Planning, Measuring, and Controlling

Discuss the role of management accounting in an organisation (make comparisons to financial accounting).

Discuss the classification of costs by function (production, non-production); by type (direct, indirect); by behaviour (fixed, variable, stepped fixed) and relevance. Provide examples and diagrams where necessary.

Discuss the FIFO (First In First Out) and LIFO (Last In First Out) methods of inventory valuation making comparisons between them.

Discuss the concept responsibility accounting. Your discussion must include responsibility centres – cost, revenue, profit and investment centres.

Management accounting is a method used to analyze an entity’s financial information and plan accordingly for fulfilment of the organisational objectives (Kaplan and Atkinson 2015). Further, it has been defined as the process of identifying, presenting and interpreting economic information which are significant for financial judgement procedures or firm’s decision making approach. In order to prove that management accounting belongs to the accounting information system, this report will provide a detailed overview of each activity used for strategies, decision-making and resource optimization, employee information, planning for assets protection and control of activities and so on.

The main purpose of this report is to illustrate the function of the management accounting in an organisation and provide sufficient information for different users which will help  users to understand that the management accounting concept is completely different from the financial accounting.

This report will explore how management accounting helps in cost control and performance evaluation process by collection of financial data, record maintenance and report from separate units of the organisation, understanding and examining their budgets and takes suggestive actions for that. By analysing costs in different dimensions, the users will get a clear idea about their significance in the cost evaluation approach of a particular organisation.

Management accounting refers to a function of tracking the internal cost for any business process that helps a firm, organisation or an individual’s decision-making approaches relating to production, operation and investment in market (Goetsch and Davis 2014). The management accounting explores three major activities that help managers to attain efficiency and effectiveness of the business goals (Drury 2013). The primary activities are planning, directing and controlling (Bebbington, Unerman and O’Dwyer 2014). The process of the management accounting is to create and using quality of costs to make several effective decisions within the firm. Many people have contributed in the process. The operational efficiency is completely depends on the internal audit department who has the responsibility to reviewing the cost control efficiency within the organisation (Chua, Lowe and Puxty 2015). On the contrary the financial accounting is mainly providing information to the outside stakeholders such as governments, shareholders, creditors for evaluating the financial performances of the organisation. This financial information helps in their decision making like management accounting. Conceptually, management accounting and financial accounting deals different issues of the organisation, This management accounting evaluates internal management system of the organisation whereas the financial reports are analysed periodical values for making appropriate financial decisions regarding investments of an enterprise. However, financial accounting has to maintain standards such as IAS, GAAP for statutory accounts maintenance while management accounting is completely internal management driven. The above mentioned three primary activities are as follows:

Cost Classification

Planning: Planning procedure should be undertaken before management takes decisions regarding what needs to be done, how it will be done and who will do it. Planning involves establishing the objectives of an organisation and formulating relevant strategies after examining the prior to the past financial records so that future decisions can be made (ValanÄÂiene and GimžauskienÄ— 2015). For example, managers need to know the previous sales volume for setting the latest one.

Measuring: In order to verify the actual position of the company, the management accounting provides two or more alternative choices. However, the effectiveness of these measuring activities depends on reliable information which is relevant to compare the different courses of actions available in the internal management system of the organisation. By this, users get a clear about what consequences might be of choosing each of them.

Controlling:  The information relating to the actual results have been used for controlling internal costs by enhancing performance measurement standards. The managers shall take the decision regarding the budget planning and the “feedback loop” is illustrated in the following diagram.

Diagram 1: The management accounting process of planning, measuring and control

(Source: Created by author)

Cost can be classified by function, type, behaviour and relevance. Here are as follows:

By function: There are two types of costs divided by its function: Cost of production and Cost of commercial. Commercial costs can be sub-divided into production costs, administrative costs, selling and distribution costs, research and development costs (Shepherd 2015). Production costs represent the total manufacturing costs. This costs also segregated by direct and indirect cost of production. The direct material cost is the direct production cost example. On the other hand, commercial costs comprises with all operating costs of the business such as transportation costs, audit fees and so on.

By types:  Costs can be segregated by nature into three types:  material, labour and overhead. The material cost related to those materials that are used for production like cost of fuel, packing material costs and so on (Kaplan and Atkinson 2015). This can be classified into two parts: direct material costs and indirect material costs.  On the other hand, the labour related costs are recorded under the labour costs like incentives of employees. This can be further segregated into direct and indirect labour costs. The overhead costs are related to indirect factory costs like indirect material, depreciation and so. In other words, the overhead costs are essential for daily business operations but these are not directly attributed to any particular business activities, services, products like property taxes, utilities, salaries for administrative peoples and so on.

By Function

By behaviour: under this section, the costs can be divided as fixed, variable and semi variable costs.

Fixed costs are those, which remain unchanged with time irrespective of production volume like rent of the factory, insurance and so on. Here the cost of units tends to fluctuate with the production. Therefore, fixed costs are those expenses that have to be paid by the enterprise, irrespective of the company’s financial positions. On the contrary, variable costs maintain the direct association with its unit (Salako and Yusuf 2016). Variable costs are those costs that directly varies on the production volume of the business.  The cost of variable increases or reduces to the production volume such as direct labour is the most common cost of variable. Lastly, certain costs are used as fixed as well as variable costs. These costs are considered as semi-variable costs. For example, the electricity bill where the minimum amount per month is $40 for 100 units is fixed costs whereas excess consumption amount will be treated as variable portion of that bill.

By relevance: Cost can be classified by relevance in decision-making: Sunk costs, Opportunity costs, and out of pocket costs (Shepherd 2015). The costs incurred in past is called sunk cost or historic cost. On the other hand, the substantial benefits that are given up when another option is selected are termed as opportunity costs. However the sunk costs and opportunity costs are co-related because it is a past opportunity costs such as research and development costs, cost of inventory because these are already incurred. Furthermore, out of pocket costs are relevant for decision-making and needs for ascertaining the future outlays of cash.

The main issue regarding the inventory is the determination of the value at which it is incurred in the financial statements until the revenue is generated (Cook, Huston and Kinney 2012). According to the accounting standard, if the inventory is properly valued, revenues and expenses cannot be appropriately matched which would make difficult for organisations in decision-making. However, companies may have options for the valuation of inventory such as “Last-in-first-out”, “First-in-last-out” “Average cost” method. Here companies need to select which accounting method would be apt for the company. This decision will directly impact the statement of records in an organisation.  

FIFO method:

Generally, an inventory is purchased or manufactured at different rates over an accounting period. Under the “First in first out” takes those items which are initially acquired. The rest of the items will be evaluated at the recent incurred costs, so that inventory assets recorded on the statement of financial record contains cost quite close to the cost, which could be obtained in the marketplace (Kaplan and Atkinson 2015). However, the main drawback of the FIFO method is that the actual flow of inventory is difficult to understand in this pattern (Goetsch and Davis 2014). It means when production costs are rise, the company is normally used this method to report COGS which do not show what actual cost of materials at the time of financial statements are released.

By Type

Example of FIFO method:

A Ltd purchased 12 motors and sold 5 motors during the year. Details are as follows:

March 1 purchased 6 motors @ each

March 4 sold 3 motors

March 9 purchased 6 motors @ $55 each

March 13 sold 2 motors

The value of the remaining 7 motors under the FIFO methods are as follows:

(Source- created by author)

LIFO method:

“Last-in-first-out” is one of the common inventory valuation techniques used in cost accounting and the COGS during the period (Kamath, Rodrigues and Mathew 2013). In this method, those goods, which are acquired or manufactured early, are sold last. It means that the newly acquired or manufactured inventories will be assigned to COGS and older inventories would be considered to the ending inventory account (Li and Sun 2016). Therefore, this method is suitable for matching cost and revenue at the time of prices is rising. This method is also simple to understand and facilitates recovery of material cost. However, the comparison of cost is difficult under LIFO method due to variation of prices.

Comparison between LIFO and FIFO

Under the FIFO, unsold inventory comprises goods acquired most recently whereas earliest goods acquisition is considered in LIFO method. However, LIFO method does not permitted by IFRS, but FIFO does not follow “GAAP OR IFRS” while using it (Gray, Spencer and Pumphrey 2016). Both the methods are affected differently at the inflation time. At the time of increasing cost, the items acquired first would be less costly and with decrease value of COGS, profit will be increased. On the other hand, recently acquired items will be costly at inflation. Thus it will increase COGS under LIFO and reduced the net profit.

Definition:

A responsibility accounting system is an accounting program that gathers information relating to the departmental managers about how they are currently performing. This accounting system consists with collection, summarization and maintain records of accounting data relating to the individual managers of the organisation. In this way, the management can control costs and expenses relating to them. For example, the cost of scrap incurred for a  machine is the responsibility of the shift manager.

Responsibility centre:

The centre of responsibility is a functional segment of an organisation for which a particular executive is responsible who has its own objectives, goals, assigned staffs, particular policies, procedure, and financial reports (Apostolides 2016) . Responsibility centre is responsible for generating revenues, incurrence of expenses or/and funds invested to individuals.

By Behavior

 Cost Centre:

Cost centre can be defined as a responsibility centre, incurred only cost items and no direct revenues are produced from the sale of services of goods (Weygandt, Kimmel and Kieso 2015). It includes accounting department, human resource department, maintenance department, information technology department, research department and so on (Kokubu and Kitada 2015).   Therefore, responsible authorities are only responsible for handling specified expense items. The performance of a cost centre is generally examined through the comparison of standards to actual costs (Ibarrondo-Dávila, López-Alonso and Rubio-Gámez 2015). Furthermore, the cost centre may be performed services for the other business units. In that case, the cost incurred by cost centre may be aggregated into a cost pool and assigned to other units of business.

 Profit Centre:

A Profit centre is a division or branch within a business that is mainly accounted for generating revenue and expenses or losses. It other words, it is a department that uses company resources to generate income like net income, pre-tax income or net contribution. Management closely looks at the results of profit centre since this entity is the key drivers of total performance of the organisation. In short, Profit centre is an operational-oriented unit, used for controlling purposes internally (Kokubu and Kitada 2015). It is a decentralised approach where areas of responsibilities are distributed to units and thus treating them as “companies within the company”. For example, Wal-Mart, which has diversified into nearly every sector of the retail market, but the management, is considered the clothing and electronic sections are the most consistent income from such profit centre.

Investment Centre:

An Investment centre is a business unit responsible for top management for its profitability in relation  to analysis of the investment base of an individual unit within the organisation (Kinney and Raiborn 2012). Investment centre is an extended version of profit centre because revenue and expenses are measured as in profit centre. Apart from that assets of the business are also measured in an investment centre. The main approach of investment centre is to increase the company’s returns because it measures profit in comparison to  invested capital in a branch that gives a more precise picture of which division is contributing to the organisation’s well-being than does the profit centre approach (Drury 2013).

Conclusion:

As a conclusion, it can affirm that management accounting is the  most important and diverse component of the accounting information system along with the essential contribution made in the management process of an economic entity. Here three basic concepts are analysed: cost accounting, accounting of finance and management accounting. Here the management accounting is the prime consideration for analysis, which helps managers in making effective decisions to achieve particular production, operational goals of the organisation. It has been established in this paper that the role of management accounting   is helpful for providing the information for internal management of the enterprise.

References:   

Apostolides, N., 2016. Management Accounting for Beginners. Routledge.

Bebbington, J., Unerman, J. and O’Dwyer, B., 2014. Sustainability accounting and accountability. Routledge.

Chua, W.F., Lowe, T. and Puxty, T. eds., 2015. Critical perspectives in management control. Springer.

Cook, K.A., Huston, G.R. and Kinney, M., 2012. Managing Earnings by Manipulating Inventory: The Effects of Cost Structure and Valuation Method.Available at SSRN 997437.

Drury, C.M., 2013. Management and cost accounting. Springer.

Goetsch, D.L. and Davis, S.B., 2014. Quality management for organizational excellence. pearson.

Gray, K., Spencer, A. and Pumphrey, L., 2016. practical impediments to convergence of us gaap and ifrs. European Scientific Journal, ESJ, 11(10).

Ibarrondo-Dávila, M.P., López-Alonso, M. and Rubio-Gámez, M.C., 2015. Managerial accounting for safety management. The case of a Spanish construction company. Safety science, 79, pp.116-125.

Kamath, N.H., Rodrigues, L.L. and Mathew, A.O., 2013. System dynamics model for controlling the net profit, by focusing on productive maintenance.

Kaplan, R.S. and Atkinson, A.A., 2015. Advanced management accounting. PHI Learning.

Kinney, M. and Raiborn, C., 2012. Cost accounting: Foundations and evolutions. Cengage Learning.

Kokubu, K. and Kitada, H., 2015. Material flow cost accounting and existing management perspectives. Journal of Cleaner Production, 108, pp.1279-1288.

Li, J. and Sun, M.Y., 2016. LIFO Distortions in the Manufacturing Industry.Accounting and Finance Research, 5(1), p.p191.

Salako, M.A. and Yusuf, S.A., 2016. Cost Accounting: A Pivotal Factor of Entrepreneurial Success.

Shepherd, R.W., 2015. Theory of cost and production functions. Princeton University Press.

ValanÄÂienÄ—, L. and GimžauskienÄ—, E., 2015. Changing role of management accounting: Lithuanian Experience case studies. Engineering Economics,55(5).

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & Managerial Accounting. John Wiley & Sons.