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Management Accounting

Management accounting consists of generating accounting information in order to help management plan, monitor, control and take decisions concerning the company.  It is important for the management accounting information given to the management team to be relevant and provided in a timely manner. By the end of this UK-university module, you will have a complete understanding of management accounting.

Costing

Specifically, this module explores the behaviour of the four main types of costs, namely: Variable Cost, Fixed Cost, Stepped-Fixed Cost and Semi-Variable Cost. You will learn that a variable cost moves in direct proportion with the number of units produced.  Whereas, fixed costs are not influenced by the number of units produced and are incurred even if production amounts to zero units.  Stepped-fixed costs behave in a similar manner to the fixed cost except that at certain levels of output, the cost increases and becomes stable again. The semi-variable cost is an expenditure that includes a variable and a fixed element.

You will also gain an understanding of Absorption Costing, its benefits and limitations.  In essence, this is a costing system where the full cost per unit is determined.  This full cost includes direct costs and indirect costs.  Direct costs are costs that can be attributed to a particular product, such as direct materials and direct labour. Whereas, indirect costs are costs that cannot be attributed to a particular product. 

Advantages of Absorption Costing include:

  • It provides a more complete picture of the product cost per unit by including direct costs, and indirect variable and fixed production costs.
  • It complies with the matching concept where production costs are matched with sales.

Disadvantages of Absorption Costing include:

  • The absorption of fixed production costs to units is regarded as an arbitrary approach.
  • One main driver is used to apportion fixed production costs between different products.  This limits the accuracy of the overheads apportioned to products because overheads are influenced by more than one activity.

Thereafter, the module explores the concept of Activity Based Costing (ABC), its associated benefits and weaknesses.  The key steps of Activity Based Costing are:

  1. The main indirect activities of the company are identified.
  2. Develop a cost pool for each activity.
  3. Identify the cost drivers for each activity.
  4. Determine the cost driver rate by dividing the cost pool with the cost driver.
  5. Use the cost driver rate in order to apportion indirect expenditure to products.

Advantages of Activity Based Costing are:

  • It provides more accurate cost per unit.
  • It gives a better insight of the main drivers that influence indirect costs.
  • Activity Based Costing can be adopted on service costing as well.

Disadvantages of ABC are:

  • Activity Based Costing is not highly beneficial if the firm’s overheads are mainly volume related.
  • There is the risk that inappropriate cost drivers are selected, which weaken the accuracy of this costing method.
  • Activity Based Costing is a more complicated method, which makes it more difficult to explain to stakeholders.
  • It is more costly to operate an ABC system in comparison to absorption costing.

You will gain an understanding of Target Costing, its benefits and limitations; margin costing and breakeven analysis. Target Costing is a costing system where the target cost is derived by looking at the product selling price charged in the market and the desired profit.

Advantages of Target Costing are:

  • It stimulates cost efficiency in the organisation because efforts are made in order to achieve the target cost.
  • A competitive selling price is set for the product, which is not influenced by the cost. 

A disadvantage of Target Costing is:

  • It is difficult to adopt target costing for organisations providing a service because it is hard to derive the competitive market price.  This is due to the fact that comparison of services is more complex due to the intangibility of the service.

In marginal costing, fixed production costs are considered as period costs and are not included in the cost per unit rate used to value inventories of finished goods. 

Advantages of Marginal Costing:

  • Profits are not distorted by changes in inventory levels because fixed costs are considered as period costs.
  • Technique that helps to generate valuable information for decision making, such as contribution, break-even point and margin of safety.

Disadvantages of Marginal Costing:

  • In practice, sometimes it is difficult to identify the fixed and variable elements present in costs.
  • Unrealistic assumptions are taken in marginal costing, such as that the variable cost per unit will always remain the same.  Variable costs may decrease over time due to improved efficiency resulting from better skills by employees.
  • Fails to consider qualitative factors like product quality and company’s reputation, which are also important for the company.

The break-even point is the point where the revenue generated by the company is equal to the costs incurred.  In marginal costing this is the point where the contribution is equal to the fixed costs. 

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Source:  (Kaplan Financial, 2016).

The break-even point is the point where the sales revenue meets the total cost.  At this point the profit generated amounts to zero.  The total cost includes the fixed cost and the variable cost.  However, the fixed cost is also shown in the graph, as a horizontal line.  The traditional break-even chart also shows the margin of safety, which is the difference between the sales revenue and the break-even sales.  A product with a low margin of safety holds a high business risk because losses can be incurred easily if sales decrease. 

Uses of Break-Even Analysis:

  • The main use of break-even analysis is that management can observe the impact of changes in sales volume and costs on productivity.
  • The break-even point is also useful to determine the margin of safety and evaluate the risk of the product.

Limitations of Break-Even Analysis are:

  • In practice, sales are not always proportional to the increase in the number of units sold.
  • There may be stepped-fixed costs, which are not reflected in the traditional break-even chart.
  • In practice variables costs, total costs and total income are not a straight line.
  • It is assumed that changes in the number of units produced and sold are the only factors that affect revenues and costs.  In practice this is not always the case.  For example, employee motivation may lead to changes in variable costs.
  • Break-even analysis is more appropriate for the short-term.

Capital Budgeting Techniques

Capital projects require substantial investments and have a long-term influence on a company.  Therefore, it is imperative for the management team to select the right projects for the company.  Therefore, this module also explores a range of capital budgeting techniques that managers can use. The module also examines the benefits and limitations of Accounting Rate of Return (ARR), Payback Period (PP), Discounted Payback, Net Present Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR).

The ARR represents the average operating profit the organisation will generate from the project.  This is calculated as follows:

Advantages of ARR are:

  • It’s a simple method to understand and calculate.
  • It’s based on accounting profit, which is available in the financial statements

Disadvantages of ARR are:

  • Profit is an arbitrary and subjective figure.
  • It ignores the time value of money principle.

Payback period determines the time taken for the cash flows to cover the initial capital cost of the project.  The lower the PP the better the capital project.

Advantages of PP are:

  • It is easy to calculate and understand.
  • It considers cash flow to evaluate the project and avoids subjective figures included in accounting profit.
  • It reduces risk by favouring projects that give a quick return.
  • It favours projects that give fast cash flow.  This improves the firm’s liquidity.

Disadvantages of PP are:

  • It ignores the time value of money principle.
  • It does not consider the total financial impact of the project.

Discounted Payback is similar to the PP except that future cash flows are discounted.  Such discounting is in line with the time value of money principle, which means that £1,000 received today has more value than £1,000 received next year.  Discounted cash flows represent today’s value of future cash flows.  Such principle is important because it helps to evaluate all competing projects on the same basis. 

Advantages of Discounted Payback are:

  • It complies with the time value of money principle.
  • It uses cash flow in order to evaluate the project.
  • It reduces risk by favouring projects that give a quick return.
  • It favours projects that give fast cash flow, which can improve the firm’s liquidity.

A disadvantage of Discounted Payback is:

  • It does not consider the total financial impact of the project.

NPV represents the financial wealth that the company will make from the project.  The NPV figure is derived by considering all the relevant cash inflows and outflows, which are discounted by the cost of capital. 

Advantages of NPV are:

  • It complies with the time value of money principle.
  • It considers all the financial wealth emerging from the project.
  • It uses cash flow and avoids the subjectivity present in accounting profit.

Disadvantages of NPV are:

  • It is difficult to calculate, especially to determine the cost of capital.
  • The method is more complicated and difficult to understand.

IRR represents the discount rate that will lead to a zero NPV.  Changes in the cost of capital will lead to different NPVs.  IRR calculates the maximum cost of capital that a particular project can bear.  The IRR is normally found by trial and error.

Advantages of IRR are:

  • It determines the return derived from the initial investment.
  • It follows the time value of money principle.

Disadvantages of IRR are:

  • IRR provides a relative measure of the project’s feasibility.
  • This method is unable to provide an IRR or can result in multiple IRRs when the project has non-conventional cash flows.  Non-conventional cash flows mean that cash outflows does not arise only when the project is implemented (year 0).
  • It is not appropriate to evaluate mutually exclusive projects because it can select a project that leads to lower total financial wealth.

Profitability Index indicates the proportion of pay off return derived from the initial investment.  This is computed via the following equation:

Advantages of PI are:

  • It utilises NPV, which is a calculation based on cash flows.
  • It follows the time value of money principle.

Disadvantages of PI are:

  • PI provides a relative measure and is unable to show the overall impact on the firm’s financial wealth. 
  • This method is not appropriate to rank mutually exclusive projects because it gives a relative measure.

Budgets

Lastly, the module covers the use of budgets, its benefits and limitations. In essence, budgets serve two purposes which are to help management in planning and control. 

Benefits of Budgets include:

  • Provide a system where the strategic objectives of the organisation are translated in clear measurable targets.
  • Budgets promote coordination between the different departments of the organisation.
  • The adoption of management by exception helps managers to focus on the most important aspects of the organisation.
  • Budgets enhance control in the firm because all functions are monitored in a systematic manner.  This leads to the identification of weaknesses, which are removed in order to improve efficiency, productivity and effectiveness.

Limitations of Budgets are:

  • The preparation of budgets is time consuming for managers especially if a participatory system of budgeting is adopted.  In a participatory system, the operational managers prepare the functional budgets with senior management.
  • Budgetary slack can occur when a participatory system of budgeting is used.  In budgetary slack the operational manager tries to underestimate expected revenue or overestimate anticipated costs in order to make easier targets.
  • Focus is made on financial targets and there is the risk that qualitative features like the reputation of the organisation are neglected.
  • Budgeting may lead to demotivation when the working relationships between managers and employees are poor.

In addition to this, a range of budgeting systems are explored in this module, including: Top Down Budgeting, Bottom Up Budgeting, Incremental Budgeting, Zero-Based Budgeting (ZBB), Rolling Budgets and Activity-Based Budgeting.                      

Bibliography

Atrill, P. and McLaney, E. (2015) Accounting and Finance for Non-Specialists, ninth edition, London:  Pearson, Chapter 9.

Drury, C. (2012) Management and Cost Accounting, eight edition, Hampshire:  Cengage Learning EMEA, Chapters 1, 2, 3 and 21.

Horngren, T. C., Datar, M. S. and Rajan, V. M. (2015) Cost Accounting:  A Managerial Emphasis, fifteenth edition, London:  Pearson, Chapter 6.

Kaplan Financial (2016) CVP Analysis (Single Product) [Online].  Available at:  http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/CVP%20Analysis%20(Single%20product).aspx. (Accessed on 6/06/2018)


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