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Jessup Ltd. Is the company involved in advertising and public relations and is run by four directors who are all advertising experts. The directors of the company are not aware of the fact that strategic management accounting is one of the integral parts of any organization now a day. While the company is doing very well they feel it has reached a stage where they need better management of the accounting function. Generally, they are unsure of the strategic benefits a senior management accountant would bring and particularly they have concerns with which costs are most relevant to decision making and of any methods by which they can accurately cost their activities.
I have been appointed as a consultant management accountant, and being engaged by a medium to large, fast growing company Jessup ltd. And my responsibilities are to present in a report the importance of management accounting and the relevant and irrelevant costs included therein the financials of the organization. Also to explain the management about the techniques to be used for accounting.
The report proposes the information about the quality dimensions that is scope, timeliness, format and accuracy and system quality dimensions that is integration, flexibility, accessibility, formalization and media richness, contributes positively to the use of management accounting systems for strategic sense making.
The first section provides the detailed information about the strategic management accounting and roles and functions of strategic management accountant. This is to understand the need of the management accounting in any form of company.
The second section gives a detailed scenario of the relevant and irrelevant costs in strategic management accounting, in order to understand that which costs should be taken into account while working for strategic management.
The third and the final section gives information about the ABC analysis which one of the forms of costing and the most important and easy form.
SECTION I : AN INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
STRATEGIC MANAGEMENT ACCOUNTING:
The process of planning and implementing the business strategies by an organization is known as the strategic management accounting. The strategies are a way in which an organization develops itself in order to distinguish itself from the competitors. The business strategies should be expounded keeping in view point both the internal and external environment so that final steps results in practical decisions.
Mark Lee Inman - in his article ACCA- the global body for professional accountants, 01 Nov 1999 defined Strategic Management Accounting in the following words:
''One of the main promoters of Strategic Management Accounting is the American M.E. Porter. His 1985 text on strategic management is regarded as a keystone. Porter takes a two divided approach.''
Michael Porter's acclaimed Five Forces of Competitive Position model explains a simple perspective for evaluating and analysing the competitive strength and position of a corporation or business organisation.
The strategic management accounting provides that information which helps to sustain the strategic decisions, which are the decisions which involve long term decisions and these decisions effects the organization significantly.
This kind of management accounting can play a small part in helping to ensure that the long term view is taken into account by presenting relevant information to the managers.
For example: Whether to produce a low priced product and gain market share or produce a high priced product for a niche market.
STRATEGIC MANAGEMENT ACCOUNTANT:
This section analyzes the strategic management accountant's (SMA) role in dynamic organizations operating in the global business environment. The first and foremost thing is to define a strategic management accountant: A strategic management accountant is a person who is skilled in the process of accounting and is in charge of the accounts of the organization. A strategic management accountant is held responsible for the financial results.
While in the role, the accountant deals directly with higher management of the company and contributes to strategy development and implementation with the aim of creating customer value and a strong competitive position for the organization.
The key roles which a strategic management accountant would undertake in an organization are as follows:
The accountant will look at all the records and determine what has happened in the past and according to that will try to analyze it. For example: a person is sitting on the horse backwards to looks what have he left behind and then ascertaining what is going to happen in future.
The accountant takes information and tries to analyze future decisions.
He will find out the impact of rate of return on money.
He will ascertain for example whether to buy one piece of product and giving more importance to the one which gives out maximum profits.
He will make strategic decisions in order to maximize future profits.
These decisions are to me made by a CMA- Certified Management Accountant, he is person who is able to analyze decisions as they imply to the future decisions, in order to the regular financial scrutiny to avoid any frauds in finance.
3. SECTION II- SMA: TECHNIQUES
RELEVANT COSTS FOR DECISION-MAKING
Relevance is one of the key characteristics of good management accounting information. This means that management accounting information produced for each manager must relate to the decisions, which he/she will have to make.
Relevant costs are the costs that meet this requirement of good management accounting information. The Chartered Institute of Management Accounting defines relevant costs as:
Relevant costs and benefits only deal with the quantitative aspects of decision. The qualitative aspects of decisions are of equal importance to the quantitative and no decision should be made in practice without full consideration being given to both aspects.
The items of costs that are expected to differ from one alternative to another are the costs which are relevant/ pertinent to a decision. In comparing alternatives, only the relevant cost needs to be considered. The costs that are not affected by the choice made are not required to be considered. In computing costs for decision involving choice amongst alternatives, it is essential to filter out those items of costs that are irrelevant to the purpose for which the costs are wanted and to consider only those costs that are affected by the decision in question. Such terms are termed as RELEVANT COSTS. If fixed costs remain the same, then fixed cost will be treated as irrelevant cost for decision making. Marginally cost or the variable cots vary between alternatives and only such costs are referred to as relevant cost under the circumstances.
Example: should cheaper quality of material be used or not to reduce the costs of material?
The factory managers' salary, insurance, depreciation, plant repairs and maintenance may be irrelevant cost since these will not be changed by the decisions made. The management can disregard these for purposes of comparison.
Identifying relevant and non-relevant costs
The identification of relevant and non-relevant costs in various decision-making situations is based primarily on common sense and the knowledge of the decision maker of the area in which the decision is being making. Armed with these two tools you should be able to sift through all the information that is available in respect of any decision and extract those costs (and benefits), which are appropriate to the decision at hand.
In identifying relevant costs for various decisions, you may find that some costs not included in the normal accounting records of an enterprise are relevant and some costs included in such records are non-relevant. It is important that you and relevant costs for decision-making, and while the latter may be recorded in the former this is not always the case.
Accounting records are used to record the incidence of actual costs and revenues as they arise. Decisions, on the other hand, are based only on the relevant costs and benefits appropriate to each decision while the decision is being made. This point is particularly appropriate when you come to examine opportunity costs and sunk costs that are dealt with below.
In practice, you may also find that the information presented in respect of a decision does not include all the relevant costs appropriate to the decision but the identification of this omission is very difficult unless you are familiar with the area in which the decision is being made.
Opportunity cost refers to the advantage, in measurable terms, which has been foregone on accounts of not using the facilities in the manner originally planned. For example, if an old building is proposed to be utilized for housing a new project plant, the likely revenue which the building could fetch if rented out is the opportunity cost which should be taken into account while evaluating the profitability of project.
Opportunity cost is the net benefit that would have been received from an asset if put to its next best use. The concept of opportunity cost is implicit in any comparison of alternatives. The merit of any course of action is its relative merits, the difference between one action and another.
Example: a manufacturer confronted with a problem of selecting any one of the two following alternatives:
Selling a semi-finished product of Rs.2 per unit
Introducing it into a further process to make more defined and valuable.
Alternative b will proof to be remunerated only when after paying the costs of further processing the amount realized by the sale of the product is more than Rs.2 per unit, then the revenue which could have been otherwise realized. The revenue of Rs. 2 per unit is forgone in case of b is adopted. The alternative revenue foregone is the opportunity cost of alternative b.
In the above decision-making situation it is the opportunity cost which is the relevant cost and, hence, the cost which should be incorporated into your cost-versus-benefit analysis. One may find the idea of opportunity costs difficult to grasp at first because they are notional costs, which may never be included in the books and records of an enterprise. They are, however, relevant in certain decision-making situation and you must bear in mind the fact that they exist when assessing any such situations.
A manufacturer or an organization rendering service may have to suspend its operations for a period on account of some temporary difficulties example shortage of raw material, non-availability of requisite labor etc. during this period though no work is done yet certain fixed costs such as rent and insurance of buildings, depreciation, maintenance etc. for the entire plant will have to be incurred. Such costs of the idle plant are known as shut down costs.
A sunk cost is historical or past costs. These are costs which have been created by a decision that was made in the past that cannot by changed by any decision that will be made in the future.
Example: investments in plant and machinery. For example a departmental store is considering selling a fleet of trucks it now owns. It wants to buy delivery service from an outside firm in their place. The sunk costs of the investment in delivery equipments are irrelevant in making decision. Relevant cost in decision making are operating costs such as gasoline, repairs and maintenance and salaries of truck drivers that would be eliminated if a decision to buy delivery service is made
Relevant and Irrelevant cost- summed up
The following are irrelevant items for decision making:
Past committed cost
Cost associated with stock evaluation
Existing fixed assets
Depreciation on existing
The following are, by enlarge, relevant items for arriving at decisions:
Likely cash flow from alternate use of resources
Selling prices of existing assets
Tax impact on sale of scarp
Tax impact on expected profit
Tax impact/ saving on incremental/ detrimental costs
Tax impact on depreciation
Change in requirement of working capital
Alternate use of discarded assets or labor or other resources
Incremental revenue due to further processing
Incremental costs- cost vary, but certain fixed cost may also vary at times
Inter-product relationship- changing products effecting cash flows
Joint costs if one alternate product is to terminate
Purchase of additional fixed assets.
SECTION III- ACTIVITY BASED COSTING
The crux of activity based costing is in accurately assigning the overhead cost to the end product. The traditional costing system does not serve effective purposes of product costing and pricing decisions. Activity based costing is a method of cost attribution to cost units on the basis of benefits received from indirect activities. Their performance of particular activities and demands made by these activities on the quantity of resources of organization are linked together so that the cost of product is arrived as per the quantum of actual activities performed to produce a product or service.
Activity Based Costing may be defined as a technique which involves identification of costs with each cost driving activity and making it as basis for absorption of costs over different products or jobs.
CHARACTERSTICS OF ABC
The characteristics of activity based costing can be summarized as follows:
It increases the number of costs pools used to accumulate overhead costs. The number of pools depends upon the cost driving activities. Thus, instead of accumulating overhead costs-in a single company-wise pool or departmental pools, the costs are accumulated by activities.
It charges overhead costs to different jobs or products in proportion to the cost driving activities in place of a blanket rate based on direct labor costs or direct hours or machine hours.
It improves the traceability of the overhead costs which results in more accurate unit cost data for management.
Identification of cost during activities and their causes not only help in computation of more accurate cost of a product or a job but also eliminate non-value added activities. The elimination of non-value added activities would drive down the cost of the product. This is in fact the essence of the activity based costing.
ELEMENTS INVOLVED IN ABC
Activity cost centre
Non value added activities
Activity based costing is very useful as it involves a deep evaluation of the product and helps scrutinizing the product, the following are the steps involved in activity based costing:
Evaluation of prevalent costing system
Selection of cost pools
Determining cost pools
Assigning cost pools
Determine activity hierarchies
A- stands for the most used products
B- stands for the products used averagely
C- Stands for the products which are used the least.
Selecting suitable cost drivers
Computing cost drivers rates
Identifying cost to products
USES OF ACTIVITY BASED COSTING
Focus on cost: focus on where the cost originates i.e. the causes of the costs.
Accuracy: accurate product cost due to understanding of the cost behavior.
Only value added activities: identifies source of non-value added activity or wasted efforts and thus eliminates them.
Strategic information: strategic cost information of which long term profitability decision for a product can be taken.
Non-quantitative information: non financial information regarding quality, flexibility and value to the customer can be received.
Rational decisions: improved cost basis available both at head office and plant level for better decision making.
ACTIVITY BASED COSTING ADVANTAGES
More accurate costing of products/services, customers, SKUs, distribution channels
Better understanding overhead.
Utilizes unit cost rather than just total cost
Integrates well with Six Sigma and other continuous improvement programs
Makes visible waste and non-value added
Supports performance management and scorecards
Enables costing of processes, supply chains, and value streams
Activity Based Costing mirrors way work is done
ACTIVITY BASED COSTING DISADVANTAGES
More time consuming to collect data
Cost of buying, implementing and maintaining activity based system
Makes waste visible which some executives and managers don't want their boss to see.
Cost factors- cost of change will be high as everything will have to be worked out from scratch.
Difficulty on establishing relationship: it would be difficult to correlate the marginal increase in cost with a particular cost driver.
Difficulty in standardization: over a period of time, the ABC will tend to standardize the cost of activities related to a particular product or process. But in practice there will be differences in set up time, production run, and meeting a delivery order.
For a business to grow larger in terms of quality and market target, it has to follow the strategic management accounting techniques. The accounting techniques helps the organization to cut down its waste costs and thus increasing the profit margin of the organization.
While small business owner and managers may consider management accounting to be an unnecessary drain on their time in the starting life of the business, but it is being proved that using management accounting to support strategic planning in any organization be it large or small, it has a positive and significant effect on performance. Even from an early stage or in a sole trade ship, a basic information system might be developed. Overtime, as the company grows, then so to should accounting information system. Then it can be used to support future plan and strategies, to assist in decision making and to act as a control mechanism by providing a benchmark against which performance can be assessed.
Every kind of business has a vision and a mission. The Strategic management accounting takes into account both of these. It helps in accomplishing the organizational goals in an effective manner.
Updating the strategic management processes time to time also helps in putting in the development of the more complex management structural that are needed as firms grow.