in the chapter. The numbers in parentheses provide you with the page riumbers to refer to if you cannot answer a specific question. ‘The remaining chapters also contain review problems. These are more complex and require you to relate and apply the chapter content to various business problems. REVIEW QUESTIONS 1.1. Identify and describe the different users of accounting information. (op. 2-3) 1.2 Describe the differences between management accounting and financial accounting. (op. 3-4) 1.3 Explain each of the elements of the decision-making, planning and control process. oo opie) ‘ : : 1.4 Describe what is meant by management by exception. (p. 6) 1.5 Explain how the business environment that businesses face has changed over the past decades and discuss how this has had an impact on management accounting. (op. 7-11) 1.6 Describe each of the key success factors that companies should concentrate on to achieve customer satisfaction. (op. 11-13) 4.7. Explain why firms are beginning to concentrate on social responsibility and corporate ethics. (p. 10-17) 4.8 Describe the different functions of management accounting. (pp. 14-15)