This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
Banking firms are constantly seeking new approaches to enhance their finical growth and prosperity. Due to turbulent business environment, global competition and more sophisticated demand of customers, banking firms are reconsidering the importance of management accounting theories and practices in the decision making process. This paper discusses the importance and usefulness of management accounting to overcome pitfalls and difficulties faced by baking firms. The paper underpins the case of economic crisis that hit the local market of Kuwait as well as international market in the period of 2008-2009. From this view, the understanding of vital role of management accounting in enhancing the decision making process of banking firms would be very important. primary, the paper discuss the role of management accounting in banking firms, measuring and understanding cost concepts, using accounting approach such as Activity Based Costing (ABC), understanding the relevant information for decision making and finally understanding budgeting and master budget. The literatures presented in this paper expected to support banking sector to underpin the usefulness of management accounting that would allow retail bankers to triumph over the fierce global competition.
Keywords: Cost behavior, Cost driver, opportunity cost, differential cost, Activity Based Costing, Mater budgeting
1. OVERALL BANKING FIRMS IN KUWAIT
Kuwait has a well-developed financial system and several banking firms in the country date back to the time before oil was discovered. The banking firms in the state of Kuwait have significantly participated in the economic development of the country (Global Investment House, 2007). The Kuwaiti banking firms play a significant role in enhancing the development and of the infrastructure and various pivotal projects in the country (Institute of Banking Studies, 2009). Moreover, the banking firms have huge capital investments in the Gulf region and international market, which underpin the importance of management decisions in the capital development of these institutions (Kuwait Institution of Banking studies, 2008).
The Kuwaiti banks operate in two types: Conventional: a banking system that is based on the principle of interest. Islamic: The principles guiding Islamic banks are significantly different from those for conventional banks. Islamic banks are organized under and operate upon principles of Islamic law, which requires risk sharing and prohibits the payment or receipt of interest (Olson & Zoubi, 2008).
The banking sector of Kuwait consist of both commercial and Islamic banks such as; National Bank of Kuwait (NBK), Kuwait Finance House (KFH), Bobyan Bank, Commercial Bank of Kuwait (CBoK), Gulf Bank (GB), Al-Ahli Bank of Kuwait (ABK), The Bank of Kuwait & the Middle East (BKME), and Burgan Bank (BB). In addition to the central bank, the banking sector in Kuwait composed of fourteen conventional banks and three Islamic banks (Institute of Banking Studies, 2008), while studies conducted in the local market reported that the structure of Kuwaiti banking sector is fairly concentrated (e.g. Imed Limam, 2002).
Unfortunately, to many banks, the importance of management accounting has become a vital issue after incurring high costs associated with incorrect decisions in the period of the economic crisis. The economic crisis that hit the world at the end of 2008 has leaded banking firms in Kuwait to face many challenges that affected its ability to grow and operate within a more competitive environment. The total assets of the banking firms in Kuwait stood at KD39.2bn at the end of 2008 (Institute of Banking Studies, 2008). During the last five years, many banks and banking firms have lost its competitive position in the market. Banks and banking firms incurred many loses that lead to lost of customers, stakeholder and creditor confident in the bank performance. The banking firms witness mermaid difficulty and challenges that lead eventually to change management, vision and mission, retain customers and to build the reputation and image. As results the development of the local market of the country has greatly affected.
This report question the comprehending understanding to the usefulness of management accounting in the decision making process of the financial institutions. Kuwaiti banking firms have suffered through the erroneous decisions resulted by lack of understanding to management accounting. Such a lack has negatively affected investments of banking firms and resulting in high finical losses and turnovers. To reveal the importance of management accounting the paper focus on period of 2008 to 2009 as a case as explain various usefulness of accounting theory that would eliminate pitfalls and difficulties of the decision making of financial institutions. The following section explains the concept of management accounting and its role in an organization.
2. THE ROLE OF MANAGEMENT ACCOUNTING
Like any other organization, banking firms have goals and objectives, while their managers need information to meet those goals and objectives. Information is needed for the various level of management at banking firms for the purpose of decision making, planning, directing operations, and controlling. The managerial accounting has been defined as "the process of identifying, measuring, analyzing, interpreting, and communicating information in pursuit of an organization's goals" (Horngren, et al, 2006). Managerial accounting is an integral part of the management process, and managerial accountants are important strategic partners in an organization's management team (Horngren, et al, 2006).
Managerial accounting is an important part of the management information system of banking firms (Horngren, 2009). In their book, Khan and Jain (2010) have identified five objectives of managerial accounting activity in any organization. These objectives are;
Providing the necessary information for decision making and planning, for example, the decision of banking firms to establish the new branch would be influenced by estimates of the cost of building and maintaining.
Assisting managers in directing and controlling operational activities, for example, in directing operational activities, the office building management team would need data about customer technology-service demand patterns
Motivating staff toward organization's goals, for example, banking firms would empower employees to meet organization goals and objectives.
Measuring performance of activities, in large financial institutions, top management compensates their executives based on the profit achieved by the subunits they manage.
Assessing the organization's competitive position to ensure that the organization's long run competitiveness in its industry.
Without understand to the above objectives banking firms expected to face difficulty to take the right decision in allocation of resources (Berger, 1997). The literature of management accounting has differ the concept of managerial accounting differs from financial accounting in several ways (Maheshwari, 2009). The users of managerial accounting information are managers inside the organization. Managerial accounting information is not mandatory, is unregulated, and draws on data from the basic accounting system as well as other data sources. The users of financial accounting information are interested parties outside the organization, such as investors and creditors. Financial accounting information is required for publicly held companies, is regulated by the Financial Accounting Standards Board, and is based almost entirely on historical transaction data (Maheshwari, 2009).
In a formal organization chart, managerial accountants are in a staff capacity. However, managerial accountants are increasingly being deployed as members of cross-functional teams, which address a variety of managerial decisions and business issues. More than ever before, managerial accountants are physically located throughout an enterprise alongside the managers with whom they work closely.
Managerial accounting continually evolves and adapts as the business environment changes. The growth of international competition and dramatic changes in technology are placing ever-greater demands on the information provided by managerial accounting systems. Many organizations have moved away from a historical cost accounting perspective and toward a proactive cost management perspective. Under this approach, the managerial accountant is part of a cross-functional management team that seeks to create value for the organization by managing resources, activities, and people to achieve the organization's goals.
An organization's value chain is the set of linked, value-creating activities, ranging from securing basic raw materials and energy to the ultimate delivery of products and services. Understanding the value chain is a crucial step in the development of an organization's strategy. The overall recognition of the importance of cost relationships among the activities in the value chain, and the process of managing those cost relationships to the organization's advantage, is called strategic cost management.
The fundamental management processes are Decision making, planning, directing operational activities and controlling. The role of managerial accounting is to help top management to make a decision about choosing among the available alternatives. Managerial accounting assists management team to plan and develop a detailed financial and operational description of anticipated operation. By directing operational activities, managerial accounting helps staff to run enterprise on a day-to-day basis by asking questions that draw the way of work. Managerial accounting assists management to exercise control over operation to guarantee achieving its goals.
3. MEASURING COSTS IN BANKING FIRMS
The management accounting provides insight to banking firms to better understand costs. Different cost concepts and classifications are used for different purposes. The sacrifice made, usually measured by the resources given up to achieve a particular purposes. Management accounting defined 'expenses' as the cost incurred when asset is used up or sold for the purpose of generating revenue, while 'product cost' defined as a cost assigned to goods that were either purchased or manufactured for resale. The 'period cost' defined as all costs that are not product cost which charged against sales revenue in the period in which the revenue is earned, also cost that are expensed during the time period in which they are incurred goods are sold.
One of the most usefulness concept provided by management accounting literature is the differentiation of cost behavior and cost drivers. Cost driver defined as characteristic of an activity or event that results in the incurrence of costs by that activity or event. It's any activity that causes a cost to be incurred. Different types of costs respond to widely differing cost drivers. For example the cost of machine setup labor would be driven by the number of production run. Other example, the cost of material-handing labor would be driven by material-related factors such as quantity and cost of raw material used.
Banking firms may ask why cost driver is important? As the number of cost drivers used in explaining an organization's cost behavior increase, the accuracy of the resulting information will increase. The higher the correlation between cost and the cost driver, the more accurate will be resulting understanding of cost behavior. The three factors are important in selecting cost drivers; the accuracy of the resulting cost assignments depends on the degree of correlation between consumption of the activity and consumption of the cost driver, the more activity cost pools there are in ABC system, the greater will be the accuracy of the cost assignment, and finally, the behavioral effects in identifying cost drivers, an ABC analyst should consider the possible behavioral consequences.
Management accounting literature suggested two types of costs behavior, which are Fixed cost and variable cost. Fixed cost defined as cost that remains constant, regardless of any change in a company's activity. A cost that does not vary depending on production or sales levels, such as rent, property tax, insurance, or interest expense. For example, a good example is a lease payment. If banking firm leasing a building at $2,000 per month, the bank will pay that amount each month, no matter how well or how poorly the business is doing. As the activity level increase or decrease, total fixed cost remains constant but unit fixed cost declines. On the other hand, Variable cost defined as a cost those changes in total in direct proportion to a change in an organization's activity. Variable cost is the sum of marginal costs. For example, a company will use electricity to run plant and machinery as required. The busier the company, the more the plant will be run, and so the more electricity gets used. This extra spending can therefore be regarded as variable.
The understanding of how cost drivers affect cost behavior thus is fundamental to banking forms to better plan and control costs. Management accounting provides banking firms with various method to measure their cost behavior such as step-cost and mixed costs. step-costs defined as costs with abrupt break in the pattern of total cost as activity volume shifts from one range to another. a step cost is just a fixed cost with multiple relevant ranges-switching to higher relevant range caused a step increase in fixed costs. mixed costs on the other hand are a communication of variable and fixed costs. an example of mixed costs include banking repairs, power, and the rental of trucks at a fixed monthly rate plus a mileage rate. A mixed cost concept provides banking firms better understand to variable cost on top of a fixed cost.
Moreover, banking firms decisions about investments attributes such as quality, performance options, finishes, and so on have a great influence on cost. Planning for costs must account for these costs effects. the management accounting provide two important concept to better understand the influence on cost behavior, these concepts are capacity costs and committed fixed costs capacity costs are originate from fixed outlays for assets, people and investments. These outlays measure banking firms cost of providing a particular capacity for such investment, sales, administration and research. While committed fixed costs are incurred because of the ownership long-term assets such as land, building, machinery and equipment. an example of banking firms committed fixed costs are administrative costs, insurance, property taxes, rent, depreciation and long-term lease payments.
Moreover, the management accounting provides banking firms and financial institutions with various techniques and tools needed to better understand the effect of their output on their costs, profit and revenue. An example of these tools is Cost Volume profit (CVP). The CVP defined as technique that summarizes the effects of changes in an organization's volume of activity on its cost, revenue, and profit. CVP can cover the effects on profit of change in selling prices, services fees cost. CVP analysis provides a sweeping overview of the effects on profit of all kinds of changes. Moreover, Break even point analysis is very important to banking firms to understand the volume of activity at which their revenue, costs and expense are equal may be measured either in units or in sales dollars. Though technology has made a lot of advancement in manufacture and service sectors, concepts like cost benefit analysis are still valid and useful. They have been made more strong and convincing with the introduction of Activity Based Costing (ABC) and other accounting approaches.
4. ACTIVITY BASED COSTING (ABC) VS. TRADITIONAL ACCOUNTING SYSTEM
To support compliance with financial reporting requirements, a company's traditional cost-accounting system is often articulated with its general ledger system (Brimson, James A., 1997). In essence, this linkage is grounded in cost allocation. The traditional approach to cost-allocation consists of three basic steps: accumulate costs within a production or nonproduction department; allocate nonproduction department costs to production departments; and allocate the resulting (revised) production department costs to various products, services, or customers (Daly, John L., 2001). Costs derived from this traditional allocation approach suffer from several defects that can result in distorted costs for decision-making purposes. For example, the traditional approach allocates the cost of idle capacity to products. Accordingly, such products are charged for resources that they did not use. Seeking to remedy such distortions, many companies have adopted a different cost-allocation approach called activity-based costing (ABC).
In contrast to traditional cost-accounting systems, ABC systems first accumulate overhead costs for each organizational activity, and then assign the costs of the activities to the products, services, or customers (cost objects) causing that activity (Daly, John L., 2001). As one might expect, the most critical aspect of ABC is activity analysis. Activity analysis is the processes of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service (Cokins, Gary., 1998). Significantly, as discussed in the next section, activity analysis provides the foundation for remedying the distortions inherent in traditional cost-accounting systems.
Geared toward compliance with financial reporting requirements, traditional cost-accounting systems often allocate costs based on single-volume measures such as direct-labor hours, direct-labor costs, or machine hours. While using a single volume measure as an overall cost driver seldom meets the cause-and-effect criterion desired in cost allocation, it provides a relatively cheap and convenient means of complying with financial reporting requirements.
In contrast to traditional cost-accounting systems, ABC systems are not inherently constrained by the tenets of financial reporting requirements (Daly, John L., 2001). Rather, ABC systems have the inherent flexibility to provide special reports to facilitate management decisions regarding the costs of activities undertaken to design, produce, sell, and deliver a company's products or services. At the heart of this flexibility is the fact that ABC systems focus on accumulating costs via several key activities, whereas traditional cost allocation focuses on accumulating costs via organizational units (Daly, John L., 2001). By focusing on specific activities, ABC systems provide superior cost allocation information-especially when costs are caused by non-volume-based cost drivers. Even so, traditional cost-accounting systems will continue to be used to satisfy conventional financial reporting requirements. ABC systems will continue to supplement, rather than replace, traditional cost-accounting systems.
In most cases, a company's traditional cost-accounting system adequately measures the direct costs of products and services, such as material and labor. As a result, ABC implementation typically focuses on indirect costs, such as manufacturing over-head and selling, general, and administrative costs. Given this focus, the primary goal of ABC implementation is to reclassify most, if not all, indirect costs (as specified by the traditional cost-accounting system) as direct costs. As a result of these reclassifications, the accuracy of the costs is greatly increased.
According to Garrison (1999), there are six basic steps required to implement an ABC system:
1. Identify and define activities and activity pools
2. Directly trace costs to activities (to the extent feasible)
3. Assign costs to activity cost pools
4. Calculate activity rates
5. Assign costs to cost objects using the activity rates and activity measures previously determined
6. Prepare and distribute management reports
While ABC systems are rather complex and costly to implement, Horngren et al. (1996) suggest that many companies, in both manufacturing and nonmanufacturing industries, are adopting ABC systems for a variety of reasons:
1. Margin accuracy for individual products and services, as well as customer classifications, is becoming increasingly difficult to achieve given that direct labor is rapidly being replaced with automated equipment. Accordingly, a company's shared costs (i.e., indirect costs) are becoming the most significant portion of total cost.
2. Since the rapid pace of technological change continues to reduce product life cycles, companies do not have time to make price or cost adjustments once costing errors are detected.
3. Companies with inaccurate cost measurements tend to lose bids due to over-costed products, incur hidden losses due to under-costed products, and fail to detect activities that are not cost-effective.
4. Since computer technology costs are decreasing, the price of developing and operating ABC systems also has decreased.
5. RELEVANT INFORMATION FOR DECISION MAKING
In management accounting, decisionâ€‘making may be simply defined as choosing a course of action from among alternatives. If there are no alternatives, then no decision is required. A basis assumption is that the best decision is the one that involves the most revenue or the least amount of cost. The task of management with the help of the management accountant is to find the best alternative. The process of making decisions is generally considered to involve the following steps:
1. Identify the various alternatives for a given type of decision.
2. Obtain the necessary data necessary to evaluate the various alternatives.
3. Analyze and determine the consequences of each alternative.
4. Select the alternative that appears to best achieve the desired goals or objectives.
5. Implement the chosen alternative.
6. At an appropriate time, evaluate the results of the decisions against standards or other desired results.
A primary objective of decisionâ€‘making is to achieve optimum utilization of the business's capital or resources. Effective decisionâ€‘making requires relevant information and special analysis of data. Relevant means linked or concerned. If an event has nothing to do with a situation, it is not relevant.
Besides, a management accountant would ensure that the information must be relevant (pertinent to the decision problem); accurate (precise); and timely (arrive in time for the decision to be made). Companies will occasionally trade-off accuracy for timeliness. In order to qualify for relevancy, a cost must meet two criteria; they affect the future and they differ among alternatives.
Management accounting provides various concepts related to relevant costs that are relevant when taking investment decisions, such as 'opportunity cost', which defined as the potential benefit given up when the choice of one action precludes selection of a different action. The concept of opportunity cost provides banking firms insight to comprehend the cost of an alternative that must be forgone in order to pursue a certain investment or action. For example, when a baking firm invests put all its capital investment in the real-estate it might lose the profit in the telecommunication sector.
A differential cost is the difference in cost items under two or more decision alternatives specifically two different projects or situations. Where same item with the same amount appears in all alternatives, it is irrelevant. For example, a plot of land can be used for a shopping mall or entertainment park. The plot is irrelevant since it would be used in both the cases. Similarly, future costs and benefits that are identical across all decision alternatives are not relevant. The 'differential cost' concept defined as the amount by which the cost differs under two alternative actions. While the 'marginal cost' concept defined as the extra cost incurred in producing one additional unit of output.
Management Accounting picks up data from cost database and prepare reports for the management to facilitate decision making. Both financial and non-financial data are used in the reports. In the non-financial data, both numerical and non-numerical information are used. While numerical information consist of operational statistics such as units produced, raw materials consider and labor hours used, the non-numerical or qualitative information pertain to customers satisfaction, employees moral, access to markets and image of an organization. For a particular decision, different types of cost and benefits are considered. The relevant costs have an impact on the future and differ under various decision alternatives. If any of these qualification is absent, it would be an irrelevant cost. Since most decision are under uncertainty, some other techniques are used to given an insight in the problem such as best- worst case scenario, sensitivity analysis and simulation.
6. BUDGETING AND MASTER BUDGET
The concept budget defines as "a detailed plan expressed in quantitative terms that specify how resource will be acquired and used during a specified period of time" (Horngren, 2009). For banking firms, budget is one of the most important activities that accounting and financial management and other related department prepare at different period for the internal and external purposes. Master budget defined as "a comprehensive set of budgets covering all phases of an organization's operations for a specified period of time" (Horngren, 2009). The master budget comprises many separate budgets that are interdependent; sales budget, cash collection budget, purchases and cost of goods sold budget, cash disbursements for purchases, operating expense budget, cash disbursements for operating expenses (Maheshwari, 2009; Horngren, 2009). Because master budgets are a detailed and lengthy accounting process, they are completed on an annual basis. Banking firms prepare for the budget process throughout the year, noting changes in budget amounts or additional items that should be included in the following year's budget.
The result of economic crisis has been clearly notice in the banking firm's budgets. As shown in appendix (A), the financial highlight of Kuwaiti firms reveals overall reduction in revenue, profit and increases in costs. While appendix (B) shows how the ranking of Kuwaiti banking firms has affected in this period. This by looking at the master budget of banking firms, management accounting provide powerful tool that managers, stakeholders and customer use to better understand the financial situation of the bank. From management perspective, master budget is used to integrate and coordinate the activities of the various functional areas within the organization. For example, a comprehensive plan helps managers to ensure that all the needed inputs (capital, equipment, materials, labor, supplies, etc.) will be at the right place at the right time when needed, just-in-time if possible (Libby, et al, 2003).
Master budget also helps to insure that manufacturing is planning to produce the same mix of products that marketing is planning to sell. The idea is that the products should be pulled through the system on the basis of the sales budget, rather than produced speculatively and pushed on the sales force (Libby, et al, 2003). The integrative nature of the budget provides a way to implement the lean enterprise concepts of just-in-time and the theory of constraints where the emphasis is placed on the performance of the total system (organization) rather than the various subsystems or functional areas.
Another purpose and benefit of the master budget is to provide a communication device through which the company's employees in each functional area can see how their efforts contribute to the overall goals of the organization. This communication tends to be good for morale and enhance jobs satisfaction. People need to know how their efforts add value to the organization and its' products and services. The behavioral aspects of budgeting are extremely important.
Furthermore, the master budget also provides a guide for accomplishing the objectives included in the plan (Libby, et al, 2003). The budget becomes the basis for the acquisition and utilization of the various resources needed to implement the plan. Perfection of the guidance aspect of budgeting can significantly reduce the amount of uncertainty and variability in the company's operations (Ronald W. Hilton, 2001).
To overcome various difficulties, the master budget provides a guide for accomplishing the objectives included in the plan. The budget becomes the basis for the acquisition and utilization of the various resources needed to implement the plan (Ronald W. Hilton, 2001). Perfection of the guidance aspect of budgeting can significantly reduce the amount of uncertainty and variability in the company's operations. For banking firms, the budget can also serve as a guide to overcome the financial crisis. The master budget provides a method for evaluating and subsequently controlling performance.
Management accounting provides banking firms with various techniques and tools that would enhance the decision-making and reduce uncertainty and risks of investment. The tactical decisions, which must be preceded, by strategic decisions provide the historical data from which the accountant prepares financial statements. For each decision, there exists a management accounting tool that may be used to make a good decision. However, the management accounting tools can be used only if the management accountant is successful in providing the information demanded by the particular tool.